A.O.Smith Stock

Good day, and thank you for standing by. Welcome to the A. O. Smith Third Quarter 2026 Earnings Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to turn the conference over to your speaker today, Helen Gurholt. Please go ahead.

Good morning, and welcome to the A. O. Smith Third Quarter Conference Call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Steve Shafer, Chief Executive Officer; and Carrie Anderson, Chief Financial Officer.

In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow, defined as cash from operations less capital expenditures. Organic growth excludes Leonard valves and foreign currency impacts. Adjusted earnings, adjusted earnings per share, total segment earnings, adjusted segment earnings and adjusted segment margin exclude the impact of restructuring and impairment expenses. EBIT margin excludes the results of the China business.

Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. On a forward-looking basis, we provide guidance for net sales excluding China and adjusted earnings per share, excluding China, which are non-GAAP measures. We do not provide a reconciliation of these measures to the most directly comparable GAAP measures, net sales and diluted earnings per share, because we cannot predict or estimate certain reconciling items without unreasonable efforts.

These items include forecasted China sales and a forecast of China's contribution to earnings per share. These items are uncertain, depend on factors outside of our control and could have a significant impact on our GAAP results for the guidance period.

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 Steve to begin our prepared remarks.

Thank you, Helen, and good morning, everyone. I'd like to begin by highlighting an important step forward for A. O. Smith. On October 27, we announced a definitive agreement to sell a majority interest in our China business to CPE, a leading alternative asset manager. These agreements complete the strategic assessment we began in July of last year.

I want to sincerely thank all of our China team members for their continued dedication and professionalism throughout this process. I am confident that the increased clarity and certainty that this announcement provides will be energizing for both our employees and customers in China.

We approached the assessment with one objective. Determine the path that would allow our business in China to have the best chance to compete and win in a very competitive and changing market. China has been an important part of our company's history. And our team there has built a strong brand on the back of great innovation and great service. But the market has changed significantly, and we need to continue to make changes to remain competitive.

As a result, we concluded the business is best positioned for its next chapter under an experienced local owner prepared to invest in the business. And CPE brings deep knowledge of the Chinese market with the right capabilities to make that happen.

The transaction is structured to deliver value today while preserving a potential upside in the future. CPE will acquire 81% of a business valued at approximately $400 million. We will retain a minority stake of 19% and the A. O. Smith brand will remain in the market under a multi-decade licensing agreement. Including the estimated value of future royalties, we expect total value to exceed $500 million.

We intend to prioritize the after-tax proceeds, along with roughly $80 million of cash we expect to repatriate from China to share repurchases. We plan to close in the first half of 2027 and subject to regulatory approvals and customary closing conditions. This transaction sharpens our strategic focus and simplifies our portfolio. Later in the call, I'll come back to talk about what this means for A. O. Smith going forward.

Let me now turn to our third quarter results on Slide 5. At the total company level, Q3 sales were $941 million, essentially flat with last year and earnings per share were $0.93. In North America, we delivered 3% growth despite the continued challenging macro environment.

Excluding Leonard Valve, organic sales grew 1%, led by double-digit growth in our boiler business and mid-single-digit growth in our water treatment business. We continue to believe our investment in product innovation, customer service and channel partnerships position these businesses as well in attractive markets.

In water heaters, sales decreased 1% in the quarter. We maintained our market share amid continued softness in residential water heater demand, particularly in the wholesale channel.

Commercial water heater volumes remained resilient, adding to the stability of our water heater portfolio. In this environment, our leading brands, broad product offering and channel presence and strong customer relationships continue to differentiate A.O. Smith.

Leonard Valve contributed $15 million in sales in the quarter, and we remain excited about how the business will expand our capabilities in commercial water management.

At the same time, we continue to face rising input costs. We expect steel and freight, two of our largest cost categories to each increase by double digits for the full year. Freight costs rose sharply in Q3, with second half increases expected well above the full year rate, driven by tighter trucking capacity and record diesel prices.

In the quarter, IEEPA tariff refunds helped offset these pressures. However, we expect these elevated costs to continue. To address these pressures, we recently announced an additional price increase of up to 9.5% on most of our water heater products effective in December. We are also pursuing additional offsets including future pricing actions in other parts of our business and cost actions, such as procurement savings, supply chain productivity and disciplined SG&A cost management. We expect these actions to help mitigate the impact of higher costs on our margins over time, while still supporting our customers and remaining competitive in their markets.

I'll now turn the call over to Carrie, who will provide more details on our third quarter performance.

Thank you, Steve, and good morning, everyone. Please turn to Slide 6. We North America segment sales of $762 million increased 3% compared to last year. As shown on the left side of the slide, organic growth contributed $4 million or approximately 1% and Leonard Valve contributed 2%. Organic growth was driven primarily by a 13% increase in boiler sale and 5% growth in water treatment. These gains were partially offset by a 1% decline in water heater sales as lower residential volumes more than offset the benefit of our pricing actions.

Our boiler performance reflected continued share gains in residential boilers, strong demand for our high-efficiency commercial condenser boilers and the benefit of pricing actions. In water treatment, growth was led by our professional dealer and specialty wholesale channels, where we have added approximately 30 new dealers since the beginning of the year.

As mentioned earlier, Leonard Valve contributed $15 million in the quarter. Performance in our mixing and digital valve business was in line with our expectations. Partially offset by softness in voice controls, where delays in energy efficiency upgrade projects in the New York region affected order timing.

The fourth quarter is seasonally Leonard Valve's strongest and we continue to expect that pattern this year. So we anticipate these regional project delays will moderate the seasonal step up somewhat. This is reflected in our full year outlook.

Moving to the right side of the slide. North America segment earnings were $180 million, flat with the prior year, and segment margins decreased 60 basis points to 23.6%. The Lower volumes reduced earnings by $3 million and Leonard Valve contributed 15 -- $5 million. Higher-than-expected input costs driven by the double-digit steel and freight increases Steve mentioned, reduced earnings by $18 million. IEEPA tariff refunds and other cost savings partially offset this with a total benefit of $16 million.

Finally, we made meaningful progress on water treatment footprint and portfolio optimization initiatives. In October, we ceased manufacturing in our s Groveport, Ohio facility and transfer production to other sites. As is typical with the transition of this scope, we expect some near-term shipment delays as those lines come up to full output, which I'll touch on in our guidance.

We continue to expect annual savings of approximately $6 million to $8 million associated with these initiatives with approximately $1 million to be realized in the second half of 2026.

Moving to Slide 7. Rest of World segment sales of $193 million decreased 7% compared to prior year. Lower organic sales reduced revenue by $20 million, partially offset by a $5 million favorable currency impact, primarily related to China.

In local currency, China sales decreased 17%, this reflects continued weak consumer demand as well as some disruption to the business related to the strategic assessment we recently concluded.

Turning to the right side of the slide. Rest of World segment earnings were $11 million and segment margin was 5.4%. Lower volumes in China reduced earnings by $9 million partially offset by a $5 million benefit from SG&A and other cost actions. Our team in China continues to manage costs carefully, which helps limit the impact of lower volumes on this segment.

Turning to cash flow and capital allocation on Slide 8. We continue to generate strong cash. Operating cash flow for the first 9 months of 2026 was $429 million, compared to $434 million in the same period last year. Capital expenditures were $33 million, lower than the $53 million we spent last year. Our healthy cash flow lets us invest in growth and return cash to shareholders at the same time.

On investing for growth, we deployed $470 million in acquisitions this year with the addition of Leonard Valve. It strengthens our water management platform and is already contributing to our North America growth.

On returning cash to shareholders, we returned $410 million year-to-date. Through $149 million in dividends, up from $145 million last year. This reflects our long record of consecutive annual dividend increases, including the 6% dividend raise we announced in Q3.

As well as $261 million in share repurchases. Recall earlier this year, we raised our full year repurchase target by 50% and to $300 million, which leaves about $39 million planned for Q4. Our debt-to-capital ratio was 27% at the end of September, up from 9.2% a year ago. mainly because of the Leonard Valve acquisition. Our balance sheet remains strong with $235 million of cash and net debt of $439 million, and that gives us continued flexibility.

Looking ahead, our priorities have not changed. Invest in organic growth, pursue disciplined acquisitions that expand our core and adjacent water platforms and return test to shareholders. As announced earlier this week, we intend to prioritize share repurchases as the use of the after-tax proceeds and repatriated cash following the closing of the China transaction.

If we move to Slide 9, I'll provide an update on our full year guidance. Following the CPE agreement, we expect to classify the China business as held for sale and reported as discontinued operations beginning in the fourth quarter of 2026, with prior periods we cast accordingly. As a result, we have updated our full year 2026 guidance to exclude the China business for all of 2026 and reflect our updated outlook for the remaining businesses.

Full year sales, excluding China, are expected to grow approximately 4% on with adjusted EPS between $3.42 and $3.52 per share.

Within North America, our top line outlook includes the following assumptions: our outlook for the residential water heater industry remains down low single digits, with the commercial water industry flat to 2025. Retail channel momentum has been sustained while most of the market pressure year-to-date has been in the wholesale channel.

In our boiler business, we are now raising our growth expectations. Full year boiler sales are now expected to grow 10% to 12% and up from our prior range of 6% to 8%, reflecting strong year-to-date performance, robust quoting activity and a healthy order pipeline.

For our North America water treatment business, 2026 sales are expected to grow approximately 3% to 4% compared with our previous outlook of 5% to 6%. This reflects the continued weakness in the consumer channel and the timing of shipments following the transfer of growth for production. We expect to end the year with an elevated backlog that we expect to convert to sales as output increases into 2027. We also continue to make good progress in our priority dealer channel, including the expansion of dealer network, and we expect sales in this channel to grow approximately 10% in 2026.

For Leonard Valve, we now project sales of approximately $65 million in 2026 compared with our prior expectation of approximately $70 million. The valid portion of the business continues to perform well, reinforcing our confidence in the strategic value of the acquisition and the long-term growth potential of our water management platform.

As I mentioned earlier, the updated outlook reflects timing delays on several regional projects within the control of business. We remain encouraged by the underlying opportunities across the Leonard Valve portfolio and are focused on capturing that growth as project activity progresses.

And rounding out the revenue guidance is Rest of World, excluding China. We expect foreign currency translation to be a meaningful headwind on to our Rest of World businesses in 2026. Excluding currency impacts, India remains a bright spot. Including [ Pure ], we expect Indian sales to grow double digits in local currency in 2026, in line with our expectations as we continue to expand our brand and channel coverage. Our local currency India performance is partially offsetting macro challenges in other international businesses.

Turning to costs. Input cost inflation remains significant and is affecting all of our businesses. The impact is greatest in water heaters, which are steel intensive and in both water heaters and boilers, where product size and weight drive higher freight costs. Full year steel and freight costs are expected to each increase approximately 15% compared to 2025, adding approximately 5% to our full year North America segment cost of goods sold, and we expect to exit 2026 at a meaningfully higher cost run rate.

We are responding with pricing. As a reminder, our 4% to 7% price increase on most North America water heater and voice products took effect at the end of the second quarter with fuller realization beginning mid-third quarter. To help offset these escalated costs, we have announced an additional price increase of up to 9.5% on most water heater products effective in December.

A longtime pricing, we continue to work the cost leverage within our control. With inflationary pressures persisting our teams across the business remain focused on identifying savings opportunities and running our operations efficiently and we continue to look for ways to offset higher costs where we can.

As we head into the final quarter of the year, our priorities are clear when the heating season and when the holiday season. In boilers, we entered Q4 with strong momentum. In water heaters, we are working closely with our channel partners to be ready as colder weather drives replacement demand and to manage order patterns ahead of our December price increase. And in water treatment, we are increasing output across our facilities to fulfill our backlog and serve customers throughout the holiday season. Across all of our businesses, we remain focused on execution, disciplined pricing and cost management to finish 2026 strong.

And with that, I'll turn the call back to Steve.

Thank you, Carrie. Please turn to Slide 10. Earlier, I described the recently announced China transaction itself. Now I'd like to show you what A. O. Smith looks like once it is complete. On this slide, we recast our 2025 results to exclude the China business. The picture is clear: a more focused company with an enhanced growth and margin profile.

First, we keep our scale. Excluding China, our 2025 revenue would have been approximately $3.2 billion, and we retain leading positions in our core markets.

Second, we improve our growth profile. Excluding China, our 2025 revenue would have grown approximately 3% compared to flat on a reported basis. China has weighed on our consolidated growth. and removing it gives us a more focused portfolio anchored in North America where we have the strongest position and greatest opportunity for near-term value creation.

Third, we have a higher-margin business. Excluding China, our 2025 EBIT margin would have been approximately 200 basis points higher, reflecting the structurally higher margins of our core business.

And finally, as you can see on the right side of the slide, our geographic mix shifts decisively. North America would represent approximately 94% of revenue, up from 77%. This is a market where we have deep customer relationships, leading brands and resilient demand, driven largely by replacement. Simply put, the company that emerges from this transaction is a focused water platform anchored in North America with a stronger growth and margin profile.

So where do we go from here? Slide 11 summarizes how we intend to grow and create value for shareholders. It starts with our portfolio priorities shown on the left. Our foundation is our leadership in North American water heaters and boilers. We hold leading residential and commercial market share earned through decades of innovation and deep customer relationships. And with 80% to 85% of sales driven by replacement demand, this core is highly resilient through the cycle.

Building on that core, we have three growth platforms. Water treatment is a growing, scalable business supported by long-term health and sustainability trends with recurring filter revenue that creates attractive operating leverage.

Water management is a new growth platform. With Leonard Valve, we're moving deeper into the commercial mechanical room with spec-driven digital, high-margin solutions that we can scale through bolt-on acquisitions and future connectivity.

And in India, we see compelling long-term market dynamics where our innovation and expanding brand and channel coverage are driving growth.

On the right are the three levers we use to turn that portfolio into shareholder value. First, market-led innovation, differentiated products that help us navigate the changing regulatory environment strengthen our brands and win share.

Second, operational excellence, delivering pricing and productivity that protects our margins and fund our growth investment.

And third, disciplined capital deployment. Our strong cash flow and balance sheet led us reinvest in the business, pursue targeted acquisitions and return cash to shareholders. as reflected in our increased share repurchase target this year.

In closing, A. O. Smith is entering its next chapter as a simpler, higher-margin company with a resilient core and multiple platforms for growth. I'm proud of how our team continues to execute, and I'm confident we're well positioned to deliver long-term value for our shareholders.

With that, we conclude our prepared remarks and open the call for questions.

[Operator Instructions] Our first question comes from Mike Halloran with Baird.

A lot of happy people including me. So first question, kind of just a simple one. Can you just calibrate the current guidance to the old guidance there's some ranges in the outlook. So I just want to make sure I understand what has or hasn't changed. Obviously, the treatment side touch lower boilers, decent amount higher any moving pieces that you're seeing on the -- more on the residential or commercial water heater side? And then maybe just touch on what's changed on the price cost side, if anything going into the fourth quarter?

Yes. So maybe I'll start with just kind of level setting July guidance to our current guidance. So as you know, we took China out of the current guidance, and we're not providing a direct loss from the July guidance because the assumptions for China have materially changed since either when we had last talked back in July. And no doubt, our China results in Q3 were well below our expectations. And I've talked about a bit of the fact that, that continued China softness itself, but also the impact of the strategic assessment process concluding in the third quarter also was a part of that.

So at this point, I think the China outlook for Q4 is very -- is highly variable given the recent announcement. So made the decision in concert with the fact that we're going to intend to move that to discontinued operations to remove China from the outlook. So there's -- I can appreciate there's no like-for-like bridge between July and August.

But what we have done, Mike, is to update those assumptions for the rest of the business, and I covered those in my prepared remarks. I would say the guidance ex China is within the ranges that we would have assumed in the July guidance. with some puts and takes, as you talked about, and I'll have Steve talk a bit more about the water heater industry volumes.

But no doubt the strength of the boiler side of the business, we've raised expectations there. And it's offset some other softness in some of the other parts of the business. So net-net, still will be within the ranges that we provided you back in July.

Steve, do you want to provide some comments on...

Yes. I would say just as relative to the kind of final few months here, we've got a lot of variables that make it maybe more kind of a wider set of outcomes as we finish the year. We've obviously got this announced price [indiscernible] out there. The industry has kind of had made these price announcements. We've got some competitive situations. We've got how our customers are going to kind of pick up on that, which makes the water hear side of the business a bit uncertain relative to the finish. But as Carrie mentioned, the boiler business is coming on really strong. We've got a little bit of softness in some of the other portfolios. So that's kind of where we kind of net out relative to the growth profile and the change on the earnings side is primarily that piece of the China removal.

Got it. No, that's super helpful. And then maybe just a little bit more on the price/cost comments there or the pricing in the environment and just still uncertain how that's going to shake out.

Maybe just what's embedded in the fourth quarter specifically in terms of what that price cost spread might look like and how you're accounting for that in the guidance. And then when do you think that a more neutral or position will be achieved based on all the actions you're taking?

Yes. Mike, we have maintained the North American margin guidance of approximately 24% for the full year. And as I reflect on our Q3 performance, our margin performance in North America actually came in slightly higher than what we expected. And as I went through the prepared remarks, I called out the benefit of the IEEPA tariff refunds that actually did help offset some higher-than-expected costs. And that was notably on freight. That certainly was higher than what we expected in July. As well as other input costs that are certainly related to some of the things we're seeing on oil prices and derived oil pricing and other input costs and other steel-related component costs as well.

So the good news is that for Q3, between our own cost savings and the health of the IEEPA benefit tariff refunds, we were able to come in slightly stronger on North America margins. But for the full year, we are expecting to basically hold the original 24%, which means that Q4 will come under -- have some amount of pressure. And it really goes back to the fact that there will be a lag. So there are these cost increases that are coming in. We're taking action with additional price increases, but there will be a lag on when those additional price increases come into effect. But overall, between the third and the fourth quarter, it's allowing us to stay balanced at that approximately 24%.

Our next question comes from Bryan Blair with Oppenheimer.

Good morning. To approach price costs from a slightly different angle. If we were to assume that cost to levelize at the current run rate kind of snapped the line as flood that assumption inevitably be for the sake of this exercise, I assume that what level of incremental price realization would you need to reach price cost parity in early '27? .

I mean it's -- what I would say is we always are looking to price through inflationary cost pressures that we can offset ourselves, right? And I think as we do our own calculations as we kind of enter next year, that's what's behind kind of our announced price changes.

As Carrie mentioned, there's sometimes a time lag in there. But as you think about heading into 2027, our goal is to offset inflationary pressures and some combination of the cost management controls that we put in place and pass-through pricing when necessary.

And as you refer back to Steve's remarks, we did comment that there will be other price increases in other parts of the business. So we've done the 9.5% announcement for water heaters to get ahead of that. And so we'll continue to balance that, as Steve said, with our own cost management, creating additional opportunities there with a balanced approach to price to pricing.

And it's fluid, right? So as we think about things like diesel costs and where steel is going to evolve to just 1 of the things we can monitor, and we'll continue to react for you.

I understand. I appreciate the color. Boiler sales were obviously a good guy again in the quarter. You've raised your 2026 guidance and in turn, can you parse out how much of the upside has been driven by stronger industry demand versus share capture for your team?

Yes. I mean we're definitely very, very pleased with that weather performance, being able to deliver 10% to 12% is pretty impressive.

I would say there are three main things that are really driving that fiscal '26 growth. The first one is a really strong portfolio that's really built around high efficiency. So it's allowing us to have a leading lineup that's well placed for continued demand for higher efficiency solutions.

Also, we're seeing some of that growth coming through pricing benefits. We've taken pricing actions in the year were needed to offset cost pressures as well.

And the third 1 is the share gains in the residential or a market driven in part by some competitors that have exited the market, and we'll begin lapping those gains in the late fourth quarter of 2026. And because of the -- some of these tailwinds, as you can appreciate, won't repeat at that same level. And so we wouldn't expect 10% to 12% growth to be an ongoing rate. Over time, we would expect boiler growth to really settle into a 4% to 6% range compared to with our a market expectation of low single-digit growth for the overall market, which means that we should be able to drive unit growth that's a little bit above the market growth, and then we'll have normalized pricing benefits to basically get into what we would say a normalized growth rate of 4% to 6%. So we remain confident that the strength of our portfolio in the boiler area, our quality and our service capabilities are going to let us keep outperforming the market.

One of our next question. Our next question comes from Matt Summerville with D.A. Davidson.

A couple of questions. Can you remind us what your tariff refunds were in Q2 and Q3? And what, if anything, you expect in Q4? And then can you also maybe talk a little bit about actionability as you see it in your M&A pipeline now that China is kind of getting put in the rearview mirror? And then I have a follow-up.

Great. I would say in the second quarter, it was a couple of million dollars, so not material impact to our second quarter results. In Q3, we called out that they were about $10 million. And then I would say, going forward for Q4, we're not expecting anything material there in Q4. I think all of the benefit came in, in Q3. And I think the timing of that actually worked out well because we did see some higher than expected input costs coming into the quarter that really allowed us to manage the margin in North America quite well and come in a little bit better than what we expected.

I'll maybe step in on the M&A pipeline. I think we've got a strong pipeline. It's in the areas that I talk to often, which is in our core business, right, our core North America business, in our growth platforms, namely water treatment here in North America and now the building out of the water management platform.

So those are the areas where we focus our platform -- or sorry, our pipeline I would say we continue to cultivate it. We invest time and energy in terms of developing that pipeline. We also remain very disciplined about how we approach it.

So it is a priority for our growth strategy is to build out those platforms and at the same time, protect our core franchise, which generates a lot of cash. And so I feel good that it's an active pipeline, and we're going to continue to work on it and develop it. And obviously, still, at the same time, remain disciplined in our approach.

And then maybe could you comment on what you're seeing sort of the updated view on the discretionary side of the resi replacement market and just more broadly kind of macro thinking do you have a view on an early view on what the market might hold for residential volumes in '27.

Yes. I mean it's not a seismic shift that we see. I think we watch that trend very carefully. I think one of the things that in the repair replace that we know is -- well, then we talk a lot about new home construction, but also when homes aren't being transacted and changing in ownership and because of those inspections that often identify the need to or interest in refreshing a water heater, for example, that in a wall as well.

So that replacement market is seeing a little bit of pressure, but the dynamics are still there. Some of it generational, right? So younger generations tend to replace more proactively than the boomer generation does. So we see that as relatively stable but a little bit soft just given the environment that we're navigating through.

And it's still [indiscernible] over 30% proactive. It's still over 3%. So as Steve mentioned, we're not seeing any real moves in that number.

And it's some of the things we think about over longer terms, too, right, in terms of just how we collect our data.

We're preparing as we go into next year, we've talked about some of the things of how we see ourselves exiting 2026 that we're preparing for a continued kind of muted environment on those fronts. And we'll be ready if that changes, but also a resilient business model that navigates through the cycle is something that we also invest in and make sure we're ready for it.

Our next question comes from Susan Maklari with Goldman Sachs.

Good morning, everyone. My first question is on your comments on exiting this year with a more elevated backlog in some of the product categories. Can you just talk more specifically about your expectations there? And how we should think about your ability to work that through as we move into 2027? .

Yes. That was specifically water treatment. And it relates to the fact that we did cease manufacturing at our s Groveport facility and transferred that production to two other facilities. And it's really just associated with the ramp-up of production at those current facilities taking on the additional work.

So that's the backlog. So I think the good news is that we would expect to continue to ramp up and be able to work through that backlog as we move into 2027. And again, we expect water treatment to continue to be an area of growth for us. with some of the priority work that we're doing in both our consumer channels as well as the dealer side of our Pro channel, including wholesale as well. So I think that bodes well for us to continue to focus on that in 2027.

Okay. All right. That's helpful. And then you mentioned that you've added 30 new dealers so far this year. Can you talk about the kind of dealers that you are adding to the portfolio, what the value proposition is? Are you taking share from others? And how we should think about further expansion of the network?

Yes. Where we're engaging is kind of independent dealers who are looking for a reliable and trusted kind of OEM manufacturer for water treatment and to be a part of our brand. And I think what they find us is we've got a great product and an innovative lineup, a brand that we stand behind and provide the technical service that those are sort of hallmarks of A. O. Smith.

We also really are investing in supporting for these independent dealers, how do they actually go out and drive demand generation find new business, be able to provide the technical support out in the field. And so that's part of the value proposition. It's a space it's highly fragmented today in terms of the people who are in this space is very regional. Again, those are some dynamics we know well from maybe the plumbing side of the business and our ability to bring a compelling product offering, but then wrap it up into how we actually support small business owners and help them drive their business forward as part of how we go and sign those guys up.

The next question comes from Nathan Jones with Stifel.

Good morning. Just a quick question on the bridge for operating earnings on North America. There's an other cost savings in there that's $6 million that goes along with the tariff refunds. Is that something -- those structural savings that continue going forward or something that was more onetime in nature in the quarter?

Yes. Go ahead. Go ahead, Steve.

Just -- it's a continued evolution of our A. O. Smith operating system that I talked about, and that's our model for how we go after and eliminate waste and deploy lean across the company, and so our goal is to make that repeatable, right, in a repeatable process.

And I would say, as we've made some changes, we brought in some new leaders to the company over the last few years. I think those new leaders are bringing in even fresh ideas on how we can even expand that further. And so we're thinking about how do we take our AOS operating system and make it broader and make it even more impactful. So our goal is certainly to make it sustainable and get the flywheel spinning and you're seeing some of that in some of the results that we talk about, but I think there's more to come.

Okay. So that sounds like something that's more structural I guess my other question is around potential inventory levels in the channel at the end of the year. Typically, when you have price increases, you see demand pull forward. you had a price increase at the end of June, which maybe pulled demand forward into 2Q. You've got another price increase in December. So maybe there would be some demand pulled forward into the fourth quarter, but maybe it was already pulled forward earlier in the year to get through some of the other price increases.

So there's a lot of stuff going on there with -- related to where inventories might end the year. So just your thoughts on whether or not it's going to be in kind of a balanced position, whether there will be a need to run out some of that inventory in the first quarter of '27 or just how you're thinking about that?

You characterized with more color on my previous comment about there's a lot of uncertainty for the final 2 months, right? And we've got a previous price increase that's now kind of in the marketplace. Now we've introduced a new one. We've got a holiday period, how our customers sort of respond? We're going to work closely with them as we always do to kind of navigate through to the end of the year.

So there's some variability there, but I will say we'll be ready, and we'll serve our customers well, and we'll work closely with them to figure out how to navigate and provide them the product that they need.

So it's -- not every year is the same, right? And this is a unique situation in terms of both the timing of the price change, the impact of kind of what's happening in calendarization. There's other things at play here in terms of what our competitors are doing. So we'll follow it closely, but we'll be ready to serve our customers.

Yes. Our lead times -- our order lead times remain pretty stable and so we can respond if there on any changes there.

Our next question comes from Jeff Hammond with KeyBanc Capital Markets.

Just on the China deal. One, what are the cash proceeds? I know you talked about the $80 million you can repatriate? And then just speak to how the royalty work? And if there's any predetermination around eventually exiting the 19% or if that's just at some point in time in the future?

Yes. Maybe I'll start there. I would say, right now, we're estimating that the after-tax proceeds plus the repatriated cash would give us about $350 million to prioritize towards returning cash to shareholders that's really what we want to prioritize when we get it closed. So we'll finalize the details at that point. But my current estimate is that approximately $350 million would be the number.

And I would say that as we think about the minority or the royalty rate, I would say we aren't disclosing the specifics on the royalty rate. But we believe it is consistent with arm's length rates for [ RAN ] licenses of that type. And so the transaction in our earnings announcement and in the announcement that we put out a couple of days ago on the China transaction, we did estimate the value of that royalty at about $100 million, so essentially $400 million for the transaction value and the royalty present value of about $100 million. So totality of $500 million.

So I'll ask Steve to comment on the minority...

Yes. I mean I think, first of all, I'll go back and reiterate, we see the 19% retained ownership stake as a way to participate in future upside of the business along with the brand licensing.

And we -- part of the rationale for selecting CPEs, they are very capable company. They've got a very capable set of leaders that they're going to help bring into the business, and we believe in the plan that they have to grow the business. They're also great passionate stewards of the brand in A. O. Smith.

So we feel optimistic about where the future of the business could go under their leadership and that there will be value that we'll participate in along with that. We've always -- we're going to stay connected with them because the brand is a big part of the value that they're buying into and the A. O. Smith brand means obviously a lot to us.

And I think the monetization of that in the future, we'll see. We think we're optimistic of where to go. And I believe that the China market will have a recovery period in front of it. And obviously CPE, as a kind of financial asset manager, we'll look at some point for their own exit, and we'll work closely with them on what that will look like.

Okay. Great. And then just on the price increases, it seems like the second price increase kind of midyear was maybe more difficult than in the past. And I don't know if that's competitive dynamics with wholesale retail timing or just consumer fatigue. But I'm just trying to get a sense of how confident you are that you can kind of push this price?

And then, Steve, I didn't know if I caught this, have you heard -- have you seen your competitors do a similar price increase? Or you said you haven't seen it yet?

We've seen announcements from competitors in the marketplace for similar price changes and similar timing. So that's out there in the industry right now. I think we're all dealing with very similar realities. We all are making products primarily made of steel and that are big and multi and have to be shipped. And those are rates that I think are pressuring the entire industry.

As you mentioned, past dynamics around retail wholesale. I mean those are equalizing because of the changes happening in the marketplace. Past dynamics in the past that made a [ Murphy ] were [indiscernible] refunds, right? We're kind of through that too. So we're pretty confident that I think this is a price change that is going to be required for the industry to remain profitable.

Our next question comes from Brendan Shea with JPMorgan.

This is Tomo Sano from JPMorgan. So if we step it back and once China is largely out of the portfolio, how should we think about the through cycle growth profile of the new A. O. Smith? Like what would you need to go right for the company to sustainably grow above its historical rate, please?

Well, I'll kind of walk through kind of our portfolios and where they stand. Our core North American water heater boiler business. So you've seen the growth profile of our boiler business. That is a terrific franchise. Our lock in bar business is a great business. And with the product offering, the value proposition and the technical support we supply -- we supply the marketplace, we expect that, that will continue to be kind of a growth business and be very competitive and take share in the marketplace.

I think on the commercial water heater side, it's also a very -- a great franchise business, and we're the market share leader there, and we have a great offering and again, supported by our go-to-market model and our technical capabilities.

I think on the residential side, we're going to continue to navigate through the cycle on that. Ultimately, a recovery in some of the macro factors will help improve the growth profile there.

Also regulatory changes. We had a regulatory change on the commercial side this year that did not go through. We still believe, longer term, regulation is going to drive greater efficiency and greater technology upgrade. And so that's an opportunity to kind of grow the business as well as we tend to lead through those technical changes. And so those are some areas in our core that I would highlight as future growth opportunities for us.

And then really a lot of growth for us, we see coming through the additional growth platforms in water treatment, which we've been on a journey with, but I think we've got a great strategy for how we're focusing that business and in the right areas where we have the right to compete in.

And then with our Leonard Valve acquisition this year, we've stepped into building out a platform around water management. And like I said, there's more work to be done on both of those platforms, including on the M&A front. And I think that's going to position us into some higher growth markets and then also allow us to think about how innovation and connectivity can bring that together longer term.

Our next question comes from Scott Graham with Seaport Research Partners.

Back on this price increase for water heaters, apart from changes in efficiency standards, I don't remember, price increase this large.

So I'm wondering, since you're telling us, I'm sure you've talked to customers, I'm wondering what that feedback has been? And is there a risk here that the couple of new entrants use this as an opportunity to kind of gain more ground in the territory.

Well, I would say the industry has had a track record of meaningful price changes and often the driver for it has been steel, right? Because one of the things for tank-type water heaters in particular, steel is a major component. And that's the case for everybody. And even new entrants who want to get into that space.

So from that standpoint, I think the industry does have history around when there's meaningful movements in steel the industry understands that there is a price pass-through because it's a very steel-based product. So from that standpoint, I think there is -- and look, we always take new entrants seriously, and we watch folks who look to get into the space.

And I think as I've said in the past, it's not just about reaching a price point. It's the holistic business model is you need to have a comprehensive portfolio of with the right channel partners that can have inventory available when a customer needs it and support that with all of the technical service and the reliability and the brand trust that we provide.

So it's a comprehensive business model, one that we invest heavily in. And I think it's also -- that business model that makes it difficult for somebody to play in a small scale way.

Fair. Just a follow-up on capital allocation. So you indicated in your agreement with -- to divest China announcement that you'd be looking seemingly heavily towards share repurchases. I guess with that agreement signed visibility on what the proceeds will be, and you're having a like small level of net leverage. Is there a reason why we can't start that acceleration in share repurchases now?

Yes. I would say, certainly, part of the transaction unlocks cash. So we want to -- the transaction needs to close to be able to get a portion of that. We also want to make sure we have a general idea of all of the after-tax -- the tax consequences of the deal as well as any of the customary closing costs, those things to get a better estimate.

We did increase our buyback earlier this year from $200 million to $300 million. We're on track with that. So we'll finish out the fourth quarter with additional share buybacks to close out the $300 million program. And then as part of our 2027 planning, we'll then figure in, again, approximately $350 million is what we're expecting. So I think it will figure prominently in how we think about our 2027 plan. at this point.

Our next question comes from Andy Kaplowitz with Citigroup.

Give us a little bit more color on what's going on in Leonard Valve. I think you mentioned you're seeing some project delays, maybe, just a little bit more detail into those delays and how the business should fare as we go into '27?

Yes. There's primary components of the Leonard Valve portfolio. There's the mixing valves and the digital mixing valve side of the business, and then there's the boiler control side of the business, which prevail goes to market as heaters its brand.

And when we bought the business, we really like both sides of that business. The mixing valve is a key component is stepping into water management. And the boiler control side too is part of that, but also has a great connectivity to our franchise around the lack of our boiler system. So we like both of those parts of the portfolio for very strategic reasons.

In terms of the kind of the performance that we talked about today, the mixing valve side of the business continues to perform very well. And as we -- as expected and is providing good growth for our business going forward. And we also like a lot of the synergies that we've been having in the dialogues with our customers in the marketplace about adding that to the A. O. Smith lineup.

On the timer side, the boiler timer piece, that can be tied to like other parts of our business are at times, certain regulatory changes and policy decisions made, right, about upgrading for higher efficiency. So the heat timer business is tied to increasing building efficiencies. And right now, in parts of the country where they have high penetration, there's been some changes in policy decisions, which have put projects on delay. That's what we're feeling right now in terms of the near-term financial performance.

We don't believe it's structural or a fundamental shift in how that business will perform. We believe that many of those policy decisions just need to work their way through the system. Ultimately, at the end of the day, building owners are still going to look to improve the efficiency of their buildings, and we're part of that solution.

And longer term, we just think having the time our business is a great synergy with how we go to market with our boiler franchise and then more broadly, how water management is going to play within our portfolio.

Got it. And maybe to that point, like obviously, we understand the focus on repurchases with the divestiture -- but as you probably know and there's been a fair amount of derating on water assets out there. So do you see more opportunity as you go into '27, whether it's adding into water management or some other adjacency. Should we expect a little bit more activity out of you guys at that point?

Maybe I'll start there, and I'll ask Steve to comment specifically on M&A. But I would say our use of the after-tax China proceeds and the repatriated cash for share repurchases isn't going to limit our opportunity to do other capital allocation priorities.

So it doesn't mean choosing between share repurchases or growth investments, so it's not an or, but I'd like to think of it as an and. Our balance sheet and our cash flow are strong enough that we can continue to balance capital allocation priorities.

So Steve, to kind of pick up on this...

Yes. I would just say, as it relates to how we want to deploy capital costs, our allocation priorities and specifically as we think about how we want to build out the portfolio on the platforms that I talked about.

From my standpoint, it starts with having a clear strategy of where you want to go. Clear understanding for how you're going to create value by going there. And then you have to have conviction around following through and doing it.

And I think what we have is a clear strategy, understanding how we're going to create value and conviction of what we want to do. That alone doesn't get you to then putting capital to work, right? So in the world of M&A, particularly timing has to line up -- sometimes you got to be patient, right? As I mentioned, we're going to be a disciplined acquirer.

And -- but I like our strategy, I think we have clear understanding of where we want to go. I think we've got a robust pipeline, and it's just a question of continuing to work it, staying active and then making sure we have the conviction when the time is right and we've got the right asset that we can find a way to close it and build out our portfolio.

But it's difficult to control the time, and we're playing this for the long game, and we're going to take the time if needed to do it.

Our next question comes from Ryan Connors with North Coast Research.

Just a couple of very quick housekeeping points of clarification on the China cash and proceeds. Number one, is the $80 million in cash being repatriated, is that the entirety of the cash balance in China? Or is there anything else after that?

Yes, I would say that there's certainly cash that is needed to run the business. So this transaction obviously facilitates to bring back some of that excess cash back as a result of the transaction. But there is still cash there as we are -- need to operate the business still.

Right. But nothing material in terms of further repatriation?

As the business kind of moves through and continues to return to a growth path, the royalty stream that will come from that schedule for in payments and other things down the right.

Got it. Okay. And then the second one was the $350 million in proceeds, will that be repatriated immediately? I would assume that was the case, but then you did use the term portion when you talked about the repatriation post closing?

No. Again, I would just say that our intent is to prioritize my estimate of around $350 million to share repurchases after closing.

So that money will come back immediately and be free and clear for repurchases immediately upon closing.

Doesn't [indiscernible] that close.

And I'm not showing any further questions at this time. I'd like to turn the call back to Helen for any further remarks.

Thank you, everyone, for joining us today. 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 two conferences this quarter. Baird on November 10 and Goldman on December 2. Thank you, and enjoy the rest of your day.

Ladies and gentlemen, that concludes today's presentation. You may now disconnect, and have a wonderful day.

Good day, and thank you for standing by. Welcome to the Second Quarter 2026 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] Please be advised that today's conference is being recorded.

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

Thank you, Lisa. Good morning, everyone, 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 Steve Shafer, Chief Executive Officer; Chuck Lauber, Executive Vice President; and Carrie Anderson, Chief Financial Officer.

In order to provide improved transparency into the operating results of our business, we provided non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. North America segment organic growth excludes the impact of Leonard Valve. Adjusted earnings, adjusted earnings per share and adjusted segment earnings exclude the impact of 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 1 question and 1 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 Steve to begin our prepared remarks.

Thank you, Helen, and good morning, everyone. Before we get into our results, I want to start by recognizing Chuck Lauber and thanking him for his many years of service as our CFO. Chuck has had a long and meaningful career with A.O. Smith, and his leadership has had a significant impact on our company. On behalf of all of us, Chuck, thank you for your many contributions, and we wish you all the best in retirement.

At the same time, I'm very pleased to welcome Carrie Anderson to A. O. Smith as our new Chief Financial Officer. Carrie brings extensive financial leadership experience across multiple industries, including complex global manufacturing organizations. She also brings a collaborative leadership style and a disciplined approach to execution. Carrie has already become a valued partner to the team, and we look forward to her leadership in strengthening our execution rigor and advancing our strategic priorities. This is another plan and orderly leadership transition at A. O. Smith, and it reflects the strength of our broader leadership team.

We have a highly experienced group of leaders with the right balance of fresh perspective and deep industry knowledge to continue executing our strategy and serving our customers well.

Now, moving on to our second quarter 2026 financial performance. Please turn to Slide 4. While the quarter reflected very different market conditions across our businesses, I am pleased with how the A. O. Smith team executed. We continue to gain traction in North America, delivered strong free cash flow performance and took additional actions to create value for shareholders.

At the company level, sales were approximately $1 billion and adjusted earnings per share were $1.03. While our results were impacted by the continued weakness in China, our teams remain focused on operational execution and cost management across the business. One of the highlights of the quarter was the North America sales increase of 5% to $821 million, which includes Leonard Vale, our recent acquisition that expands our water management and digital control capabilities.

Excluding Leonard Vale, organic sales grew 3%, supported by strong boiler growth, carryover pricing actions and continued focus on serving our customers. Another highlight of the quarter was our cash flow performance. Free cash flow increased nearly 70% in the first half of the year, reflecting the strength and resilience of our operating model. Supported by that performance, we increased our 2026 share repurchase target by 50% to $300 million, reinforcing our commitment to disciplined capital deployment and returning cash to shareholders.

As expected, China sales decreased 28% in local currency, largely due to broader market conditions. While the China appliance market remains challenging, particularly in the premium segment, we continue to manage the business thoughtfully while completing our strategic assessment. We expect to share our conclusion on that assessment by our next quarterly earnings call and remain focused on identifying the best path forward to support long-term value creation.

With that overview, let's take a closer look at the performance of our North America businesses. North America water heater sales increased 2% in the quarter. Residential water heater industry demand remained pressured by softness in new construction as well as existing home sales, which can weigh on replacement demand. While the residential market remains competitive, we continue to make progress in our market share performance. In an environment where demand remains muted, our leading brands, broad channel presence and strong customer relationships continue to differentiate A. O. Smith and reinforce our confidence in the long-term fundamentals of the business.

Our North America boiler business delivered a strong quarter with sales increasing 21%, contributing to 12% growth in the first half of the year. Growth was driven by continued momentum in residential boilers and a return to growth in commercial boilers. We remain encouraged by the performance of this business and believe our investments in product innovation, customer service, and channel partnerships continue to position us well in an attractive market with significant long-term opportunities.

North America water treatment sales decreased 2%, as growth in our priority dealer channel was offset by softer demand in other channels. While consumers remain cautious in portions of the market, we continue to focus on the channels, products and customer relationships where we see the greatest opportunities for growth.

During the quarter, we advanced actions to optimize our footprint and streamline our brand portfolio, which we believe position the business to operate more efficiently and accelerate profitable growth over time. We expect annual savings of approximately $6 million to $8 million beginning in 2027. Leonard Valve contributed $16 million to sales in the second quarter of 2026, and we continue to target double-digit growth for the full year.

I'll now turn the call over to Chuck, who will provide more specifics on our second quarter performance.

Thank you, Steve, and good morning, everyone. Before I begin, I want to say how grateful I am for the opportunity to observe as CFO of A. O. Smith. It's been our privilege to work alongside so many talented colleagues and to be a part of a company with such a strong culture, trusted brands and a long history of creating value. I'm proud of what we have accomplished together and confident in the company's future. It's been a pleasure representing A.O. Smith and my many interactions with investors and analysts over the years.

I also want to welcome and congratulate Carrie and wish her great success in our new role. I look forward to working with her over the next couple of months during the transition.

Let's now turn to Slide 5. North America segment sales of $821 million increased 5% compared to last year. As shown on the left side of the slide, organic growth of 3% in the quarter contributed $26 million of additional sales, while Leonard Valve sales contributed another $16 million. The organic growth was driven primarily by 21% boiler sales growth as well as carryover pricing benefits in our water heater business. These benefits were partially offset by lower residential water heater volumes as industry demand remains soft.

Our boiler performance this quarter was driven by strong commercial demand, including seasonal orders under early buy programs. In addition, the quarter benefited from customer pre-buy activity ahead of announced price increases on both water heater and boiler products, resulting in some demand pull forward into the second quarter.

North America adjusted segment earnings were $200 million, modestly above the prior year period. Adjusted segment margin was 24.4%, a decrease of 100 basis points compared to last year. The benefits of organic growth and the contribution from Leonard Valve were largely offset by higher steel and other input costs. Steel costs rose year-over-year, approximately 20% in Q2 and combined with tariffs and other inflationary costs largely offset pricing benefits. IEPA refunds had a minimal impact in the quarter.

Moving to Slide 6. Rest of the World segment sales was $195 million, decreased 19% due to continued weak consumer demand in China driving lower volumes, which was partially offset by favorable foreign currency translation. Rest of the World second quarter segment earnings of $10 million and segment margin of 5.2% decreased significantly compared with the prior year period. The lower segment earnings and margins were primarily due to lower sales volumes in China, which were partially offset by continued cost management.

Please turn to Slide 7. Cash flow performance remained a significant strength in the first half of this year. We generated free cash flow of $233 million in the first half of 2026, a 67% increase over 2025, primarily driven by working capital management, which more than offset lower earnings. We ended the quarter with $181 million of cash and a net debt position of $456 million. Our leverage ratio was 25.7% as measured by total debt to total capital, reflecting the financing associated with the Leonard Valve acquisition completed earlier this year.

Even after funding the acquisition and returning capital to shareholders, our balance sheet remains strong and provides substantial flexibility to support future growth investments and acquisition opportunities.

Let's now turn to Slide 8. Our capital allocation framework remains unchanged and continues to balance investment in long-term growth with meaningful returns to shareholders. Our priorities remain clear, actively manage our portfolio, invest in innovation to drive organic growth and advance operational excellence to improve productivity. Within portfolio management, we continue to evaluate M&A opportunities that fit our strategic direction and meet our financial criteria.

Earlier this month, our Board approved our next quarterly dividend of $0.36 per share. In addition, we repurchased approximately 2.6 million shares for a total of $162 million during the first half of the year. Given our cash flow performance and confidence in the business, we increased our 2026 share repurchase target by 50% from $200 million to $300 million. Importantly, this increase in repurchase commitment still preserves significant flexibility to invest in growth and pursue strategic opportunities as they arise.

I'll now turn the call over to Carrie to share our 2026 earnings outlook.

Thank you, Chuck, and good morning, everyone. I'm excited to join A.O. Smith and appreciate a warm welcome from Steve, Chuck, Helen and the broader team. As I've settled into the role over the past several weeks, I've been impressed by the strength of the business, the quality of the team and the discipline around capital allocation and financial management. I look forward to helping build on that foundation, as we execute our strategic priorities and create long-term value for our shareholders. And I'm very grateful for Chuck's partnership during this transition and wish him all the best in retirement.

With that, let's turn to our 2026 outlook summarized on Slide 9, as we enter the second half of the year and have greater visibility into our end markets and our expected full year performance. Based on our first half results and current outlook, we have narrowed our guidance range. Importantly, our overall view of the business has not materially changed since April. Our outlook for China, North America commercial water heaters, boilers, water treatment, India and Leonard Valve remain largely unchanged from the assumptions we provided last quarter. The primary change in our outlook relates to the North America residential water heater market, where industry demand has remained softer than we anticipated earlier in the year, reflecting continued weakness in both new construction activity and existing home sales.

As a result, we now expect full year sales growth of approximately 2% to 3% and adjusted EPS of $3.70 to $3.85 per share compared with our prior outlook of 2% to 4% sales growth and adjusted EPS of $3.70 to $4 per share. The upper end of our prior guidance assumes that residential water heater industry demand during the second half of the year would be similar to the first half. Based on what we have seen through June and into July, we now believe results are more likely to skew towards the lower end of that prior range.

Within U.S. residential water heaters, we are narrowing our industry outlook to down low single digits for the year compared to our prior expectation of flat to down low single digits. While emergency replacement demand remains stable, we continue to closely monitor proactive replacement activity, which accounts for approximately 30% of total replacement demand and is more sensitive to consumer spending behavior. End market conditions tied to new housing activity have remained soft, primarily impacting the wholesale channel.

Looking at our other major market assumptions, we continue to expect U.S. commercial water heater industry volumes to be approximately flat with last year. We are maintaining our North America boiler sales growth of 6% to 8%. North America water treatment sales growth of 5% to 6% and approximately $70 million of sales from Leonard valve. We also continue to expect our China sales to decline at a low double-digit rate in local currency.

As we think about the phasing of the balance of the year, Q2 earnings benefited from early buy programs in our boiler business as well as customer pre-buy activity ahead of our announced water heater and boiler price increases, which accelerated a portion of expected Q3 demand into the second quarter. In addition, Q2 benefited from a slightly lower effective tax rate than we expect for the full year.

And while our full year outlook still assumes steel costs will be approximately 15% higher than 2025 levels, we expect steel inflation in the second half to be somewhat higher than the first half. Non-steel material inflation and tariffs are expected to remain a headwind as we move through the remainder of the year.

Tariff policy remains dynamic. And while we continue to evaluate the recently announced changes, we currently expect the new tariffs to have a modestly higher cost impact than the tariffs they replace. While we continue to expect the overall impact to be manageable, the timing of these cost pressures, combined with the customer pre-buy activity and seasonal boiler early buy programs is expected to create a less favorable earnings profile in the third quarter. Together with continued weakness in China, these factors are expected to result in Q3 EPS that is lower than both Q2 and Q4. The midpoint of our range assumes Q3 segment margins in both North America and Rest of World are generally consistent with the margins reported in Q1.

I'll now turn the call back over to Steve for closing remarks.

Thanks, Carrie. Moving to Slide 10. I'd like to close with the key messages. First, we delivered solid second quarter results with sales exceeding $1 billion, 3% North America organic growth and adjusted earnings per share of $1.03. These results reflect the strength of our North America businesses, disciplined execution across the organization and the contribution from Leonard Valve as we begin to build out our water management platform.

Second, our boiler business continued to perform exceptionally well. Boiler sales increased 21% in the quarter, driving year-to-date growth of 12%. We continue to benefit from strong commercial demand and remain confident in our outlook of 6% to 8% boiler growth for the full year.

Third, while residential water heater industry demand remains softer than we anticipated, we are confident in the long-term strength of our North America water heater business. The replacement market continues to represent approximately 80% to 85% of industry demand. Our market position remains strong, and we've continued to make progress stabilizing market share in a highly competitive environment.

Fourth, our strategic assessment of the China business is nearing completion. While market conditions remain challenging, we are focused on determining the best path forward to support the long-term success of the business and create value for shareholders.

Finally, our business has continued to generate strong cash flow, which provides flexibility to invest in our businesses while returning capital to shareholders. This confidence is reflected in the 50% increase in our 2026 share repurchase target to $300 million.

As Carrie discussed earlier, we have updated our full year outlook to reflect continued softness in North America residential water heater industry demand. Importantly, our outlook for our other major businesses and markets remains largely consistent with the assumptions we provided earlier this year.

Overall, we remain confident in our strategy, our market positions, the resilience of our replacement-driven businesses and our ability to create long-term value for shareholders.

With that, we conclude our prepared remarks and open the call for your questions.

[Operator Instructions] The first question of the day will be coming from the line of Bryan Blair of Oppenheimer.

Chuck, thank you very much for all the help over the years, and Carrie, look forward to working with you.

Thank you. Likewise.

Glad to be here.

I guess to start, you did revise the U.S. resi water heater industry volume outlook. Although down low single digits still entails stabilization going forward. And that certainly counters pretty weak industry data year-to-date and then generally unchanged macro variables. So I guess, simple question, what gives your team confidence in that stabilization over the coming months?

Yes, Bryan, when we kind of look at the way the industry rolls out, just recall that in '24 and in '25, we really had also price increases in the first half of the year, pulling volume into the first half, so some of the comps that we're seeing industry data, kind of through May are comping against a pretty strong front half of the year. The way we have the year laid out, the last couple of years, has been in the 52%, 53% in the front half. And this year, we have it about 51% in the front half. So we don't have quite as much pull forward in the overall outlook, and we have a little easier comps as we go into the back half of the year.

Okay. Understood. That makes sense. I was hoping you could offer some more data on how your team is thinking about North American margins in Q3 and Q4. We obviously have your full year outlook sweeping back into the second half overall. But just given all the moving parts at hand, price costs certainly amongst those factors, that would be very helpful if you spoke to quarterly expectations.

Yes. I'll take that call. And Chuck, if there's something I missed, feel free to chime in here. I would say, generally, in the second quarter, our price cost relationship was slightly positive. And overall, we're taking pricing actions in our water heating at 4% to 7%. They're expected to begin to be realized midway through the third quarter. So we expect to see more of a contribution of that price, as we move into the second half. But at the same time, we're also -- if you go back to my prepared remarks, you see a ramp-up in some of our cost that is expected to increase, particularly steel in the back half of the year.

And so overall, I would say in the back half of the year, we're going to be more neutral, more neutral in that price-cost relationship. Specifically for the third quarter, I mentioned that the North America margins will be similar to Q1. And that's more reflective of the fact that, as you think about the demand that we saw move into the second quarter compared to the third quarter, that's going to have a bit of some volume pressure there and the fact that we're going to have some of that price kind of build over the quarter, as those new effective price increases come into effect. So we won't have a full quarter impact of those new price increases in Q3 and will have the full benefit in Q4.

Anything else Chuck to add?

No, I agree.

Next question is coming from the line of Mike Halloran of Baird.

And let me echo Bryan's comments about Chuck, I enjoyed working with you for what was a very long period of time. And Carrie, welcome. I look forward to working with you as well.

Chuck is a little sensitive to when we say a very long period of time.

Look, I'm incrementing myself there, too, unfortunately. So can we talk a little bit about the residential landscape specifically? Obviously, the environment is weaker. I understand the back half guide. But maybe just talk a little bit about the market share comments and how you feel like you're stabilizing things on that side. And any difference or trend line that you're seeing on the wholesale versus retail side of things?

Yes. So maybe first off, regarding wholesale, retail, we can see -- continue to see kind of retail overall in the industry gain a little bit of share. Some of that is because of the dynamics in the industry like impact wholesale a little bit more than retail, but also some of the big box retailer players are really getting organized around how to go after, in particular, kind of the small pros. And so there's that dynamic that's playing out. We've been playing out, I'd say, for years and maybe accelerated a bit in the last few quarters, as there's been a lot more pressure, I think, on the wholesale side of the business. So that's 1 fact that's out there.

I've talked about in the past kind of market share specifically on the wholesale side. We're very pleased with sort of how we perform in retail with our retail partners. But on the wholesale side, it can be a little bit lumpy as there are some channel movements, and there are some actions that are taken either by us or competitors. And so we see that kind of right up and down a little bit. But what we look to really do is make sure that we have a stable share performance, and with the end of last year, we kind of had a concerted effort to go back and win back a little bit of share that we felt like maybe we had lost in that wholesale channel. We have great relationships across the wholesale channel, we obviously know the players in that space very well, and we had some targeted actions to win back a little bit of share. And then, we're happy with the progress we're making there and some of the stabilization that we see in our share performance.

And then second question, just pricing. Maybe just talk a little bit about price acceptance in the North America channels, both on the boiler and then the commercial and residential water heater side? How that's being shuffled through? And then, I know you answered a little bit for Brian, but as you look at the last -- next 2 to 4 quarters here, how does that price cost relationship start tracking? And when do you feel like you're going to be in a really good spot on a net basis? .

Maybe I'll start with that 1 and then Chuck can pick up the first part of the question. But I would say it's too early to talk about future price increases at this point. The material cost environment inclusive of tariffs remains quite dynamic. And as a result, we're watching and managing this quite closely with our teams. And our goal is to always maintain a balance in that price-cost relationship, as we also want to work to make sure that our customers are kept competitive here. So at this point, I would say we're always going to continue to monitor to try to maintain that relationship.

As far as acceptance of the price, I mean, it's pretty early days of the price increase, right? We expect that we're going to start seeing the positive impact of pricing call it, midway through the third quarter, and that's both on water heaters and boilers. It was delayed. It was delayed a couple of months. So we have a little bit of pressure in Q3 that we may not have seen had it been affected immediately that we're going to always keep competitive in the marketplace, and we feel that it should act out, as it has, as history would act out. So we, right now, have it in our outlook.

Next question is coming from the line of Susan Maklari of Goldman Sachs.

One moment for the next question. Our next question is coming from the line of Nathan Jones of Stifel.

Carrie, welcome to the team. I guess, first question, Chuck, you just mentioned that the price increases were delayed by a couple of months. Can you talk about the dynamics around that and why they were delayed and confidence in them getting out into the market now than they're supposed to?

Yes. I mean, it was roughly a month that it was pushed back, and it really was because we wanted to remain competitive with some of the other market participants that came out with pricing, but everybody is in the market with pricing. We expect it to go forward as planned.

Okay. I guess the second question is, you guys have had a fair amount of experience over the last several years with large price increases to cover inflation, so is the industry. And a lot of experience with the demand pull forward dynamics that come along with that. Can you talk about how that's played out this time versus in previous occasions? How confident you are on -- I guess, what you've estimated as pull forward into 2Q that plays out in the back half? I guess, the risk around maybe the pull forward being a bit more, the market being a bit weaker than you think and the risk to the second half, just any color on your confidence there?

And I would say it's a little bit of science and a little bit of art relative to how you manage that. And the important thing is we work really closely with our customers, as we think about stepping in and stepping through a price change. A couple of years ago, we saw a really big pull forward in 2024 and 2025. We look to manage that and balance that a little bit with our customers to help on the production efficiencies.

Every time we go through this, we try to find the right balance of serving when our customers need, responding to the marketplace, but also then optimizing for what makes sense in terms of our own production efficiencies. And so we continue to work with our customers, and I'd say it's not a formula every year is exactly the same. There's always different dynamics to navigate through and different priorities from our customers that we work through with them. But I'd say -- this year, I think we continue to work closely to make sure we serve the demand serve our customers well but also work with our customers when it made sense in terms of getting the efficiencies on that back end. So I think it's a little bit more of a muted pull forward this year just by some of the nature of the dynamics that were out there.

And just as a reference point, you mentioned prior price increases. I mean, this price increase of 4% to 7% is probably on the lower end of what we've experienced over the last couple of years from price increase amount. And to Steve's point, we expect and feel like I said, a little bit less of an impact than maybe some of the other previous price increases.

Our next question will be coming from the line of Scott Graham of Seaport Research Partners.

Chuck, congratulations on a great run. Thank you for being so easy to work with, and Carrie, welcome aboard. I have sort of a similar question to Nathan. Is there any way to size the dollars on the prebuy? What was pulled into the second quarter from the third quarter?

And then secondarily, could you talk about some of the competitive and maybe more promotional activity you're seeing in the wholesale channel because we kind of know what they are all about and not a reduction in foot traffic in all of this? And within that, maybe discuss you have a new -- another new competitor, and I know it's not a big overlap with you, but the dynamics of what they're doing in that channel.

I'll take the first part on question on the size of the revalue. We generally don't sign that, but I think within my prepared remarks, we did want to make sure that we gave you a little bit more commentary around the phasing of the year because there was some pull forward demand in the third quarter into the second quarter. So I think my comments around the shape of the second half was specifically those comments on the third quarter can help you kind of think through that in terms of thinking through the dynamics in the third quarter, inclusive of some higher steel costs that we expect in the half -- in the second half of the year, tariff dynamics as well as the pricing that we expect to have full traction in the back half of the quarter.

And I would just supplement that with -- if you look at how we're -- we have the industry laid out for the year, this year, we're saying 51% in the first half, 49% in the back half. Prior 2 years, we're closer to 52% to 53% in the front half. So we do expect to have less of an impact than what we've seen in other price increase pull forward.

Your question around kind of wholesale dynamics, we've talked about some of the things that are putting pressure on the wholesale market. There's a couple of players that I think look to serve that market, and it's a competitive environment. And even more so when you don't have kind of meaningful growth that helps all the players sort of kind of move forward. So yes, it's a competitive space. I do think, though, I go back to -- as it relates to new entrants and people trying to get into that space, it's difficult to do because you really have to have full conviction, I think, to serve the wholesale market well. You need to have the full breadth of the product portfolio, be able to circle the replacement market as well as the new construction demand.

You've got to be able to support it with obviously high-quality products at scale. You've got to be able to have the relationships and the brands to reach the contractors and that they know you're going to stand behind the products and it's the products that they're comfortable with and used to and you also have to have products that have the technology moving forward. And I think from that standpoint, that's how we serve that market with conviction. And I think it has served us well and especially served as well as new people try to get into that space. It's difficult to do without that full level of conviction in the full business model.

Next question is coming from the line of Tomo Sano of JPMorgan.

This is Brendan on for Tomo. So if I could just start on your product portfolio. As we think about the ongoing evolution of your product portfolio, which product categories or technologies are your top priorities for incremental R&D investment? And then specifically, what kind of milestones should we watch for progress there?

Well, as we've been talking about, certainly here in North America, in the water heater and the boiler space, we've been making big investments to expand our portfolio in the tankless segment as well as with heat pump technology. We believe those technologies have a relevant position in the future for how the water heating and the boiler space will evolve. So we've been making over many years now, investments there to kind of complement the strength of our more traditional tank portfolio. And we're really happy with the progress we've made in terms of the performance, the technical steps forward and how we roll those out into the marketplace and how they've been accepted in the marketplace. So I think those are areas that I think on the tankless side, we'll see how it has to play out with new construction on the heat pump side, obviously, still very much connected to regulatory and rebate actions, but we do believe that those are technologies relevant for our future.

Water treatment is a space where I think there's more innovation happening and lots of awareness happening around water treatment in North America and then how do you serve that awareness with the right types of technologies in the marketplace. That's an area that we've got to date.

An increased focus on innovation as we go forward because we think it's a market space that is right for more innovative products.

I'd say as you think about outside North America in our markets in China and India, those are real, I'd say, innovation juggernauts. The pace of change and innovation in those markets requires us to move at an incredibly high pace and they evolve and consumer tastes evolve pretty quickly there. So that's a little bit really embedded in our DNA of how we bring new products to those consumers.

Great. And then if I can get 1 more here. So you've highlighted deploying AI tools across order management, warranty processing, technical service, just sort of thinking how you're thinking about the scale and timeline of productivity benefits from those initiatives. Is this primarily a cost story, a customer experience story, both? And how does that kind of fit within the broader margin improvement framework?

Yes. I mean, I think like a lot of companies now where there's AI kind of experiences and experimentation happening all across the company. Some of it is just more in general productivity gains and how all employees everywhere kind of bring it into their lives and bring it into their professional careers. And then, there's more targeted kind of AI use cases that we're developing, and you mentioned a few of them. And I think, we see the reality is having a meaningful impact on both things like customer variance and our productivity. .

It takes time a little bit to kind of build up the -- first of all, get the data structured and oriented and build up the models to really drive those programs. So we do feel like it's still early to kind of really size that for folks, but we're learning really quickly, right? It's just as you think about how quickly AI is learning, and I think our use cases of AI is evolving very quickly. And so it is 1 of those things that I think you expect we'll all be talking about more and more as we go forward and as we step into the next few quarters and years about how we are putting to work those types of models. But I do see it playing out very much in serving our customers better and doing it much more efficient, more productive ways.

[Operator Instructions] Next question is coming from the line of Jeff Hammond of KeyBanc Capital Markets.

This is Mitch Moore on for Jeff. Just on the China decision, it sounds like you're getting close, look forward to the update next quarter. But if you look at the spectrum of potential outcomes, any chance you could give us any color on which direction you're leaning?

Yes. I mean all outcomes are still on the table, Mitch. And we've been at this process for almost a year. We've had a lot of great conversations with a lot of different potential parties. We've learned a lot about our business and the potential levers we can pull. And I think we're actually getting pretty good clarity of what we think we need to do to kind of position the business for success going forward, whether that's done in a structure where somebody else leads those changes and pull those levers or whether we do it in a partnership or whether we do it ourselves, I think all those options at this point are still on the table. And I think that's part of the clarity we'll look to provide by our next earnings call is exactly how we're going to move forward there. .

And that clarity, I know we owe it to you and our investors, but also our customers and our employees. Obviously, as we've gone through this assessment, there's a lot of uncertainty there. And so we recognize the need to kind of move forward and step forward and drive some of the changes that we think that are needed for the business. And like I said, how we do that or how somebody else moves forward to that is what we're trying to finalize.

I appreciate the color there. And then just a cleanup question. I think you mentioned the refunds were minimal in the quarter. Could you just quantify that? And do you anticipate any more in the second half?

Yes, I'll take that question. I mean, I think just as a reminder, we are primarily a domestic manufacturer. So a significant portion of our tariff exposure is in direct. Those tariff costs pass through to us supplier price increases. And as Chuck mentioned, in Q2, we did receive some refunds related to the EPA tariffs in the cases where advancement was the importer of record. However, the amount in the quarter was not material, I would say, about $0.01, but recognize that the tariff environment remains fairly fluid, including the recently announced tariffs. So if I step back a bit more broadly, overall tariffs, including tariff refunds, we aren't expecting to have a material impact on earnings or margins for the full year. And we just continue to monitor that evolving environment.

Our next question is coming from the line of David McGregor of Longbow Research.

This is Joe Nolan on for David. I just wanted to follow up on the tariff comments right there. I think it was mentioned in the prepared remarks that you'd be a slightly higher impact from tariffs. Could you just quantify the impact to the second half from higher tariffs?

Yes. We didn't quantify that. I think, again, when you think about the Section 301 tariffs replacing the Section 122 tariffs, as you think about how that was described, it would be a slightly higher headwind there. But I think our intent is to try to continue to manage those costs, like we're managing all of our different material cost inflation headwind in the back half of the year. So at this point, we didn't quantify that other than to say we're working through those changes and obviously believe that there will be a modest cost increase. But at this point, our plan is to continue to mitigate and manage best we can.

I would say we're getting pretty good at navigating tariff uncertainty, reactions, understand our supply base. So there's a lot of levers we can pull to sort of to navigate through that. And I'd also say anything you can count on going forward on tariffs, right, I think it's just going to be a continued evolving landscape. So I think all companies sort of have to get really good at just responding to those changes. And I think we're getting better at that.

Got it. That's helpful. And then I just wanted to circle back on pricing. I was just wondering, in a softer demand environment, are you seeing higher price elasticity on the recent price increases relative to increases over recent years?

Not, I would say no. In a softer environment, consumers are not really focused on the end price when they put in the water heater. So from a price elasticity, we're not seeing consumer push back. When you do have a situation, though, when you have volumes down and Steve mentioned earlier, some of the challenges in the wholesale channel, the wholesale channel, as a reminder, is a large part of warehousing gets pulled through is the housing side. And certainly, it's a competitive environment. But we wouldn't say price elasticity plays out directly.

Next question is coming from the line of Ryan Connors of Northcoast Research.

Congrats, Chuck, and welcome, Carrie. I wanted to -- you've covered a lot of ground here. I appreciate you fitting me in, but you talked about dating ourselves. One thing I can -- I've been around the story long enough to remember that next week is the 10-year anniversary of closing on Aquasana, which was really the platform creation of the water treatment business in North America. And obviously, I don't think it's quite reached the critical scale we would have thought at this point. So I guess as you go through the restructuring, can you just update us on your strategic thinking there? I mean, are we at a point where that's going to start moving the needle in the next few years? Or at some point, do you have to make a strategic decision that it's just not reaching that scale? And what's holding it back from doing that? Just curious if you could step back from the tactical restructuring talk and just address that business from a strategic context relative to where expectations would have been than it was today?

I'd say when we decided 10 years ago to step into the water treatment space, a lot of work was done to understand the landscape, understand the megatrends, Trying to understand where the world was going around interest and understanding of water cleanliness, how regulatory frameworks were going to impact that. So we view it as an attractive space. And we knew we needed to get inorganically into it so that we can get a collection of people and businesses that really understood the space well. And as you mentioned, Aquasana was kind of the initial entry into this. And we bought a number of businesses since then, really high-quality assets that have served that water treatment space well for a number of years.

And I think as we've gone through that journey and as we put these businesses together, we ourselves have learned a lot about the market space and learned about kind of what the different elements of the market, the different channels, the different products. And I think what we -- what you see now is putting that learning to work, right? So what did we learn along the way? And then, what does it mean for us in terms of how A.O. Smith can participate and create value going forward?

And sure, we have every aspiration to make the business more scale, more profitable and a bigger contributor to our portfolio, and that's some of the actions we're taking now are related to trying to position the business to do that going forward. Obviously, as you sort of refine and you focus and you prioritize, it can take a step back in terms of just sort of the growth profile and you do that. And we've got to focus on really fine-tuning where we want to compete and win that will help us, I think, drive more profitable growth going forward, and we've been taking some of those actions. And I think we still see it as a really attractive space. And I think now we see it as a really active space with I think even greater clarity having been a participant in it for the last decade about where it is we can go and where we think our business model could create on.

Got it. That's a very helpful update. I appreciate that. And then secondly, you talked a lot about the shifts in the wholesale channel. The 1 thing in particular, we hear a lot about is some of your channel partners talk about this dual trade evolution where HVAC and plumbing being melted into one. Can you talk about how that impacts A. O. Smith? Is that an opportunity? Is that a risk? And how you view that? And whether that's part of the shift that you talk about in wholesale?

When I talk about shift in wholesale, it's a little bit more, I'd say, kind of near-term dynamics related to kind of housing starts and how they're serving the pros and how the retail side of the channel serving the pros. So that's a little bit more of kind of what we're seeing right here and now. I think that the topic you're talking about is how are the trades coming together with the HVAC world, what does that mean for the wholesalers who serve those spaces, what does that mean for OEMs, manufacturers. I think that's a longer-term trend. And I'd say it's 1 we follow closely, and we have a lot of conversations across our industry and the HVAC industry about those changes and what does it mean.

Right now, at the end of the day, you can have -- you have plumbers and you have HVAC technicians. They're very different people. There's different skill sets. The replacement cycles are different. That converging isn't necessarily driving big impact for how people want to interact with their water heater OEMs.

Now, over time, I think it does create opportunities. It's 1 thing we need to watch carefully. It does consumers and does do trades folks shift the way they think and operate. But it's 1 of those ones that because we're an industry leader, and we're a thought leader across the industry, we're very much actively involved in understanding how those dynamics are changing. But we view it as a bit of a longer term.

Our next question is coming from the line of Susan Maklari of Goldman Sachs.

I'm sorry, I missed you earlier. I want to start on the boiler outlook, which seems to imply that you expect a meaningful step down in the second half despite the pricing that you're getting there. I realized that there was some pull forward in that. But could you talk about the broader outlook there and your performance relative to that?

Yes. I mean, we're really pleased with our boiler performance in the first half of the year. If you recall, the first quarter was a little weaker on the commercial side, but we've built momentum and overall year-to-date being up 12% is a pretty healthy position. We haven't changed our outlook. We haven't changed our outlook for the full year, 6% to 8%. We are watching -- if you recall, a couple of years ago, there was more channel inventory built up on a price increase than perhaps what we've seen before.

And in our prepared remarks, we do have pre-buy programs that occur in the second quarter, somewhat fall into the third quarter, but largely in the second quarter. And so there will be some softness in the third quarter as a result of some of those prebuy and price increase pull forward that happened in Q2. So overall, though, commercial order and quoting remains healthy, and we're very pleased with how we're performing in the market on the residential side of the business.

Okay. That's helpful. And then you also mentioned that you're seeing inflation in areas outside of steel. Can you talk about that headwind, quantify it for us a bit? What's driving that and your ability to offset that pressure?

Yes. I mean when you look at our cost, right, so steel is the largest, and we really see Q4 steel taking a meaningful increase in our cost base, but the other factors that are out there are kind of well related, I would call them. So if you think about transportation, we've seen a meaningful amount of increase in our transportation costs due to diesel surcharges and just demand in transportation being a little more costly than what it has been in the past. And then also oil-based products, we have quite a bit of film that we put on our product and other plastics that are under pressure for some of the oil-based pricing -- costs that we see hitting us particularly driving up costs in the back half of the year.

Second part of the question was...

Ability to offset.

Offset. And I think Carrie covered that pretty well. I mean, we have pricing in the marketplace in Q3, but we will see some pressures on margins as we go through the back half of the year because the cost, particularly in the fourth quarter, are ramping up pretty quick.

Yes. But overall, I think we -- in my comments were -- to 1 of the questions was the price cost relationship fairly neutral in second half. So we'll continue to find ways to mitigate that. But I think there is some nuance in the phasing that to pick up in my prepared remarks that should help you kind of shape that back half of the year. .

One moment for the next question. Our next question is coming from the line of Amit Mehrotra of UBS.

This is Pratap on for Amit Mehrotra. So my first question is like looking at the North America, I think you mentioned third quarter margin is similar to the first quarter, and it seems second half could be similar to the first half as well. But when we take a look at the last 3 years, margins have been down in the second half compared to the first half. So can you walk us through some key drivers pressing there? And what makes it different from prior years?

Yes, it's a little different. And each of the last few years have been somewhat unique. So we've had somewhat of a volatile environment as far as pricing and timing of pricing. So some of the reasons last year, our volume was a little bit more under pressure. I mentioned earlier about at least the residential water heater industry being 51% in the front half, 49% in the back half. Prior years were a little bit more skewed towards the front half because of pricing. So that helps a bit even that out. So I think volume is a big part of that. .

Great. That's very helpful. And just a follow-up on the commercial water heater market that is like outflow is still flattish for the year. But can you give details on how it has been trending in the first half? And are there end markets doing better or worse? And additionally, like what would need to improve for growth to reaccelerate in this business, like other than the regulatory changes which got pushed forward?

The end markets on the commercial water heating side remains stable. We did -- we talked about it a bit on our last call is the 2026 commercial DOE efficiency change. We adjusted in our first quarter, our outlook on commercial because that was pushed out a year or the enforcement of that regulation was pushed out to 2027. So we probably saw a little bit more strength on commercial in the early part of the year before that announcement came out. And then since then, a little softness on commercial as there's probably some prebuy. But I think as we exit the second quarter, we're probably in a pretty neutral position for that change. .

And that concludes today's Q&A session. Now, I would like to turn the call back over to Helen for closing remarks. Please go ahead.

Thank you, everyone, for joining us today. 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 2 conferences this quarter: Seaport on August 18 and D.A. Davidson on September 24. Thank you, and enjoy the rest of your day.

This does conclude today's program. Thank you so much for joining. You may now disconnect.

Good day, and thank you for standing by. Welcome to the A. O. Smith Corporation First Quarter 2026 Earnings Conference Call.

[Operator Instructions]

Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Helen Gurholt. Please go ahead, ma'am.

Good morning, everyone, and 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 Steve Shafer, Chief Executive Officer; and Chuck Lauber, Chief Financial Officer.

In order to provide input transparency into our operating results for our business, we have provided non-GAAP measures. Free cash flow is defined as cash from operations plus capital expenditures. Adjusted earnings per share excludes the impact of 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 1 question and 1 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.aossmith.com. I will now turn the call over to Steve to begin our prepared remarks. Please turn to the next slide.

Thank you, Helen, and good morning, everyone. Before I discuss our first quarter results, I want to sincerely thank all A.O. Smith employees for their exceptional dedication and resilient during the first quarter. In particular, I would like to recognize our North American water heater team for their swift response to weather-related damage at 1 of our facilities as they acted to ensure the safety of their colleagues while at the same time, finding a way to recover from our production loss and continue to serve our customers well. I remain grateful for your dedication and teamwork, which continue to strengthen our company and our culture.

Now moving on to our first quarter 2026 financial performance. Please turn to Slide 4. North America sales increased 1% to $753 million and Rest of World sales decreased 11% to $201 million, resulting in total company first quarter sales of $946 million, a decrease of 2%. Our EPS was $0.85, a decrease of 11% due to lower volumes and transaction-related expenses recognized in the quarter for the Leonard Valve acquisition.

Despite these headwinds, diligent working capital management helped to drive strong free cash flow performance in the quarter. Our China sales decreased 17% in local currency in the first quarter, which was in line with our expectations as well as broader market performance. With the discontinuation of most government stimulus programs and continued low consumer confidence, the water heater and water treatment markets remain challenged, especially the premium portion of the market where we compete. We expect this softness to persist. We also believe that our ongoing strategic assessment has created some uncertainty in the market and has delayed certain investments, putting further pressure on our business.

We continue to make progress with our assessment and are moving with urgency to provide greater clarity on the future of -- the future of our customers and employees with the goal of defining a clear path forward in the coming months. Now I would like to share some additional color on our North America businesses. North America water heater sales decreased 2% year-over-year. Production and shipping constraints caused by adverse weather, most notably at our Ashland City, Tennessee facility, combined with softer-than-anticipated residential industry demand early in the year negatively impacted the quarter.

As we discussed on our January earnings call, the wholesale residential channel continues to face challenges, including a soft market in new construction and continued initiatives by retailers to expand into serving the professional. Despite these pressures, we are encouraged by the stabilization of our market share in the wholesale channel in the first quarter, while recognizing there's still work to be done with more improvement to come. Additionally, we are pleased with our share performance within the retail channel and the strength of our retail partnerships. Our strong market leadership and balanced presence across both channels provide us with clear visibility in the market trends supported by robust data, analytics and deep customer relationships.

I'm encouraged by the positive momentum we have going into the second quarter. Our North America boiler sales grew 2% compared to 2025 as residential boiler volume growth and carryover pricing benefit more than offset lower commercial volumes. North America water treatment sales increased 1% in the first quarter. 10% growth in our priority dealer channel was largely offset by softness in the specialty plumbing wholesale channel. A cautious consumer environment led to flat growth in our more consumer-facing channels with a general trend towards the trade down to lower-priced products. We expanded operating margin by almost 100 basis points despite the slower start to the year as we continue to work on improving the profitability of this platform.

Leonard Valve contributed $16 million to sales in the first quarter of 2026, led by strong performance in the valves business. We exited the quarter with a strong backlog and Leonard remains on track to achieve another year of double-digit growth. I'll now turn the call over to Chuck, who will provide more details on our first quarter performance.

Thank you, Steve, and good morning, everyone. Please turn to Slide 5. First, I'd like to highlight 2 items impacting the quarter. As Steve noted, we had weather-related headwinds in the quarter, including damage to a portion of our roof at our Ashland City manufacturing facility. Because of our team's swift response and our insurance coverage, we project minimal impact to our full year performance. However, we estimate that production and shipping constraints, offset by insurance coverage on direct costs negatively impacted our first quarter by approximately $0.04 per share. In addition, we acquired Leonard Valve on January 6, and as a result, recognized $0.03 of transaction-related expenses in corporate expense for the quarter. North America segment, first quarter sales of $753 million increased 1% against the top comp.

Carryover pricing benefits in Leonard Valve sales contributions were largely offset by lower residential water heater volumes and weather-related production and shipping constraints. North America segment earnings of $175 million and segment margin of 23.3% decreased by $10 million and 140 basis points, respectively, versus the prior year period. The lower segment earnings and segment margins were primarily the result of lower residential water heater volumes and more than offset the earnings contribution from Leonard Valve. Carryover pricing benefits more than offset cost inflation in the quarter.

The first quarter of 2025 benefited from pull forward demand ahead of an announced price increase and a stronger mix towards higher efficiency products.

Moving to Slide 6. Rest of the World segment sales of $201 million decreased 11% year-over-year due to continued weak consumer demand in China, driving lower sales, which was partially offset by favorable foreign currency exchange. Rest of the world first quarter 2026 segment earnings of $12 million and segment margin of 6.2%, decreased by $8 million and 250 basis points, respectively, versus the prior year period. The lower segment earnings and segment margin in 2026 were primarily due to lower sales volumes, which were partially offset by continued cost management in China.

Please turn to Slide 7. We generated strong free cash flow of $119 million in the first 3 months of 2026, a significant increase over 2025, primarily driven by diligent working capital management and the timing of customer payments that more than offset lower earnings. Our cash balance totaled $204 million at the end of March, and our net debt position was $412 million. Our leverage ratio was 24.7%, term loan used to acquire Leonard valve. We continue to have significant available capacity for future acquisitions.

Turning to Slide 8. In addition to returning capital to shareholders, we continue to drive organic growth through the development of innovative product offerings and productivity through operational excellence, 2 of our key strategic priorities. Earlier this month, our Board approved our next quarterly dividend of $0.36 per share. We repurchased approximately 700,000 shares of common stock in the first quarter for a total of $51 million.

We expect to repurchase $200 million of our shares during the full year 2026. Consistent with our focus on portfolio management, we continue to actively assess M&A opportunities that meet our strategic and financial criteria. Please turn to Slide 9 for our 2026 earnings guidance and outlook. Our revised 2026 outlook includes an adjusted EPS range of $3.70 to $4 per share. This excludes a relatively net cash neutral North America water treatment restructuring and impairment charge of approximately $20 million that we expect to recognize in the second quarter. Key assumptions within our outlook include: steel costs have steadily risen throughout the first quarter, leading us to increase our full year 2026 steel cost assumption to be a year-over-year increase of approximately 15% compared to 2025.

In addition, due to recent oil price volatility, our transportation and certain material cost assumptions have also increased since our previous guidance. We now project that freight, non-steel material costs and tariffs will increase our overall total company cost of goods sold by approximately 3% in 2026. Our guidance assumes oil prices and tariff levels will remain at a similar level to where they are today. We continue to monitor the situation. We maintain our estimate that CapEx 2026 will be between $70 million and $80 million.

We continue to expect strong free cash flow of between $525 million and $575 million, interest expense is projected to be between $30 million and $40 million, an increase over previous years due to the $470 million of additional debt incurred to acquire Leonard Valve. Corporate and other expenses are expected to be between $80 million and $85 million and includes $6 million of transaction expenses associated with the Leonard Valve acquisition recognized in the first quarter.

Our effective tax rate is estimated to be between 24% and 24.5%. And we project our outstanding diluted shares will be $138 million at the end of 2026. I'll now turn the call back over to Steve to expand on our key markets and our 2026 top line growth outlook for each business, staying on Slide 9. Steve?

Thank you, Chuck. Within North America, our top line outlook includes the following assumptions. While the residential water heater industry had a slower-than-expected start to the year, we maintain our view that full year 2026 industry shipments will be flat to down as softness in new construction persists and proactive replacement remains steady. Due to a recent statement from the Department of Energy indicating a 1-year enforcement delay of the October 6 commercial regulatory change, we revised our outlook and now expect less prebuy activity in the quarters leading up to the original transition date. We now project that U.S. commercial industry volumes will be similar to last year. In response to rising steel, freight, and other input cost inflation, we have announced price increases for most of our water heater and boiler products in North America, with increases varying by product, but ranging from approximately 4% to 7%.

We have seen some cost increases already leading into the second quarter, particularly within transportation. We expect to begin realizing the benefit of these announced price increases beginning in the third quarter. As always, we are maintaining ongoing communication with our suppliers, customers and stakeholders as we address current market challenges while also implementing diligent cost management strategies. We continue to project our North America boiler sales to grow between 6% to 8% in 2026 due to pricing benefits and a strengthening backlog in commercial and residential borders.

We have reduced our 2026 sales guidance for North America water treatment to growth of 5% to 6%. The decrease in our outlook reflects the impact of cautious consumer behavior in our consumer-facing channels, which is approximately half of our business, where we have experienced soft demand as well as a shift toward lower priced products. We are pleased with the progress of our priority dealer network expansion efforts and expect sales in that channel to achieve double-digit growth in 2026.

Our guidance at Leonard Valve will achieve double-digit growth and contribute approximately $70 million in sales in 2026 is unchanged. Integration efforts are on track, and we are pleased with the reception we are receiving as we explore ways to go to market together.

Moving to our Rest of the World outlook and assumptions. We have updated our full year guidance for China sales, which we now expect to be down low double digits in local currency compared to last year, with sales in Q2 down approximately 15% compared to Q1 as we balance channel inventories to the current environment. This revised guidance reflects our updated view of the China market where we expect persistent headwinds throughout the year due to continued low consumer demand severely limited government stimulus and ongoing competitive pressures.

We continue to advance our China assessment, evaluating strategic alternatives to strengthen our long-term competitive position. The valuation is providing valuable insights into both the advantages and challenges facing our business. Many actions we've identified to improve the performance of our China business are pending the conclusion of our assessment which is impacting our expected recovery time frame. We are looking to provide greater clarity within the next few months. We project our India business, inclusive of Pureit will have top line growth of approximately 10% and is unchanged.

Based on these 2026 assumptions, we expect total top line growth of approximately 2% to 4%. We expect our North America segment margin to be approximately 24% and Rest of World segment margins to be between 6% and 7%.

Please turn to Slide 10. This morning, I'd like to provide additional color on our operational excellence value creation opportunities. Our focus is to provide sustainable margin improvement in mid-cycle markets and protect our profitable growth in times of less market certainty.

Over many years, we have looked to drive continuous improvement throughout our operations with our AOS operating system. Today, we are building on that foundation with new tools and making more strategic moves to help prioritize around our strengths and drive improved profitability. The tool sets we are now bringing to our operations included enhanced ability for process intelligence and AI capabilities to drive better customer experiences at greater levels of productivity. Initial application examples include order management, warranty claims processing and technical service support, where we are identifying opportunities, developing process improvements and using AI agents to drive that improvement.

Still early days, but we are excited by the potential of what we see. The streamlining of our North America water treatment business is an example of focusing on our strengths to drive more profitable growth. As we announced this morning, we are taking actions to continue improving our profitability and accelerate long-term growth through footprint optimization and brand rationalization. These steps are part of our ongoing water treatment strategy evolution and allow us to further focus on the areas where we expect to be most competitive going forward.

We expect to recognize a restructuring charge of approximately $20 million in the second quarter and a projected annual savings of between $6 million and $8 million beginning in 2027. These exciting new tools that help us reimagine our operating processes and our continued strategic focus on prioritizing around our strengths are 2 ways in which we are bringing operational excellence to life at A.O. Smith. I look forward to sharing more details as this focus area for us matures going forward.

Moving to Slide 11. Our team responded well based with pressure in several of our key markets in the first quarter. I am pleased with the market share improvement we saw in residential water heating, the double-digit valve sales growth that Leonard Valve contributed to the quarter and the strong free cash flow achieved through diligent working capital management. With the strategic actions that we are taking, supported by our consistent operational discipline, I believe A. O. Smith will continue to strengthen its leadership position and be well equipped to capitalize on future opportunities.

With that, we conclude our prepared remarks, and we are now available for your questions.

[Operator Instructions]

And our first question will come from the line of Susan Maklari with Goldman Sachs.

My first question is on the channel inventories in residential. You mentioned that you did have some pull forward around the pricing that you announced. Can you talk a bit more about how much you're seeing in there and how you're thinking about the channel going to the second quarter and how we should think of the flow through in the next couple of quarters as a result of that?

Susan, this is Chuck. The reference that I made to pull forward in the first quarter was to last year. So we really haven't seen any pull forward in Q1 of 2026. It is kind of thinking about the quarters -- so by the way, the channel inventories, we think, are kind of in line with what we would expect coming out of the first quarter.

Okay. Okay. So you haven't seen anything from the pricing you announced this year yet?

Yes, not meaningful. The price increase that we have is effective mid-May roughly, so it's pretty early days.

Okay. All right. That's helpful. And then turning to commercial, you mentioned that, that regulatory change got pushed out for a year. Can you just give us more color on what drove that? And how you're thinking about the demand there now for the balance of this year and then even into next year, is the channel positions for that?

Sure, Susan. So the regulatory DOE commercial rule that was set to take effect in October of this year, that's been being challenged through the court system, and it's been held up so far through the court system, but it is pending and waiting to see if the Supreme Court will review it. So we don't know whether the Supreme Court will take on that challenge or not. But with the DOE issued late last week was because of that uncertainty around what would happen through the legal system and because we're obviously getting closer and closer to the October 6 date.

They issued, in essence, a letter that they would not be enforcing the rule until October of 2027. However, that might also change as things play out, both in the court system as well as how DOE thinks about the rule going forward. So that was new information as of last week. There's still a lot of uncertainty out there, both on the legal front as well as the DOE positioning, but it has us feel there was a more prudent thing to do to think that the industry may do less buy ahead because of that announcement.

Our next question will come from the line of Matt Summerville with D.A. Davidson.

A couple of questions. On the water treatment side of things, I guess I was under the impression that getting out of the retail big box channel was the reset sort of recipe for that business, and it sounds like you're initiating yet another reset in water treatment. Remind us how big that business is, and just help us understand a little bit more around how we should be thinking about that looking ahead.

Yes. The business -- the water treatment business is just over $250 million, roughly. I'd say last time we talked about a reset was the exiting of on-the-shelf retail, and I'll call that ingredient 1 of the reset. This is kind of the next step of focus, and it's really a step into focusing on leveraging our brands, focusing on our A.O. Smith brand more than some of the brands that we acquired and then rationalizing our manufacturing footprint. So think of it in terms of in 2026, we're looking to expand 200 basis points in our margins to move about 15% operating margins in North America water treatment. We would expect in 2027 with this next restructuring an incremental couple of hundred basis points. So think of it as just kind of the next step in moving that profitability up.

As a follow-up, if I think I heard you right, you expect your China business to now be down low double digits. How does that sort of sync up to what is actually happening in the market? Are you assuming you're losing share? I guess, how do you sort of justify the length of this review process with the potential that you're continuing to kind of lead share in that business because of how long that process is taken to unfold?

Yes. I mean, first off, regarding the market environment and our performance in it. In the first quarter, I think the whole market saw a lot of the challenges and many of the things that we highlighted in our prepared remarks around the stimulus is kind of run its course. Still, there's a low level of consumer confidence. So it was a challenging first quarter, I'd say, across the market, at least in the categories that we participate in. From the third-party data we track, we didn't lose a lot of share. I think we actually maintained our share in the first quarter, but it was certainly a down market condition. I think it is probably a driver to why the assessment is taking a bit longer than we had hoped. It's -- there's still a lot of really positive things coming out of the assessment for us and just as context I go back to -- we've done some third-party assessments on our business in China and our brand is just very strong. Our pricing power is very strong.

That has been sort of validated also with the partners that we're talking to. There's a lot of interest in the A.O. Smith business in terms of partnering with us. So it's been a process and an assessment that's had -- there's a lot of interest and lots of competition in terms of people who have thoughts and ideas of how they could work with us the strength in the business going forward. So that's all been very positive. But we are doing it in the backdrop of a very challenging market environment. And any time you're having those kinds of conversations, with partners, and we're all being challenged by the current context of the environment. It gets tough and it makes the length the dialogue take a little bit longer.

And I think that's what we're going through right now. But as I mentioned, we've been having these conversations now for quite some time. They're maturing, and I'm hoping that in the coming months, we'll be able to get clarity on our path forward.

Our next question comes from the line of Tomohiko Sano with JPMorgan.

We understand the guidance revision was mainly driven by external factors in China and North America. In this challenging environment, have you observed any changes in your market share across key regions?

Well, as I mentioned, in China, in the last few years, there's been some market share loss. But I'd say, as it is right now in Q1, we don't see any meaningful market share loss. We think we're kind of holding our own in a challenging market. Within the U.S., as we mentioned in the water heater side, we've stabilized our share position in the wholesale side of the channel. That was a big focus for us over the last quarter, and we're happy with the progress we've made there, but there's still more work to be done in terms of share. And then on the retail side, we're very pleased with the share position we have and the strength we have with our partnerships on the retail side. So at this point, nothing meaningful, but it's a big focus for us is to continue to maintain our share position in the markets where we [indiscernible].

And just a follow-up on the Leonard Valve. And how is the integration of the Leonard progressing in? Are you on track to realize the expected synergies?

Yes. We're very pleased with our first quarter in with Leonard Valve. We think it's a great fit with our portfolio, serves as the foundation for our water management strategy going forward. More work to be done there more broadly. But in terms of Leonard Valve and the integration, we think we're working well. We're on track with the plan that we have. Most of our opportunity we see as ways to go to market together. And that's been a big focus for us. And so we've been out talking to customers in the market, and it's been very well received. So we're pleased with the progress so far.

Our next question will come from the line of David MacGregor with Longbow Research.

This is Joe Nolan on for David. I just -- I just wanted to focus on the margin and price cost outlook over the remainder of the year. So just in the second quarter, you'll be feeling the impact of higher steel and freight costs, but it sounds like you're not expecting to get price benefit until 3Q. So could you just walk through your kind of margin cadence over the remaining quarters of the year?

Sure. I'm happy to do that. So we were happy with our price cost relationship in Q1. Pricing overcame the cost that we incurred, plus a little bit of margin. So we're walking into the second quarter in a good position for the costs that were behind us. However, we are seeing incremental cost in the second quarter. So we're seeing cost raise up on transportation, diesel fuels out. We've seen cost on steel continue to have, and we have the announced price increase. So the announced price increase would come into effect in the third quarter. So we're going to see a little pressure cost before we see pricing in the second quarter. We'll see a little pressure in the second quarter that will be overcome in the third and fourth quarter with the pricing that we expect to have in place. So we feel pretty comfortable with where we're positioned right now. And -- but we're watching costs closely, right? Because some of those costs related to oil, it seemed to be pretty persistent.

Got it. That's helpful. And then another one, just a clarification question. On the commercial water heater industry outlook coming down to flat now, is that really just a reflection of the regulatory change? Or is there any other moving pieces within that?

Yes. That's the biggest driver for the change in our outlook.

Our next question comes from the line of Mike Halloran with Baird.

Could you help put all this in context on how you expect the earnings to cadence through the year here? Obviously, the $0.03 from Leonard goes away, but maybe the price cost dynamics in 2Q, as you just referenced are a little less favorable, more favorable in the back half of the year, the timing around some of these other headwinds, demand dynamics? Do you get a catch-up in Q2 from the weather? Or how does that [indiscernible] in through the year? So I guess, could you just put it together and put the cadencing in line with maybe how it looks normally versus this year and any other nuances we should think about?

Sure. Happy to. Yes, there's a couple of moving parts and a couple of moving parts since our last guidance outlook, right? So let me start with China and start with maybe Steve's comments on China in Q2 being down. We believe it will be down roughly 15% from Q1 and think of that in terms of decremental margins, 35% to 40%. So we expect a difficult quarter in China. We expect that will come out of that quarter with a little bit better balancing of the inventories in the channel. The inventories in the channel are relatively the same as last year. It just -- we'd like to be a little bit leaner in this environment.

In North America, you're right, we have costs kind of ahead of us in the second quarter before we see pricing in the third quarter. So that's a bit of a headwind to the margin in the second quarter. We also -- on the DOE, so if you look at what we're thinking about for the regulatory change for the Department of Energy policy statement. Previously, we would have expected a meaningful amount of pull forward in Q2 and Q3. We just softened that a bit. We may have some, but we would not expect to have the same amount in Q2 and Q3 is what we had before. So that kind of level sets to a flat commercial volume year-over-year, and that cadence would be pretty similar to other years.

On the -- so I mean, when you kind of look at, Mike, on Q2, overall, Q2 EPS is expected to be roughly 25% of our full year guidance midpoint. That's with a little bit of help in Q2, I would say, from some pricing pull forward. So we do expect a solid performance in North America in the second quarter based on a little bit of pull forward. Our overall industry, we have pretty weak on the first quarter, but coming back decently in the second quarter with that price pull forward. The back half of the year, a little stronger on, I'll call it, the boiler part of the business. Third quarter is always stronger. And we have China, if you think about China as normal cadence, the fourth quarter is typically the strongest. So China had a fairly muted first quarter.

We're happy with the performance in China at 7% operating margins in Q1. But Q2 and Q3, we expect to be a little bit challenged and then bounce back a bit in Q4, like normal seasonality happens in China. So overall, a little stronger Q2 on the top line, some headwinds on cost, some real headwinds in China and a little bit more normalization in the back half.

And then a question on the pricing side of things. maybe a twofold question here. One, are you expecting any pull forward of demand ahead of the 4% to 7% price increases you're pushing through here? And then secondarily, how do you think the acceptance is going to go in the channel given some of the moving pieces that are happening in the water heater space in general right now?

Yes. I mean we'll see regarding kind of pull ahead, Mike. I think there's always a little bit of that, but we work closely with our customers. And as we've talked about in the past, we navigate through those transitions. We always look to serve our customers well as we go through the price changes and also look to make sure we're being smart around operationally, how we serve those transitions. So we'll see, but we'll stay close to our customers as we step through that in the second quarter. In terms of going forward, we'll see how the market plays out. I think ultimately at the end of the day, we remain committed to keep our customers competitive, and we'll continue to do that. But also we know we're in an environment of a lot of uncertainty and a lot of cost pressures.

Our next question will come from the line of Jeff Hammond with KeyBanc Capital Markets.

Maybe just to go at the guide a little bit different. It seems like you're just cutting EPS $0.15, but a lot of the macro assumptions are kind of moving the wrong way. Can you just talk about offsets to that? I mean I know you're now expecting some price, but any other offsets around restructuring savings or catch-up from this plant issue that would kind of mitigate the EPS impact?

Yes. We had a little bit of catch-up on the plant issues, not a lot, but that would help us a bit in the second quarter. I think if you kind of look at the year, really from last guidance, the big change was what we saw in China and then this Department of Energy Policy Statement. So other opportunities, the teams continue to look at cost management like we have in China and continue to do that in North America as we watch kind of the market mature throughout the rest of the year.

On the cost side, we're just going to have to really watch costs. I mean costs are pretty volatile right now with the oil -- with oil up in transportation. But that's probably the biggest driver that's keeping [indiscernible] cost.

I mean the cost control is sort of the near-term lever a little bit longer term, but obviously, the lever we're going to continue to look at pulling operational excellence, and I mentioned a little bit of some of the tools we're putting to work there. And I think the time frame of when that will kind of play out in terms of giving us some productivity space, it's still -- we're still trying to get our head around and understand. But I think that's another area where we're investing significant time and focus is to figure out how do we get our operations even more productive with some of those tool sets.

Okay. Great. And then just on, I guess, competitive dynamics between wholesale, retail and kind of this price increase. One, have you seen the other players in the water heater space are now similar pricing around steel, fuel inflation. And just any kind of changes you're seeing in that wholesale channel, which has been pretty competitive.

Yes. I mean we won't comment on competitor pricing. But we kind of look backwards on our historical performance and how successful we've been to offset costs. So we feel good about our positioning and point the history on that, our ability to be able to cover cost over time. It remains a competitive environment. We would expect our -- the whole industry to be experiencing very similar cost inputs. And as Steve said a little earlier, our commitment is to make sure we keep our customers competitive.

Our next question will come from the line of Nathan Jones with Stifel.

This is Adam Farley on for Nathan. Following up on the commercial water [ heating regulatory ] impact, does that change how you guys are planning to ramp capacity for that commercial water heating change? And then maybe more broadly, just update us on capacity plans for this year and into next year.

Well, we were prepared for the transition from a capacity standpoint and we made a bit of the investments to get ready for that. And I think at this point, if the demand is pushed out and customers delay their orders, and in fact, the regulatory rule goes into effect later, we'll be ready with those investments that most -- many of them made and some of them were still in front of us, and we're delaying until we have the certainty of the need for the demand.

Okay. Fair enough. And then maybe on tariffs, was there any incremental change to the gross tariff impact is the recent changes to some of the rules? And then what does maybe contemplate any guide on tariffs?

Yes. I mean we saw some relief on the IEPA tariffs and then other tariffs came in. So I mean, overall, kind of the tariff outlook, maybe a little net neutral, maybe a little favorable, but then kind of overshadowed by some of these other costs that we see in front of us related to oil. Diesel fuel going up transportation. We've seen steel be very resilient. So net-net, it's just a bit of a headwind on our costs, and that's why we have pricing out there.

Our next question comes from the line of Andrew Kaplowitz with Citi.

This is Natalia on behalf of Andy Kaplowitz. First question, I'll start with, you have the outlook for boilers despite lowering expectations across most other product categories. Can you maybe just unpack what you're seeing in underlying demand. I know you mentioned earlier on the call, you're seeing strength in commercial and residential, but specifically, how much of that is volume is pricing.

Our growth for the year has a big price component into the carryover pricing from last year. I think Q1 was a little bit softer on commercial, which was we highlighted. But we see those orders coming up, and this is a typical seasonality, too, for that business. So we still remain confident in that 6% to 8% growth forecast. Commercial is the one that I think is -- we see from the order book is catching up, but price is still a big component of that growth guidance.

Got it. That's helpful color. And then my second question. As you think about capital deployment, how are you viewing the current M&A pipeline, particularly in terms of opportunities within your core business for adjacency areas?

Yes. I mean there are a few opportunities to strengthen our core as it relates to M&A, but there's also a lot of organic investment we do to make sure we maintain our leadership position there. I think getting scale and profitability in our water treatment platform, that's been a big focus for us on the M&A side over the last 7, 8 years, and there's still a few opportunities for us to strengthen that business through M&A. And then a big focus for us is on the water management platform. And Leonard Valve was a business that we closed on in January that we put into that category, and we think that's probably the richest area for us from an M&A standpoint is how do we build out and expand in that water management category.

And I'm showing no further questions, and I would like to hand the conference back over to Helen Gurholt for closing remarks.

Thank you for joining us today. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join us at 4 conferences this quarter: Oppenheimer on May 5, KeyBanc on May 27, Stifel on June 2 and Wells Fargo on June 9. Thank you, and enjoy the rest of your day.

This concludes today's conference call. Thank you for participating, and you may now disconnect. Everyone, have a great day.

Hello, and thank you for standing by. Welcome to A.O. Smith Corporation Fourth Quarter 2025 Earnings Conference Call. [Operator Instructions] I would now like to hand the call over to Helen Gurholt, you may begin.

Good morning, everyone, and welcome to the A.O. Smith Full Year and Fourth Quarter Conference Call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Joining me today are Steve Shafer, Chief Executive Officer; and Chuck Lauber, Chief Financial Officer.

In order to provide improved transparency into the operating results of our business, we provided non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures. Adjusted earnings adjusted earnings per share and adjusted segment earnings exclude the impact of restructuring and impairment expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation 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 1 question and 1 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.aomith.com.

I will now turn the call over to Steve to begin our prepared remarks. Please turn to the next slide.

Thank you, Helen, and good morning, everyone. I want to take a moment to sincerely thank all of our employees for their outstanding dedication and hard work in 2025, allowing us to navigate a dynamic environment and deliver record EPS. Their commitment to serving our customers, adapting to new challenges and consistently delivering high-quality solutions is instrumental in our success. Each and every member of the A. O. Smith team plays a vital role in building trust with our customers and upholding the values that define A.O. Smith. I am truly grateful for your ongoing passion and collaboration that has me excited for our potential together in 2026 and beyond. Now moving on to our 2025 financial performance. Please turn to Slide 4. Our 2025 sales increased slightly as pricing benefits and higher commercial water heater and boiler volumes were offset by lower China sales. Our EPS increased 6% to a record $3.85 driven by profitability improvements in both segments.

North America segment margin improved 20 basis points over 2024 adjusted segment margin, led by profitability improvements in our water treatment business as well as mix benefits from higher commercial sales. In our Rest of World segment, benefits from our 2024 restructuring actions and other cost control measures in China resulted in margin expansion of 40 basis points, even with lower China sales. We returned $597 million of capital to shareholders with our dividends and share repurchases. In the fourth quarter, we announced the acquisition of Leonard Valve, which we completed earlier this month. This acquisition expands our water management market reach, digital capabilities and integrated product portfolio. I welcome the Leonard Valve team to the A. O. Smith family.

Now turning to our North America segment performance. North America water heater sales increased 1% in 2025 as cost and tariff-related pricing benefits and higher commercial volumes offset lower wholesale residential volumes. We project that full year 2025 residential industry unit volumes were roughly flat to 2024, and the commercial water heater industry volumes increased approximately 5%. We are pleased with our performance in the commercial market and retail residential channel. However, we faced some challenges in the wholesale residential channel in the fourth quarter. This part of this market is experiencing pressure from a new construction slowdown and continued initiatives by retailers to expand into serving the professional, which is leading to increased competitive intensity. The benefit for us as an industry leader is that we have a strong presence in both the retail and wholesale channels, and we have a good line of sight into how the market moves, backed by data, analytics and extensive customer relationships. We are actively working with select customers to address the specific geographies and product offerings that are under the most pressure to deliver better outcomes in the wholesale market in 2026.

Our North America boiler sales grew 8% compared to 2024 due to higher commercial and residential boiler volumes as well as pricing benefits. We are pleased with our 2025 boiler performance and the continued strong demand for our market-leading high-efficiency products. North America water treatment sales decreased 2% in 2025 as our strategic shift away from the on-the-shelf retail channel offset growth in our more profitable priority channels. Sales in our priority dealer, direct-to-consumer and e-commerce channels grew 10% in 2025. We also expanded operating margin by 400 basis points to almost 13% last year, which we expect to improve by an additional 200 basis points in 2026.

In China, full year third-party sales decreased 12% in local currency as a result of continued economic weakness and soft consumer demand, particularly in the second half of the year as government subsidy programs were discontinued. The restructuring actions we took in late 2024 and expense management drove profitability improvement of 130 basis points despite lower sales as the team executed well in a challenging environment. I'll now turn the call over to Chuck, who will provide more details on our full year and fourth quarter performance.

Thank you, Steve, and good morning, everyone. We delivered sales of $3.8 billion in 2025, a slight increase over last year. 2025 earnings were $3.85 per share compared with adjusted earnings of $3.73 per share in 2024. Turning to Slide 5, full year sales in the North America segment of $3 billion increased slightly compared to 2024. Pricing actions and the higher boiler and commercial water heater volumes were offset by lower volumes of residential wholesale water heaters. North America segment earnings of $728 million increased 2% compared with 2024 adjusted segment earnings. Segment margin was 24.4%, an increase of 20 basis points year-over-year. The higher segment earnings and segment margins were primarily driven by improved profitability of our water treatment business and higher commercial volumes.

Moving to Slide 6. Rest of the World segment sales of $880 million decreased 4% year-over-year primarily driven by lower sales in China that were partially offset by a 13% sales growth in our legacy India business and Pure sales of $54 million. Rest of the World segment earnings of $76 million were flat to 2024 adjusted segment earnings as the impact from lower sales in China was offset by the benefits from our 2024 restructuring actions and other cost saving measures. Segment operating margin was 8.7% and an increase of 40 basis points over 2024 adjusted segment margin.

Please turn to Slide 7. Turning to fourth quarter performance. We delivered sales of $913 million in the fourth quarter of 2025, flat to the same period in 2024. Earnings in the fourth quarter were $0.90 per share, a 6% increase over adjusted earnings of $0.85 per share in the fourth quarter of 2024.

Please turn to Slide 8. In Fourth quarter sales in the North America segment increased 3% to $714 million compared to the same period in 2024, primarily as a result of pricing benefits. North America segment earnings of $165 million increased 7% compared to 2024. Segment margin of 23.1% increased 70 basis points compared to last year's adjusted segment margin. The higher 2025 segment earnings and segment margin were primarily due to pricing benefits and actions taken to improve water treatment profitability, which were partially offset by higher input costs.

Moving to Slide 9. Fourth quarter Rest of the World segment sales of $206 million decreased 13% year-over-year, primarily driven by lower sales in China. Organic India sales grew 18% in local currency in 2025, and Pureit contributed $8 million to sales in the quarter. Rest of the World segment earnings and segment margin of $16 million and 7.8% and respectively, in 2025 compared to adjusted segment earnings and adjusted segment margin of $19 million and 8.1% in 2024. The lower segment earnings and segment margins compared to the prior period were primarily due to lower sales in China, partially offset by the benefits of our 2024 restructuring actions and other cost saving measures.

Please turn to Slide 10. We generated strong free cash flow of $546 million during 2025, a 15% increase over 2024, primarily driven by lower year-over-year capital investments as well as higher earnings and the benefit of a onetime tax adjustment. 2025 free cash flow conversion was 100%. Our cash balance totaled $193 million at the end of December, and our net cash position was $38 million. Our leverage ratio was 7.7% as measured by total debt to total capital. While our 2026 leverage will increase due to the cash we borrowed under a new credit agreement used to acquire Leonard Valve, we continue to have significant available capacity for future acquisitions.

Let's turn to Slide 11. In addition to returning capital to shareholders, we continue to drive organic growth through the development of innovative product offerings and continuous improvement in productivity, 2 of our key strategic priorities. Consistent with our portfolio management priority, we continue to actively assess opportunities that meet our strategic and financial criteria. Earlier this month, our Board approved our next quarterly dividend of $0.36 per share. We have increased our dividend for over 30 consecutive years. We repurchased approximately 5.9 million shares of common stock in 2025 for a total of $401 million. We continue our strong track record of delivering returns to shareholders. Over the last 2 years, we have returned almost $1.1 billion to shareholders through dividends and share repurchases.

Please turn to Slide 12 and our 2026 earnings guidance and outlook. Our 2026 outlook includes an expected EPS range of $3.85 and to $4.15 per share. The midpoint of our EPS range represents 4% growth over our 2025 EPS. Our outlook is based on a number of key assumptions, including within material costs, our guidance assumes that steel prices in the full year 2026 will increase approximately 10% compared to 2025. Other material and freight costs including the carryover impact of tariffs will also be a headwind in 2026. Our guidance assumes no change to the current tariff levels that are in effect today, but we continue to monitor the situation closely. We will continue to invest in our gas tankless offering. As a market leader, we believe that it's important for us to offer best-in-class product in this category. We project our year-over-year impact to our North America margins would be minimal as we continue to build a foundation in this category and gain scale over time. We estimate that 2026 CapEx will be between $70 million and $80 million. We project to generate a strong free cash flow of between $525 million and $575 million. Interest expense is projected to be between $30 million and $40 million, an increase over previous years due to the $470 million of additional debt incurred to acquire Leonard Valve.

Corporate and other expenses are expected to be approximately $80 million to $85 million and include advisory fees associated with the Leonard Valve acquisition. Our effective tax rate is estimated to be between 24% to 24.5%. Our Board has approved million additional shares of stock were repurchased and we expect to repurchase approximately $200 million of our stock in 2026. We project our outstanding diluted shares will be $138 million at the end of 2026. I'll now turn the call back over to Steve who will provide more color on our key markets and top line growth outlook for 2026 as well as the portfolio update staying all on Slide 12. Steve?

Thank you, Chuck. Our top line outlook includes the following assumptions. While we believe that U.S. new home construction remains in a deficit, we project that the softness in new construction will persist into 2026. We assume that proactive replacement remains steady and will be similar to 2025. Based on those factors, we project that 2026 U.S. residential industry unit volumes will be flat to down compared to 2025. Our current projection assumes U.S. commercial water heater industry volumes will increase mid-single digits in 2026 due to a buy ahead of lower efficiency non-condensing commercial gas products that are scheduled to be eliminated as part of the October 2026 commercial regulatory change. We assume that 2026 commercial electric industry volumes will be flat to 2025. In addition, our outlook includes carryover from our May 2025 price increases in North America. We project our North America boiler sales will grow between 6% to 8% in 2026 due to the carryover of pricing benefits and from the continuation of the transition of energy-efficient boilers particularly as commercial buildings look to improve their overall carbon footprint.

We expect North America water treatment sales will grow between 10% and 12% and due to tariff-related pricing benefits as we continue to grow faster than the market through the expansion of our dealer network. And turning to our outlook for China, we foresee continued headwinds in our markets due to continued low consumer confidence, a discontinued government subsidy program and ongoing competitive intensity. Because of these factors, we project that our 2026 China sales will decrease mid-single digits compared to last year. We expect the first half of 2026 to be particularly difficult as consumer demand remains subdued, and we will face comps from 2025 during which stimulus programs were in place. We anticipate a return to growth in the second half of the year.

We continue to manage our discretionary costs prudently in this environment. These decisive actions are designed to protect our profitability and strategically position the business to be competitive during an eventual recovery once market dynamics begin to improve. Our outlook excludes any potential outcomes of the ongoing China assessment. We project our India business, inclusive of Pureit, will have top line growth of approximately 10% as we continue to leverage brand synergies and introduce innovative new products to grow faster than the market. Based on these 2026 assumptions, we expect top line growth of approximately 2% to 5%. We expect our North America segment margin to be between 24% and 24.5% and and Rest of World segment margins to be between 8% and 9%.

Please turn to Slide 13. The 2025 was an exciting year of transition for A. O. Smith with several leadership changes, including myself. As I began my tenure as CEO last year, we announced 3 key strategic value creation levers that will guide A. O. Smith's path forward, portfolio management, innovation and operational excellence. These levers are fundamental to strengthening our industry leadership position, supporting our customers through a dynamic market environment and delivering long-term profitable growth. We will be providing periodic updates on each of these areas going forward. Today, we'll discuss portfolio management. Over the past year, we have been actively working to transform our portfolio to be better positioned for long-term profitable growth. We have been focused on looking at strategic options in our China assessment to better position our business there to be more competitive going forward and take advantage of the eventual market recovery. The assessment is ongoing, and I'm pleased with the quality of discussions we are having with a number of potential partners.

We are also continuing to evaluate opportunities to strengthen our core North American water heater and boiler business. Example of actions we have taken include our recent investments in gas tankless, heat pump and commercial condensing gas product development and manufacturing capacity. We continue to evaluate broader options for strengthening our leadership position in this space. We have also announced over the past year a number of actions to help scale and improve the profitability of our North American water treatment business. We have been learning much about the space through the acquisition of high-quality businesses we have used as the foundation of this platform. and have taken actions to prioritize the channels and further integrate the business to create more synergy and scale. These actions have allowed us to improve the profitability of this business by 400 basis points last year. and we believe additional opportunities are still in front of us to both continue expanding margins and returning the business to higher growth.

Finally, we have done work to evaluate expanding into the broader market of water management. This includes the broader ecosystem of moving, controlling and mixing water across the residential and commercial markets. These products, systems and solutions often interact with our water technology products that serve as our core business today. Leonard Valve and its portfolio of mixing valves and control units represents our first action expanding into this attractive market opportunity.

Please turn to Slide 14 as I share more details about our strategic rationale for this acquisition. Leonard Valve is well aligned with our strategic and financial criteria and is an excellent complement to our core water heater and boiler business. It enters us into the attractive water management market with a well-established premium Leonard and heat timer brands. Leonard's connected products, which represents approximately 30% of their sales and growing expand our digital platform and provide us capabilities to leverage going forward. By broadening and integrating our product offering, we will be able to create new and innovative solutions for our commercial and institutional customers. Along with entire growth profile, the business also has predictable demand with approximately 80% of the volume associated with repair and replacement. Leonard is also a strong cultural fit as a value-based company with deep market experience, a strong brand and reputation across the industry and many long-tenured and dedicated employees that have a passion for serving their customers and the market well. Simply put, they do business a lot like how A.O. Smith does misses, and I'm looking forward to what we can do together. We expect Leonard Valve to contribute approximately $70 million in sales in 2026.

In summary, we are further strengthening our portfolio to deliver greater value to our customers and other stakeholders. We also remain focused on leveraging operational excellence and innovation in addition to portfolio management to drive long-term sustainable growth for A. O. Smith. As we have discussed, while we had challenges to navigate in 2025, we also had meaningful achievements. Highlights include the demonstrated strength and resiliency of our commercial water heater and boiler business. Our leadership in these markets is well recognized and valued by our customers. The significant profit improvement driven by our prioritized approach in North American water treatment. We are now better positioned for long-term growth and profitability. The disciplined cost management actions in China as we look to reposition that business for a more competitive future. The continued double-digit growth of our India business, now complemented by the addition of Pureit to drive continued growth at an even greater scale.

And finally, the continued focus on making the necessary investments to ensure our bright future despite the challenging and uncertain market conditions. I am confident that the strategic actions we are taking today along with our continued disciplined operational approach will enable A. O. Smith to build on our leadership position become more agile and be better prepared to seize future opportunities. With that, we conclude our prepared remarks, and we are now available for your questions.

[Operator Instructions] Our first question comes from the line of Saree Boroditsky with Jefferies.

This is James on for Saree. I wanted to ask on the residential guidance here. Your outlook is calling for a flattish to down kind of industry volume here for 2026. And I think then this marks kind of third year. So flattish to decline in volumes which we haven't really seen for a while. So can you kind of provide me details on what is making this downturn or weaker is kind of more persistent? And can you provide more details on what you're kind of seeing in the market generally?

Yes. Thanks for the question. So just overall, as we look into 2026, there was really 3 components as we think about it, right? We have the emergency replacement, which is very resilient very reliable, very predictable, and we expect that to continue. We have proactive replacement, which we've talked about being fairly high the last 5 or 6 years. We feel like that's pretty resilient at this point. It's -- it's been out there for 5 years at above 30% of total replacement. And so we're expecting that to continue. Where we're seeing some headwind is kind of the new home completions, multifamily and single family. We see pressure on that as we go into next year. So yes, we've had a couple of years of flat volumes coming off some better growth years earlier that were a little lumpy due to COVID, but the pressure we're seeing next year is really in the new home construction, which we feel like without some stimulus with a lower interest rate or perhaps some velocity on new home sales is going to be a bit of pressure on our top line residential volumes.

Great. And I guess I wanted to ask a question on China. I think your guidance kind of implies like double-digit decline in first half and then return to growth here. What specific like indicators are kind of giving you confidence that it can kind of -- what is the return to growth in the second half?

Yes, some of it is we've got to work through a period where there was a lot of government subsidies that were driving some demand generation. So that's the challenge we're going to face in the first half of this year is we're now comping against that. The return to growth will be partly driven by as we move past that phase and we get back to the remodel wins and the refurbishments that still need to happen in China. And part of it is some of our own actions internally to get behind and focus and drive growth in certain areas.

Our next question comes from the line of Mike Halloran with Baird.

So can we first start on just the comments Steve you made about increased competitive intensity in the wholesale channel. Maybe just a little bit more context of 2 things, I suppose. One, what does it mean in terms of the price, share, et cetera, in that channel? And then secondarily, when you net the 2 together, with the strength you have on the retail side. How is that balancing out all else equal to give both the narrow view and the wholesale, but then draw it back to the -- how that's impacting the cumulative market.

Sure. I'll start by [indiscernible] I mentioned, we have meaningful share in both the retail and wholesale side. So from that standpoint, we participate when there's some movement between the 2. I'd say specific update on wholesale Mike, I mean, the dynamic of low new home construction, which we just talked about and the fact that retail has made some inroads in terms of share gains overall in the industry is just putting pressure on that part of the channel. And any time you've got kind of pressure that way, where there's limited growth or even there's some declines, it just makes it a more competitive environment. And -- from what we see right now, it's not really driven by a lot of kind of new entrants into the space. It is primarily the kind of the leaders that serve the wholesale channel today. And -- it's not new that there's dynamics playing out across the channel in terms of different partners and how that works. I would say a bit accelerated a bit in the last 6 months in particular just because of the pressure that's been in that market.

And I think as we look at it, and this is again another area where because we are such a large player in the space. We know all the industry participants. We know all the different distribution partners. We know where those pressures are the greatest, and that's really our focus going forward. So we obviously were happy with the gains we've made on the retail side and with our partners over there. We think we can do better on the wholesale side to serve that market, and that's where our focus is going to be here right now.

And then maybe just some help with the cadencing through 2026 cumulatively. You have a lot of moving pieces front half to back half. So any thoughts on how the earnings and revenue should cadence relative to normal seasonality? Any 1H, 2H dynamics that are worth mentioning? Any help would be appreciated.

Yes. So yes, as you look at 2026, Mike, it's going to look a little different than '24 and '25. Both those years, '24 and '25, on the residential side, in particular, on commercial water heating, we had price increases that pulled volume forward in the front half of the year. So '24 and '25 cadence on the residential within side was 53% in the front half, 47% in the back half. We look at 2026 and expect a much more normalized year maybe closer to 50-50 or 51-49. So there will be tough comps in the first half of the year, both compared to '25 and '24 on the water heating side. As you also step into next year, our 2026 input costs, we're looking at those very closely. Steel should be up -- is expected to be up about 10%. And as you know, we have pretty good visibility into that in our forward view of what our pricing is. We'll have carryover tariffs into the first half of the year and other costs are also causing a bit of headwind.

And then thinking about China, and we've talked a lot in the past about the cadence in China, as Steve said, a bit around -- we'll see pressure in the first half of the year because the subsidy program was in place. In 2025 this year beginning -- actually beginning midyear last year, it was discontinued, and that's why we saw weakness in the back half of this year. We expect that to continue into next year until there's some traction. We think there was some pull ahead into the marketplace and expect some of that traction to come back perhaps in the second quarter or midyear. As you know, the first quarter is always a challenge in China because of the Chinese festival New Year. We expect that to be a little bit more accentuated this year because of discontinued to the subsidy program. And then return to, I would say, in the back half of the year for China, kind of the normal a little bit better in the third quarter and your outlook expects it to be improved in the fourth quarter like it historically has been with some of the holiday shopping.

Our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets.

This is Mitch [indiscernible] on for Jeff. First, I was just wondering if you could give a bit more color on Leonard Valve, the go-to-market strategy, what end markets they play in? And maybe how much growth the $70 million in sales you're expecting this year, like what growth rate that reflects.

Yes. In terms of markets, they're very strong in kind of the commercial markets, which was appealing to us. they serve in some ways, like with their -- the heat timer controls business, it's very much a spec-in driven business, very similar to like our lock-in-wire business. In fact, we show up on a lot of the same spec sheets together. So there's a similar go-to-market model that way. And there's just overlap in a lot of the channels, both in the representatives to take our products to market and in distribution as well. So it's close to our categories in that way. And then on the actual way the product is used, it interacts in an ecosystem similar to our product. So it's down in the mechanicals, where our products are often found, and I think that similar trades and contractors operate with the product. So from that standpoint, it's a very close adjacency in terms of product expansion. And I think it's what got us excited strategically that there's both ways we can work together and serve the market better and how we go to market, but also ways in which we can innovate and find ways that our products get interface and create better solutions for our customers.

As far as growth rate, the business has been growing double digits. So in that 10% range, it's kind of baked into how we think about the growth rate, largely driven by the digital portion of the market that they serve.

Great. That's helpful. And I know there's a lot of moving pieces around price cost, just with tariffs and lapping price increases and whatnot. But can you maybe just give some thoughts about how you expect price cost to trend through the year?

Yes. I mean, Steve had comments around the competitive nature of what's happening in the marketplace today. We certainly -- we also commented that we have carryover pricing that we expect to carryover in the next year. And historically, and I'll say we do a really good job of protecting our price cost relationship. So we do expect that to continue over time. Also historically, we generally see some fade we'll be watching that closely. I'll just kind of say that we're very committed to making sure in the competitive environment that we keep our customers competitive, and we'll be focused on that.

Our next question comes from the line of Bryan Blair with Oppenheimer.

It would be great to -- I guess following up on Leonard Valve, great to hear a bit more about the build-out and prospects of your water management platform. I guess, how we think about TAM expansion given the new products and applications that are involved there or potential there? And in what way is LVC foundational to the buildout? And again, given the right opportunities, how aggressive would your team like to be on incremental M&A?

We're excited about the way we're defining kind of the water management market. As I mentioned, it's kind of thinking about how does water move, mix, get controlled through the ecosystem of residential and commercial, we play an important part in that today with the categories of our water heaters and boilers. And I think there's a lot of other products that help make that happen. And so we're still early in our journey of kind of shaping up where the right places are for us to participate. So your question around TAM, I think what we're excited about, that it does open us up to bigger market opportunities. We've got what we think is an exciting and healthy pipeline of where we could go to do that. Obviously, when it comes to acquisition, there's a lot of things that have to come together to make that work, but we think our reputation in the industry helps us because we're a good spot for good high-quality companies to kind of come together around in how we serve the market. And I think there will be a near-term opportunities as we think about how we go together into the marketplace, provide these products that are well established categories today.

And then longer term, I think it creates more growth for us because it allows us new ways to create value for our customers. Today, we do that in a meaningful way by driving more efficiency and performance in the water heater and boiler products that we serve the market. But if you think about how commercial customers use our products and are thinking about things like energy efficiency more broadly, having a way to serve the market with an ecosystem, I think is a way to create more value.

Okay. That makes a lot of sense. And you noted the strategic assessment of China is ongoing. So there isn't a definitive update, but you did mention a number of potential partners just curious if you could offer any other color on direction or whether options or considerations have narrowed and whether there's any connection to any of the incremental turnaround actions that are underway there.

Yes. I'd say we're moving with urgency because we know when we talk about an assessment of the business, right, we're still running the business, and we have employees and customers that we want to provide some confidence and certainty too. But I would say, while we do that with urgency, we're also being thoughtful to do it in the right way. And our goal, again, is to make sure that we set the business up to be as competitive as possible going forward. I can't get into the specifics of the folks that we're necessarily working with. But we are learning, I think a lot about other options out there on what we can pursue. I think as I mentioned, the quality of the conversations have been terrific. Our local team in China has been very active and involved in that to make sure we're thinking about things the right way. And we'll continue to move that forward, and we'll continue to update you guys as we learn more. But at this point, we don't have anything in terms of how we've narrowed the scope in terms of what potential options and outcomes could come from it. But I'm pretty happy that we're -- the process itself has been very helpful for us.

Our next question comes from the line of David McGregor with Longbow Research.

I guess I want to start by talking about -- I wanted to begin by asking about the water treatment business. You called out the 400 basis points of margin improvement in 2025, which is quite an accomplishment. And maybe you could maybe talk a little further about just sort of the composition of that improvement. And I guess, as well, just where now in terms of where those margins go? And at one point, I think the goal had been to grow those margins at about 100 basis points a year through a variety of different initiatives. And how are you thinking now about kind of multiyear annual profitability growth in that business?

Yes. We like the space. And for A.O. Smith, we entered in it years ago because we understood the megatrends, and we felt like there was a lot we could bring into the space in terms of how we run our businesses. To kind of build the platform, we made a number of acquisitions. And I think what we've done recently is we've now taken kind of a state of what have we learned through the businesses that we bought and through running the businesses, and that helped define for us a little bit of our journey in our path going forward. And as we've been talking about for the last year or so, part of it was prioritizing which part of the market we wanted to really focus on and invest in. And that's been obviously a little bit of a growth drag for the business as we've decided to deprioritize some things. The end of 2024, we took some restructuring charges to help reorient that business. And now I think -- what we're excited about is that we know the spaces in the market where we really want to focus and play, and that's helping us drive a more profitable part of the business, also the growth in the spaces where we want to play, we're very pleased with.

And then also along with that, it's the natural path of just sort of learning how to kind of integrate the businesses, take advantage of levers you can pull to create value by doing that. And that, I think, is a journey we're still on. And -- going forward, I think -- like I said, I think we're focused on where we want to play. We think we can continue to really add value into the water treatment market. We're excited about where this business can go. We're still very excited about the market opportunity overall. And we think we can continue, as I've mentioned in my prepared comments, to drive meaningful growth with this business as well as continue to expand margins as we scale and as we continue to pull levers on integrating the business.

Can you offer any sort of thought on where those margins might be today versus sort of the North American segment averages? And then I have a follow-up.

Yes. I mean so the margins today at 400 expansion of basis points kind of takes you into the ZIP code of about 13% operating margins. And you know our North America margins at 24.4% this year. So expanding it to another 200 basis points because it's a 15% margins. And we like the fact that we're kind of back to that mid-teens digits and looking for opportunities for M&A to match with the business to continue to grow the business and maybe have opportunities to enhance that margin profile through an M&A transaction.

Great. Congratulations on that progress. As a follow-up, I guess, I just wanted to stay close to the water treatment business and just ask for any thoughts you've got and what you're seeing in the way of consumer demand patterns and how that may be evolving and how that's influencing your guide on '26 -- for water treatment.

Yes. I think overall, that business is closely connected to the consumer. So there's I'd say some caution that we see from consumers. In some segments of the market, we considered a discretionary spend item. So we're -- from that standpoint, I think there's maybe cautiousness as we enter 2026. But overall, we still see it as growth because we see the category is still growing. We still see penetration opportunities, and we still see our opportunity to build out our own dealer network and grow even beyond the market.

Our next question comes from the line of Scott Graham with Seaport Research Partners.

I wanted to maybe get a little bit more color from you guys on maybe beyond what you provided with the initial question on this competition in distribution wholesale. And what I'm wondering is, are you kind of saying that like residential water heaters in that channel are now kind of more jump ball? Or is it that maybe some of the higher-end stuff because of the PROs that is what is maybe under a little bit of pressure. Is it -- so in other words, if wholesale is half of residential approximately, is that entire half an area of concern now? Or is it less?

No, I don't think the characterization of a jump ball is what's happening. I would characterize it more of a lot of the industry dynamics that have always been out there, right? And you have channel partners that are dedicated to certain brands, and we partner very closely with them to help reach and serve the contractors and trade groups well and then there's others that carry multiple brands and there's some share shift that happens through those dynamics. I would say that those are the dynamics they've always been in that part of the market. There's still the dynamics playing out today. What we find is oftentimes, when there are movements around share there's typically reactions to those movements and those take time to play out. And I think where we are right now in the wholesale market, like I said, it gets a little bit more intense when the market itself is not growing because the new construction builds aren't there, that the wholesale channel primarily is the mechanism that serves that part of the market. There's a little bit of pressure, as we mentioned, coming from the retail players who are really looking to make inroads with the professionals. So that intensity up a little bit, but the dynamics itself are not new.

And I'd say they're ones that we typically know how to navigate. And we do it working closely with our customers. And like I said, there are actions and movements that happen there's typically reactions. And over time, those things work their way out, and that's our focus of what we're going to navigate here when we talk about the start of 2026.

Okay. I want to maybe just ask a follow-up question on capital. And with the Leonard Valve acquisitions, it's clearly more of a pivot to Stephen, what you said about water management. And so what I'm wondering here is that with this pivot, and I know you found Leonard Valve, and that's wonderful. But for many years, the focus was on water treatment pretty much as a silo. And I'm just wondering how the pipeline is in water management with Leonard now done? Is that something that you have to build? Or have you been building a pipeline there?

I think it's a pipeline that's been pretty visible for us for a while. I mean I think when you're in kind of the plumbing space, you know who the players are. Like I said, there's a lot of overlap on how you go to market. There's a lot of overlap in terms of how you serve contractors. So it's not a starting from scratch kind of pipeline. I think that's been visible to us. I think the focus and attention we're putting on it is now kind of dialed up because there's a lot of different options of ways we could go. As you mentioned, we've been very focused on building out the water treatment platform. And this is a pivot that's not us walking away from water treatment. In fact, we think that's a very attractive growth platform that we're going to continue to invest in. But we do feel like there's more opportunity for us as a company. And we love our core water heater and boiler business today. It generates great cash flow. It's very resilient.

We're a market leader in that space. And we want to think about how do we leverage that to actually find more growth opportunities that we participate. That's what we're trying to do with our water management effort. I think we know who the players are out there. But as I mentioned, with any acquisition strategy, there's a lot dependent upon what's available and when. And I think we can be competitive there. We're also going to remain disciplined in our approach on how we go after it.

Our next question comes from the line of Tomohiko Sano with JPMorgan.

This is Ethan on for Tomo. I wanted to ask for a little bit more color on India. It seems like the guys have delivered strong growth with the Pure integration adding incremental revenue. Can you share a little bit on the road map for scaling India over the next 3 to 5 years? And maybe any details on potentially further M&A within that area?

I think right now, our primary focus is on how do we take advantage of the Pureit addition to our portfolio. India is a market that we've invested there significantly to get the business up and running and Obviously, the pure was an additional investment to that business. We've got a local team there that really understands the local market -- and we think we've got a lot of opportunities now kind of organically, if you will, with the combination of Pureit and A.O. Smith business. It's a market that requires a lot of high pace innovation, bringing new products out to market. That's a big driver of how we've been able to grow double digits for many years in a row. And that's we're now going to do at a bigger scale, as you mentioned. So that's our primary focus. Ultimately, over time, does it mean more acquisitions or not, I think that still has to play out, but our focus right now is primarily running the business we've got.

And looking more on the margin side for international, with India continue to scale up, can we kind of forecast out strength within operational improvements similar to this year out into maybe 2027 or looking more on a longer-term scale with China potentially improving in the second half of this year?

Yes, this is Chuck. I would say a little bit more longer term still. I mean we're still investing in growth in India. We love the fact we're growing double digits together with Pureit bringing those business together, India is still in the growth profile. China, I think it's a little early to call out much margin improvement. We're very pleased with how China performed this year in the fourth quarter, particularly the restructuring actions that we took in 2024 are paying off and the team managing through a tough top line did a very good job of managing the margin. So margin improvement in both businesses, I think, will take a little bit of time, and we'll have to see how that plays out. particularly the economy in China and as we grow scale and India investment growth.

Our next question comes from the line of Nathan Jones with Stifel.

One follow-up on steel prices. You guys said you're expecting steel prices to be up 10%. Can you just clarify what that means? Is that like average 2026 over average 2025? Or are you expecting steel prices to increase from where they are now? And then does that imply that you need to get more price in order to cover some of these inflationary pressures, along with some of the other things that you mentioned there are still inflationary pressures.

Yes. Steel pricing has gone up, right? So we've seen kind of a gradual increase in the index, which does drive what we pay on a 90- to 120-day lag. That 10% up is the year-over-year average I would say if you kind of box it in, it's 10%, 2026 over 2025 as well as 10% up quarter-over-quarter 2025. So we'll see steel, we project still to still rise a bit as we go through the back half of the year, but on average, up 10% year-over-year. As far as price cost relationship, we do have carryover tariffs. We've got other costs that are going up. I'll just kind of point to kind of our historical ability to be able to, over time, kind of maintain and protect our price cost relationship and our margin profile.

Okay. I guess. And then my follow-up question. The slide on Leonard Valve as 2022 to 2025 revenue CAGR of double digits, I think you said it was about 10%. There was a lot of inflation, and I assume that there's a lot of metals in a lot of their products as well. And a fair amount of that kind of growth was probably driven by price as well. Could you maybe just comment on what you think the long-term growth of that business is kind of the volume that they can generate rather than what I just assume is some price-driven growth that you've seen there over the last few years.

Actually, the biggest source and Chuck mentioned of the growth in Leonard Valve has been the digital transition of mixing valves. So it's a technology upgrade that's happening that's adding a lot of value in the marketplace. And so more so than just a pure kind of pass-through of cost pricing. That's been the big driver of the growth over the last few years. And it was 1 of the real appealing characteristics for us to both get more involved on that digital upgrade, but also bring that kind of capability of thinking into the broader ecosystem of solutions that we can serve our customers. So -- from that standpoint, we think it's a growth that has still more momentum to it.

And just to frame about 30% of their volume or the revenue is digital and connected products. it's a base that we look to grow over time.

Our next question comes from the line of Andrew Kaplowitz with Citi.

Good morning. Steve, I know that the strategic review is ongoing in China, as you said, but restructuring does seem to be helping stabilize the margin of the business. So if, for instance, the market doesn't come back as you expect in the second half, do you have more restructuring that you can do? How do you think about the ability to sort of maintain margin if the market is still difficult.

Yes. I mean, look, over long periods of time, right, the answer in China is not continuing to restructure and cut cost and not be able to grow the business. So we're doing what we think is necessary to protect the business today and and we're making, I think, smart decisions around where we do cut. There's a lot still to play out in terms of how the market will kind of respond, especially as we start to lap these subsidies. So we're watching that carefully. Obviously, the strategic assessment we're doing might change kind of how we approach our business in China. That's the high-quality discussions that we're having with partners whether there's more structuring in the future, I think we'll evaluate that as we go. I think ultimately, though, our goal is we need to find a way for the business to be even more competitive than it has been going forward. And eventually, the market will recover. But when that is, I think it's still obviously a big uncertainty. But we'll do what we need to do to make sure we can maintain the competitiveness of the business there financially. But ultimately, we need to find a strategic path forward that allows the business to grow again.

That's helpful. And then your boiler businesses continue to be pretty solid, and I think you have a good forecast for '26. So maybe just a little more color on the health of that market? I know your high-efficiency boat boilers are doing well, but is that mostly what this is? Or is it the market strength overall?

It's a good market, but I would say our lock-in bar brand, and it is the, I think, premier brand in that marketplace. We have great technology, as we've talked about, on the high efficiency and it's a great product. So it's a little bit of both. It's been a strong market, but also I think we're performing well and even taking share in that market with the strength of our product portfolio.

Ladies and gentlemen, I am showing no further questions in the queue. I would now like to turn the call back over to Helen for closing remarks.

Thank you, everyone, for joining us today. Let me conclude by reminding you that despite many challenges, A.O. Smith achieved record EPS of $3.85 in 2025. We look forward to updating you on our progress in the quarters to come. In addition, please mark your calendars to join our presentation at 3 conferences this quarter. Citi on February 19. We North Coast on March 12 and JPMorgan on March 17. Thank you, and enjoy the rest of your day.

Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect.

Good day, and thank you for standing by. Welcome to the A.O. Smith Third Quarter 2025 Earnings Call. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions]

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

Good morning, and welcome to the A.O. Smith Third Quarter Conference Call. I'm Helen Gurholt, Vice President, Investor Relations and Financial Planning and Analysis. Today, I'm joined by Steve Shafer, Chief Executive 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 less 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 use -- we will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com.

I'll now turn the call over to Steve to begin our prepared remarks.

Thank you, Helen, and good morning, everyone. I would like to start by briefly thanking the many dedicated A.O. Smith employees and broader set of partners and customers in our ecosystem for another quarter of helping to make clean, hot and safe water available to millions of people. We appreciate all you do to make that happen.

Please turn to Slide 4, and I will now review our financial performance in the quarter. Our global A.O. Smith team delivered third quarter sales of $943 million, a year-over-year increase of 4%, and EPS of $0.94, a 15% increase over 2024. North America sales grew 6%, primarily as a result of our pricing actions and strong commercial water heater and boiler volumes. We achieved North America segment margin expansion of 110 basis points and Rest of World segment margin expansion of 90 basis points.

Continued economic challenges and more limited availability of government stimulus programs led to a 12% decrease in local currency sales in China. Pureit contributed $17 million of sales in the quarter, and our legacy India business continued its strong double-digit growth trajectory by delivering 13% growth in local currencies.

North America water heater sales increased 6% in the third quarter, driven by pricing actions taken in response to higher tariffs and other input costs as well as higher commercial water heater volumes. Our market-leading high-efficiency condensing gas and heat pump products continue to have a compelling payback story in commercial applications.

Our residential water heater volumes were also positive, so we believe that Q3 industry volumes declined year-over-year. As we expected, we believe our -- we believe we outperformed the residential and commercial markets in the quarter, in part due to our production efficiency initiative that limited the prebuy impact on our sales in the first half of the year.

Our North America boiler sales increased by 10% compared to the third quarter of 2024, led by the benefits of pricing actions and higher volumes of our high-efficiency boilers. North America water treatment sales decreased 5% in the third quarter, as continued growth in our priority channels was more than offset by an expected decrease from the retail channel. Our priority dealer, e-commerce and direct-to-consumer channels grew 11% in the quarter.

In China, third quarter sales decreased 12% in local currency, as the ongoing economic challenges and reduced availability of government subsidy programs along with an increasingly competitive environment led to lower volumes. Despite these challenges and the resulting volume pressure, we achieved 90 basis points of margin expansion compared to last year through the restructuring initiatives we undertook in 2024 and other cost-saving measures.

Please turn to Slide 5. I would now like to take a moment and talk about our commitment to sustainability. For us, sustainability is not just a goal, but a core part of who we are and what we do every day. We are committed to not only developing and bringing to market innovative, high-efficiency products, but we are also dedicated to sustainability in our facilities and manufacturing processes.

Later this week, we will publish our sustainability progress report, which will include our sustainability scorecard and an update on our water conservation, greenhouse gas emissions and waste reduction goals. What the report will show is that we are meeting or exceeding the goals that we set out for ourselves.

The outcome of these efforts are providing both sustainability and bottom line results. Example initiatives we have undertaken to support these goals include the test water recirculation system, which recycles water used during our product testing processes and our glass enamel reuse process, which captures waste glass enamel for reuse in our tank manufacturing process.

These are examples of how we are seamlessly -- how we seamlessly integrate sustainability into 2 of our priority areas, operational excellence and innovation. We remain dedicated to finding better ways of doing things, including how to improve our business while protecting our planet.

I'll now turn the call over to Chuck, who will provide more details on our third quarter performance.

Thank you, Steve, and good morning, everyone. Please turn to Slide 6. Third quarter sales in the North America segment of $743 million increased 6% compared to the same period last year, primarily due to benefits of pricing actions as well as higher commercial water heater and boiler volumes. North America segment earnings were $180 million, an 11% increase over the third quarter of 2024. Segment operating margin was 24.2%, an increase of 110 basis points year-over-year, primarily due to pricing actions and higher volumes, more than offsetting higher material and other input costs.

Moving to Slide 7. Rest of the World segment sales of $208 million decreased slightly compared to last year and included $17 million of sales from the Pureit acquisition. Sales in our legacy India business grew 13% in local currency. China third-party sales decreased 12% on a constant currency basis. Rest of the World segment earnings of $15 million increased year-over-year as continued expense management and the benefits of restructuring actions more than offset lower volumes in China. Segment operating margin was 7.4%, an increase of 90 basis points compared to the prior period. Pureit will continue to be a headwind in the near term as we focus on integration, which is progressing well.

Please turn to Slide 8. Operating cash flow grew 21% to $434 million, and free cash flow grew 35% to $381 million during the first 9 months of 2025 compared to the same period last year, primarily due to lower inventory balances that were partially offset by other working capital outlays, including lower customer deposits in China. Our cash balance totaled $173 million at the end of September, and our net debt position was $13 million. Our leverage ratio was 9.2% as measured by total debt to total capital.

Let's now turn to Slide 9. Earlier this month, our Board approved a 6% increase in our quarterly dividend to $0.36 per share, making 2025 the 32nd consecutive year that A.O. Smith has raised its dividend. We repurchased approximately 5 million shares of common stock in the first 9 months of 2025 for a total of $335 million. This is an increase compared to the same period last year, as we raised our planned full-year repurchase intentions from $306 million in 2024 to approximately $400 million of shares for 2025.

Consistent with our key priorities, we are actively assessing strategic opportunities and have sufficient dry powder for acquisitions that meet our strategic and financial criteria. Our M&A priority continues to be deals that strengthen our core business or help us build new growth platforms.

Please turn to Slide 10 and our 2025 earnings guidance and outlook. We are narrowing the range and lowering the top end of our 2025 EPS outlook from a range of $3.70 to $3.90 per share to a range of $3.70 to $3.85 per share. We have included the following assumptions in our outlook. We began to see the impact from tariffs in the third quarter and expect that our tariff costs will continue to increase into the fourth quarter as additional impacts make their way through our supply chain. Though the tariff landscape remains uncertain, we maintain our estimate that annualized tariffs will increase total company cost of goods sold by approximately 5%, which includes tariff rates currently in place as well as the mitigation efforts we have implemented.

As a reminder, our mitigation strategies include footprint optimization, strategic sourcing and other cost controls and pricing actions as necessary. Apart from tariffs, we expect overall material costs for the year to remain approximately flat versus last year, with steel costs rising 15% to 20% in the second half of 2025 compared to the first half. We estimate that 2025 CapEx will be approximately $75 million. We expect to generate free cash flow of approximately $500 million.

Interest expense is projected to be approximately $15 million. Corporate and other expenses are expected to be approximately $75 million. Our effective tax rate is estimated to be approximately 24%. And we project our outstanding diluted shares will be 142 million at the end of 2025.

I will now turn the call back over to Steve, who will provide more color around our key markets, top line growth outlook and segment expectations for 2025, remaining on Slide 10. Steve?

Thanks, Chuck. Key assumptions in our top line outlook include the following. We project that 2025 U.S. residential industry unit volumes will be flat to slightly down compared to last year, a slight decrease from our previous guidance due to residential new construction expectations that have come down since last quarter. Lower housing completions, particularly in multifamily as well as concern around consumer confidence, have led to this revised outlook. The wholesale channel impact is expected to be greater due to its heavier exposure to new construction.

That said, we are encouraged by the resilient demand we are seeing in the commercial water heater market segment. And as a result, we are increasing our projection for commercial water heater industry volumes from flat to last year to up low single digits. We are pleased with our strong performance relative to the market in the third quarter and the share momentum we have going into the fourth quarter, supported by our winning products in this segment.

Economic challenges persist in China. While government stimulus programs helped to stabilize parts of the market in the first half of 2025, we believe the stimulus programs pulled forward a significant amount of demand. During the third quarter, national sub fees were discontinued, resulting in increased promotional activity and discounting from our competitors, much of which we chose not to participate in.

Because we do not expect an improvement in market conditions in the near term, we are lowering our 2025 China sales outlook to a decline of approximately 10% in local currency. We continue to benefit from the restructuring actions taken in 2024, as well as other cost-saving measures, which we project will offset the margin impact of lower volumes for the year.

Our 2025 North America boiler sales projection of an increase of between 4% and 6% compared to 2024 is unchanged. We are very pleased with our growth in the first 9 months of the year, although we believe we may have benefited from a minimal amount of prebuy related to price increases implemented in the second quarter. We continue to monitor our key markets closely. We have not changed our guidance that North America water treatment sales will decline approximately 5% in 2025, as we deemphasize the less profitable retail channel.

We continue to be pleased with the growth we have seen in our priority channels and our onboarding of new dealers during the year. Our plan to drive 250 basis points of operating margin improvement in 2025 for the North America water treatment business is on track.

Finally, we expect the addition of Pureit will add approximately USD 55 million in sales in 2025, slightly higher than our earlier guidance. It will not have a significant bottom line contribution this year, as we work through integration.

Based on the continued economic challenges in China and the softening wholesale residential water heater market in the U.S., we have lowered our full-year sales outlook from 2% to 3% growth to a range of flat to up 1% compared to last year. We continue to expect our North America segment margin will be between 24% to 24.5%, and we expect that Rest of World segment margin will be approximately 8%.

Please turn to Slide 11. Last quarter, I laid out my areas of focus. Earlier this month, the top 140 leaders of A.O. Smith gathered to talk about the future of our company, to align on key priorities and inspire each other through the opportunity to connect and share ideas on how to deliver the next great chapter of the A.O. Smith legacy. I came away from this important time together confident in our path forward and with the commitment from our leadership team to execute. I look forward to sharing more regarding this leadership summit and our focus areas in the quarters to come.

I am also pleased to welcome Chris Howe as our new Chief Digital Information Officer. Chris is the transformational leader that we need to help us invest wisely in new technologies for the future and unlock even more value potential in the technologies we are invested in today. In his previous roles, Chris led transformational effort to leverage enterprise software solutions or most recently worked on the forefront of generative AI solutions. He will be instrumental in ensuring we have the technical capabilities needed to support all our priorities, especially operational excellence and innovation.

As we shared last quarter, and as part of our portfolio management priority, we announced the intention of our formal China strategic assessment. While we remain early in the process, we are making good progress. We commissioned a third-party analysis of the China market, and it confirmed many of our assumptions entering the strategic assessment.

One, our brand remains strong, well-known and respected among Chinese consumers, especially with regard to our innovative products and premium solutions. Two, our strategy to expand into broader categories that can be connected by smart home solutions and our AI Link capability was a necessary path forward. And three, we have a number of go-to-market and business model opportunities to better strengthen the business and capture our fair share of market recovery.

We believe that we have a good understanding of our challenges and are evaluating potential opportunities to ensure the future success of this business, as we drive greater value for shareholders, employees and other stakeholders.

In conclusion, I am pleased with our third quarter execution, particularly in the North American segment. I'm also encouraged by the progress we are making on our strategic priorities, including portfolio work to help strengthen our business going forward.

Regarding execution, we delivered a solid third quarter in North America, led by pricing performance and our strong commercial, high-efficiency portfolio while expanding margins through operational discipline.

Looking forward, we remain confident in our ability to navigate the tariffs and competitive landscape in our core water heater and boiler businesses, where we serve a large replacement-driven market with a broad industry-leading portfolio and go-to-market model.

Regarding our portfolio, we are driving double-digit growth in priority areas, including boilers, select North America water treatment channels and India. At the same time, through our strategic assessment, we are working to understand and address what is required to improve the performance of our China business.

Finally, we continue to generate cash, maintain a strong balance sheet and are ready with dry powder necessary to build out our portfolio in ways that complement our business today.

With that, we conclude our prepared remarks and are now available for your questions.

[Operator Instructions] Our first question comes from Saree Boroditsky with Jefferies.

Maybe just building on some of the China color. You obviously lowered expectations around China sales. Could you just talk about your performance versus the overall market there? And is this just a weaker market? Or is there any competitive dynamics going on?

Yes. It's a little bit of both. So the market continues to have its challenges. And as I mentioned, there's been a little bit of a pull-forward demand driven by the government subsidy program. So we're on the other side of that. And I think within that down market, the competitive intensity continues to increase. So we see a lot of promotional activities trying to step in where government subsidies were playing a role to generate demand previously. And so that's adding to the competitive pressure.

And I think, as we see our path forward, as I mentioned, we've got confirmation that our brand remains very strong there. We have a really strong innovative portfolio to serve our customers, but we need to work through this period of challenging market conditions.

Appreciate that. And then obviously, one of the bright spots this quarter was in the North America commercial water heater sales. I think previously, you attributed some of the strengths to prebuy. So just maybe a little bit more detail on what you're seeing in that market and what's driving the strength there?

Yes. It's been a strong market condition for commercial products, but I'd also say we have a really strong portfolio in that space. And I mentioned on the last earnings call, the launch of our FLEX commercial water heater, and -- so we've got that out in the marketplace that I think is performing very well. So it's a combination of a really strong market backdrop, but also in an area where we've got a really competitive product offering.

And I would add that during the third quarter, we benefited from our production efficiency program to make sure that we were level loading a bit closer to the market. And some of that strength we saw in commercial and residential heater was a part of the output of that benefit in the level loading program.

Our next question comes from Bryan Blair with Oppenheimer.

Just to level set on the China strategic review. We know there isn't a timetable as of now in terms of the ultimate decision, but given the insights from the assessment so far, has the range of potential outcome has been narrowed in any way?

No, Bryan, not yet. I mean, we're still early enough in the process that we're not ruling out any outcomes at this point. So like I said, we've done some really good work just trying to profile and understand the market. We've gotten some third-party assessment to do that. We've started the process of reaching out to other participants, which is why we wanted to announce that we were putting the business under the strategic assessment, but we're not at a point yet where we've kind of narrowed down or have a view of what the outcome of that is yet. It's still too early.

Yes. Understood. Appreciate the color. The priority channel growth in North American water treatment, certainly encouraging in Q3, and that 11% nicely aligns with the 10% to 12% organic growth target you had put out at Investor Day. With mix now reset for the platform, is that kind of organic growth in play going forward?

I mean, that's certainly how we think about the business long term. I would say there's still more work to be done, right? So we've done some reprioritization of the channels and where we think we can be competitive and win. I think there's still more work and investment in that space to build out that platform. But we feel good about the growth potential of that business.

Our next question comes from Jeff Hammond with KeyBanc Capital Markets.

Just on the U.S. resi water heater market, I think you didn't change your industry shipment assumptions, but seem to lean a little more cautious. So I just wanted to understand a little bit better how you see that playing out.

Yes. Our outlook for the industry, we were talking about flat industry on our last call. And now, we're saying flat to slightly down. So we do see a little bit of pressure on the residential side. Most of that is coming through new home construction completions on the residential side that we're seeing some of that weakness. So we've taken it down just a tad.

And are you seeing kind of the market share recapture play out as you thought?

Yes. As we were looking at level loading our production this year, we've seen our performance relative to the market in Q3 come back and gain share back as we expected.

Okay. And then just -- I think you mentioned some additional tariff headwinds, maybe quantify or talk about where you're seeing that? And then just as you look at steel pricing and kind of forward tariffs into '26, how does that kind of inform pricing actions you need to take into '26? We're seeing -- we're hearing from kind of other channels that maybe next year is another above average increase. I just wanted to get your view there.

Yes. This is Chuck. I mean, the mention on tariff pressure was really framing from third quarter to fourth quarter. It's probably maybe 20 basis points on North America margins, where we are seeing a bit heavier tariffs kind of accumulate. Our full year outlook at 5% has not changed. So it's still a little bit of timing, putting a little pressure on the North American margins in the fourth quarter. We'll be back in January. We're giving a little bit of an outlook on cost. The tariff world is a bit volatile. So I think we'll kind of hold off commentary to see where material costs go in that respect.

Our next question comes from Mike Halloran with Baird.

Could you talk a little bit through what you're seeing in the residential side of things in terms of the discretionary spend? I certainly heard the commentary earlier that some of that weakness that -- or incremental weakness you saw in the residential volume side from an outlook perspective is tied to new housing starts being a little bit lower, no surprise. Are you seeing anything different on the discretionary piece?

We really haven't seen that change. We do a survey every quarter, and we look at proactive replacement, as you know. And if we kind of look at that survey, there's quarters where it edges up, edges down. But overall, it's still above that 30%. Proactive replacement remains pretty resilient. Certainly, something we'll watch as we go forward. But -- it's a backward since the last trailing 12 months survey. So we'll have to continue to watch that and make sure we understand if there is a trend developing. But right now, still above 30%.

So -- and then following up on Jeff's other question, I know you're not giving '26 thought process, but if trends were to play out, and we weren't going to get any incremental actions, the pricing that you've taken in your mind is enough to make you price-cost positive or at least be price-cost neutral on the margin line or in terms of EBITDA dollars once kind of all the catch-up happens. Is that a thought process? Or is there still going to be some gaps relative to what you're seeing from an inflation perspective with the actions you've already taken?

Yes. When we do our price increases, and it really was no different other than the amount of the price increase this time with the tariff costs hitting us, we typically look to cover margin plus cost. So just a reminder, the last one was second quarter because it was effective. When we announce those prices, they go out, and certainly, we see pressures over time on the price, and we have a bit of a fade. So I think we'll kind of still reserve kind of the answer to that as we get into the next quarter, but we're comfortable with our price-cost relationship now. But as you'll see, there's some pressure when you look at our guidance and a little bit of pressure on margins in the fourth quarter.

Our next question comes from Susan Maklari with Goldman Sachs.

This is Charles Perron-Piche. First, I'd like to go back on the China market. Understanding the market conditions are tough, but I guess, do you have any thoughts on potential additional restructuring initiatives in the region given the environment and something that would be done ahead of potential strategic announcement?

I think it's one of the things we're going to continue to kind of work through and learn more about as we go through our strategic assessment, and I kind of alluded to the fact that there's opportunities for us as we think about how we go to market, our business model. We're going to continue to evaluate those things. Whether we do those through partnerships or we do them for ourselves, it's something we still have to work through. But our goal is to make sure that the business is set up well for success. And obviously, a little bit of market recovery will help aid that in a bit. But we're going to continue to kind of learn from the changing market environment and make the necessary changes. And whether that comes through things that we'll take on and self-help to do that or whether that's done through partnerships is one of the things we're assessing right now.

Okay. That's helpful color. And then I think in your prepared remarks, you talked about the potential for a strategic acquisition within your or adjacent market. I guess, on this, can you talk about what is the pipeline for these types of opportunities in the current environment, along if the timing of any strategic decision on that is dependent on the potential announcement of the strategic review in China?

No, I think one of the strengths we have, right, is a strong balance sheet and our cash generation capabilities, so we've got an active pipeline. We continue to evaluate that from kind of a strategic lens, financial lens, where we want to go next. And as I mentioned, partly it's how do we strengthen the core of our business, how do we think about building new higher-growth businesses, and we're going to continue through that process. So I don't think it's connected to other decisions we're making across our portfolio at this time, and we're ready to move, I think, when the right opportunities come about.

Our next question comes from David MacGregor with Longbow Research.

I wonder if you could just give us an -- I was wondering if you could just give us an update on gas tankless and the progress to date on relocation of manufacturing and market development and just the impact on third quarter margin contribution and maybe the implied fourth quarter, which you've got in the '25 guide?

Sure. As you know, we've made a big investment to enter with our own products into the gas tankless space. We've been building out the right set of products, the manufacturing capability here in North America. And all of that is progressing well. I think the market itself for tankless is under pressure, heavily connected back to the residential construction market that we talked about. So from that standpoint, it remains kind of a challenging market. But I think we're really excited that I think we've got the right products, we've got the manufacturing capability ready.

As we've talked about in the past, we've made some changes. In the past, we were talking about launching in China, moving to North America. We've made some changes into that strategy, which has made some delays to our current plan in terms of how we're going to go after the market. But I think we're happy with where we're at. We'd like to move faster in the marketplace. And I think as the market picks up and recovers, especially around new construction, and with the product offering we have and the supply chain we have, we'll be ready to compete successfully.

Are you getting good feedback -- sorry, go ahead.

I was just going to answer the question on margin pressure. It's -- we're anniversarying when we first launched the product last year, so the margin pressure is a bit less than the 40 basis points we had historically talked about. For the quarter, it's probably about 20 basis points. It's not overly significant.

And I think you were asking about feedback.

Yes. I was just going to get you to talk a little bit about what you're getting back from the marketplace and people. I know that you were undertaking a phased launch on that product in terms of just incremental models, and is the acceptance level relatively good at this point? Or are people waiting for the full assortment? Just any commentary on that would be helpful.

Yes, folks love the product. And when they get their hands on it, and they get comfortable with it. And as you know, we've been building out our portfolio. So when we have the full portfolio, we'll be even more compelling. There's also elements of how we serve this market, right? A lot of more gas tankless tied to the new construction. So we're working out on the business model as well. But I would say, at the end of the day, the product is a market-leading product, and that's what we look to do when we got kind of our own product offering into this space.

Our next question comes from Nathan Jones with Stifel.

This is Adam Farley on for Nathan. Let me follow up on -- I wanted to follow up on the China commentary. I know fourth quarter is typically seasonally stronger quarter due to the shopping holidays. So what is your expectation for the selling season going into the fourth quarter, balancing that with some of the headwinds you guys are seeing there?

Well, you're exactly right. It's typically the fourth quarter is one of our strongest quarters in China. Our outlook assumes that there is an uptick in volume in the fourth quarter compared to the third quarter. But I will say when you kind of frame our outlook for China overall to be down 10%, you'll note the fourth quarter gets a little more pressure on year-over-year comps compared to the third quarter. So without the -- with the discontinuation of the subsidy program, there's a bit of uncertainty in China on how the fourth quarter may play out. But right now, we have kind of normal cadence, but not at normal volumes. But just kind of relative to the third quarter, we do see a bit of an uptick.

That's helpful. And then maybe shifting to boilers, which was a bright spot in the quarter, I think you mentioned maybe you think there's a little bit of pre-buy there, but I was also wondering if the boiler sales cycle is maybe elongating at all due to general market uncertainty or maybe that's not an issue at all?

No. I mean, we do believe that there was some pre-buy, so there is certain boilers that, I'll call it, inventoriable size. They're small enough that you'd be willing to invest and put them in inventory. We've seen a couple of strong quarters in boilers. Typically, our strongest quarter is the third quarter. So we do think we'll see a little bit of a headwind as we go into the fourth quarter for some of the unwind of the, call it, inventoriable boilers that will come out in the fourth quarter. But overall, the market quoting remains pretty steady, pretty consistent, particularly on the large CREST units. So we're not seeing any major change or elongation in, what I would say, quoting to the order cycle.

Our next question comes from Andrew Kaplowitz with Citi.

Steve, obviously, you've had good operating experience in your past positions. Maybe just stepping back as you've looked at AOS, and given how many of your markets are relatively sluggish, how have you sized the potential opportunity for cost out overall at AOS and/or the potential to accelerate new product-related growth as you begin to transition into '26?

Yes. Andy, so as I've mentioned, 2 of our priority areas are A.O. -- the operational excellence and how do we get more out of the A.O. Smith operating system and innovation. And I think that gets after both components of your question. I think -- we don't have a good sizing yet of what the value is at stake on that, but what I'll tell you is I'm encouraged by the fact that we can bring even more kind of discipline into our operating rhythm at A. O. Smith.

I think we have great manufacturing capability, and we run a lot of our business with great people with a lot of experience. And I think bringing some discipline, and I mentioned Chris Howe joining us as our CDIO, I think discipline and leveraging some of the technology investments we've made is going to be a meaningful opportunity for us. And we haven't kind of framed that in numbers yet. We're sort of building the foundation that we can build on. And I think that's something we'll continue to talk to you all about going forward.

And then, on the innovation front, we also have a new CTO, and one of the things we're really focused on is how do we kind of increase the pace and success of our commercialization capabilities and -- across our businesses. And so that's another area of focus. And again, we're kind of putting the foundation in place. But we've got a great history at this company of breakthrough innovation, creating categories. And so tapping into that culture of innovation is something that's another big priority for us.

That's helpful. And maybe just a little more color on inventories across your resi channels, anything you're seeing there? Obviously, resi HVAC is having much more difficult time than resi water heaters, given their own inventory problems over there. It doesn't seem to be the case with you guys here, but what's the risk given weaker consumer confidence that we could see some destocking?

Right now, I would say we think that inventories in the channel on both residential and commercial side is at pretty normal levels, pretty much target levels. As there's hesitancy, maybe on new home construction, may see some of the distributors looking to be very prudent on how they manage inventories in the back half of the year. But we feel like channel inventories are pretty much where they should be right now.

Our next question comes from Tomohiko Sano with JPMorgan.

My first question is on CapEx. Could you talk about the CapEx guidance compared to 3 months ago, including what kind of items like did you revise for the full year, please?

Yes. We lowered our CapEx outlook just a little bit. We pushed out some of the investments that we had planned for the fourth quarter of this year into early next year. Some of those, not all of those were related to just watching the DOE commercial regulatory initiatives out there, and we're just being prudent on making those investments until we have a more surety around that.

And my follow-up is capital allocation. So you have been aggressive with buybacks and dividend increases, how do you prioritize capital allocations going forward, especially if the macro headwinds persist, please?

I mean, certainly, the dividend is very important to us. We've raised it for 32 years. We look at that from a yield perspective, and we feel pretty comfortable with where we are at on that. Buybacks, we're framing really to not grow cash, which we're buying back a prudent amount, we believe to not grow cash and still reserve firepower for acquisitions. So as Steve mentioned, we have adequate firepower. We're looking for adding those acquisitions, and we're in a good position to do that.

And I'd say in terms of market conditions and how they change, we still recognize we need to deploy capital to our core business, and we have a very resilient core business from that standpoint. So making sure that we maintain a very strong core business that's cash flow generating is in that dynamic as well. And at the same time, we're looking to how do we provide more adjacencies that get us into kind of higher growth businesses.

[Operator Instructions] Our next question comes from Scott Graham with Seaport Research Partners.

I'm sorry for jumping on late, balancing several conference calls. So I missed your prepared remarks. Was sort of the lean into the -- I should say, the reduction to the lower end of the guide range for the year, was that on China exclusively because it looks like the North American items are fairly flat versus last quarter? Was that China? Or was it something else?

Yes. Scott, there were 2 things we pointed out. There was obviously the softness, and we did revise down our China outlook for the year to down 10%. So that was a big part of it. The other thing we've highlighted is weakness on the residential side of the North America business, and we just see that a little bit softer now, where previously, we talked about it as a flat market. We now see it as flat to slightly down. So those 2 components are what have us being a little bit more cautious.

Okay. And I'm sorry for having to ask that. It was something you already said. Does that presuppose that, or maybe contemplate that, the October industry shipments were better than September because September really dropped off there? Can you kind of talk about what you're seeing in the industry in October?

Well, the industry shipments, August really was down quite a bit on the residential side. We think September will be -- not similarly down, but was also weak. And as we think about kind of our orders, and maybe that's where we can comment in October because we haven't seen any industry data yet for October. But in October, as we look at our orders, we haven't seen resiliency, particularly on the wholesale side, which is generally more influenced by new home construction. So it's been a bit weak overall. So those all kind of -- all those factors come into play, Scott, when we're thinking about a flat industry last quarter, now flat to slightly down. We just see a little bit of pressure, particularly on the new home construction.

And we've talked about our approach to trying to level load our production a bit more for the efficiency benefits of that, working closely with our customers to do that. So we saw Q3 where the industry was down a bit, but we also gained share as was our intention as we walked through the quarter because of the way we level-loaded our production.

Thank you. I would now like to turn the call back over to Helen Gurholt for any closing remarks.

Thank you for joining us today. Let me conclude by reminding you that we are pleased with our growth in the 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 3 conferences this quarter: Baird on November 11; UBS on December 3; and Goldman on December 4.

Thank you, and enjoy the rest of your day.

This concludes the conference. Thank you for your participation. You may now disconnect.