Good day, ladies and gentlemen, and welcome to the Second Quarter 2019 Earnings Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to Patricia Ackerman, Senior Vice President, Investor Relations, Corporate Responsibility and Sustainability and Treasurer. Ma'am, you may begin.

Good morning, ladies and gentlemen, and thank you for joining us on our second quarter 2019 results conference call. With me participating in the call are Kevin Wheeler, Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. Before we begin with Kevin's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release. 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. I will now turn the call over to Kevin, who will begin our prepared remarks on slide 3.

Thank you, Pat, and good morning ladies and gentlemen. Chuck will elaborate on our financial performance in a moment. And while China continues to be particularly challenging, I am pleased to highlight several items and actions, which help position us for future success. Number one, our solid operating margin performance in North America remained steady despite expected lower water heater volumes compared with last year. We announced a price increase of up to 4% on our North America wholesale water heater portfolio, effective August 1st. Excuse me, just August, early August. We joined our Hague and Water-Right water quality dealer sales organization together, so as to represent one customer-facing our customers in that channel, and the transition has gone well. Continuing our strategy to leverage our distribution channel, we launched our A. O. Smith branded water treatment portfolio in the U.S. wholesale channel. We revised our China sales expectations as we moved into the back half of the year, with a path towards more normalized channel inventory levels, which as previously discussed, has been elevated for over the past 15 months. Chuck will now describe our results in more detail, beginning on slide 4.

Thank you, Kevin. Sales for the second quarter of $765 million were 8% lower than the same quarter in 2018. Earnings in the second quarter of a $102 million declined 11% in the second quarter in 2018. And second quarter earnings per share declined 8% to $0.61. Sales in our North America segment of $524 million declined 2% compared with the second quarter of 2018. Lower residential water heater volumes due to a tough second quarter 2018 comparison, driven by a pre-buying in advance of the price increase were partially offset by the mid-2018 pricing actions. In addition, our recently acquired Water-Right business added approximately $14 million to sales. Rest of the World sales of $249 million declined 19% compared with the same quarter of 2018. China sales were down 16% in local currency, primarily related to previously disclosed channel inventory build, which occurred in the first half of 2018 and did not repeat in 2019. The weaker Chinese currency unfavorably impacted translated sales by approximately $16 million. India sales grew over 30% in constant currency compared with the same period in 2018. On Slide 6, North America segment earnings of a $123 million were 2% lower than segment earnings in the same quarter in 2018. The favorable impact from mid-2018 pricing actions were more than offset by the unfavorable impact from the lower water heater volumes and higher steel costs and other costs. As a result, second quarter 2019 segment margin of 23.5% was essentially the same as last year. Rest of the World earnings of $22 million declined 35% compared with the second quarter of 2018. The impact to profits from lower sales -- lower China sales more than offset the benefit to profits from lower SG&A expenses. Weaker China currency translation negatively impacted earnings by approximately $2…

Okay, great. Thank you, Chuck. Our outlook for 2019 includes the following assumptions. We project U.S. residential water heater industry volumes will be down 50,000 to 100,000 units in 2019 as replacement remained stable, but new home construction appears to be lackluster due to labor shortages and weather delays. Commercial industry water heater volumes are expected to be up 1%. Based on boiler sales growth of 7% in the first half, we expect our North America boiler sales to grow approximately 7% for the full year. We project India water heater EBIT will be positive in 2019 and improvements to continue for water treatment in 2019. Overall in India, we will be profitable in 2020. Our forecast for the Chinese currency in 2019 is essentially level with where it is today and weaker than last year. Essentially all of the negative FX impact occurred in the first half of 2019. We see continued and prolonged headwinds in the appliance channel in China. Our third party analysis of overall market performance in the second quarter showed the electric water heater market was down 8% to 9%, gas tankless water heaters down 2% to 3% and water treatment systems down 1% to 2%. As previously discussed, we estimated 2018 China sales increased due to distributor inventory build, primarily in the first half of 2018. We are assuming continued weakness in the China consumer demand for the full year in 2019. We continue to improve our process to quantify inventories, while we experienced seasonality, a normal inventory level would be two to three months. Our current view is that the channel inventory is approximately four months. Based on our recent conversations with key customers, we expect channel inventory levels to decline over the back half of the year to approach normal channel inventory…

[Operator Instructions] Our first question comes from the line of Saree [ph] with Jefferies. Your line is open.

Good morning. Could you update us on how you're thinking about price cost in North America in the second half of the year and maybe into 2020 given your price increase announced today and then lower steel costs?

We've been, typically we don't talk about price. I would say historically; we've been able to offset increased costs with pricing action. Our assumption -- I'll tell you that our forecast and assumption on steel is that currently we forecast that it will be like -- it will be in this level for the rest of the year. And we have seen recently this last month some increases in steel prices or some indication steel prices may be going up.

Okay. And then, I believe you have previously done with headcount reductions in China, but given the lower outlook would you reduce this more or do you believe you have already right-sized the business for current market conditions?

No, we're going to continue to review the business, as we always have and we'll be aggressive. The first headcount reduction was about 10%. We completed that in the first quarter of this last year. We are planning an additional 5% reduction in Q3. And then the SG&A that we continue to look at and scrutinize to make sure that we're spending our money appropriately there and investing appropriately. And we're going to continue to close on productive stores. And so at the end, as we look at it, as the market was to and continues to evolve, we'll aggressively adjust our business and we will right-size the business to the current environment.

I appreciate it. That was helpful. Thank you.

Thank you. And our following question comes from Alvaro Lacayo with G. Research. Your line is open.

Thank you for taking my questions. I wanted to start with Rest of World and maybe if you could try to categorize for us the visibility that you see, I know you mentioned that you believe that the inventories may be more normalized towards the end of the year. But given the big step change from last quarter to this quarter, maybe if you could just talk about visibility and what you could see going forward? And in terms of the numbers you highlighted about the volume declines has that stabilized or has that's -- in your view or have they not found a bottom in terms of year-on-year declines?

This is Chuck. Let me just talk a little bit about China. So what we've talked about in the past is the weak economy and that continues. So we've continued to see weak economy that really has not changed. We've talked about elevated inventory in the channel that has not changed. The elevated inventory remains roughly or where it has been really since we started talking about at June of 2018. We've also talked about assuming our outlook last call, said assuming flat channel inventory, we'd be down 6% to 8%. What's changed in our visibility is that recently, as we come out of June and had conversations with customers, we've seen customers telling us that they are going to order less in the third quarter. Now, typically in the third quarter and we talked about this on last year's call because of the fourth quarter is typically our strongest call -- strongest quarter in the market, we would see inventories go up. What we're looking at now and the visibility that we see and we've scrubbed it and we think we have a clear -- we certainly have a clearer picture in the last couple of weeks, is that we would expect that those inventories would start to come down in the third quarter and by the end of the year, we'd be going out of the year, at least in our assumptions at an inventory level roughly at what we went out of 2017 at. So really, really reversing out the inventory that went into the channel last year and we'd be flushed out, and back to what Kevin said, more normalized two to three months inventory levels by the end of this year.

Got it, thank you.

And just to add on to that, you have to believe hit the bottom and we certainly hope so. And we're still going to sit back and make sure that what -- we're watching our business. And as I've mentioned to the previous caller, if additional adjustments are needed, we'll aggressively go after those to continue to right-size the business, but we do believe that we've given the best outlook based on all that what Chuck had said in our visibility into the inventory and we hope this is the bottom.

And in terms of the cost reduction initiatives that you mentioned previously; can you maybe quantify for us how much savings you expect from the initiatives you've already taken?

Yes. So for the year, it's approximately year-over-year $24 million to $25 million of savings within the SG&A category. Think of that in terms of the split roughly first half, back half equally. The back half is a little bit less and that's because we've got some investments in advertising we're going to do to -- for the fourth quarter, but that's roughly the amount. There is a little headwind on the back half as we do have some severance costs that would be associated with the headcount reductions.

Thank you. And our following question comes from the line of Robert McCarthy with Stephens. Your line is open.

Good morning, everyone. How you're doing?

Good morning.

Good. So I guess the first question is thinking through kind of I think you've guided to flat margins in China in third quarter and then 6% for the full year, you talked about some deleverage there. Could you just walk us through kind of a bridge of where you think, because I think your initial guide was kind of in the 11% range. Could you just bridge us what's deleverage, what's restructuring, what are the buckets, sales volume that get you from kind of the 11% to the 6% for the full year?

Yes. So I'll just kind of take it in the big bucket. So we talked about the inventory coming down, that's a pretty big bucket. It's rather acute in the third quarter. So when we're thinking about third quarter, you have to kind of look to the first quarter to find something that's comparable which is 20% down from last year. And at that level, we've got some pretty meaningful plant inefficiencies that we were not had expected before that gets us through the third quarter. And then the fourth quarter looks quite a bit like the second quarter. So we still have some headwinds on channel inventory, but we get back to a little bit more of a normal, not normalized, but a little bit higher volume level that runs through the plant. So when you kind of take all the buckets together, first quarter -- I'm sorry, second quarter just gets hit fairly hard by the lower volume.

Okay. And then maybe as a follow-up, how are you thinking about perhaps your balance sheet right now in terms of M&A, maybe considering, I mean obviously it looks like today there has been an anticipation of this cut given how your stock has traded intraday. But nevertheless, you're in a bit of the fight of a lifetime in terms of what's going on in China and the organic growth story. If you see a material market break with your stock, do you think given the fact that you've got a balance sheet that's may be sub-optimal from a cash redeployment standpoint, you would consider being very aggressive in terms of share buyback. If you think about it, you might be able to get your business at a substantial discount over the next 12 months as you kind of right-size restructure this business. How do you think about that in this environment?

Well, I would just back to China, I mean the China change that we have is we think we'll work through the inventories by the end of the year. Once we get through that, we would expect a bit more normalized operating performance. So we certainly have seen changes in China and we're going to work through them by the end of the year. So thinking of our balance sheet, we're going to buy back $300 million of shares or at least we're projected to buy back $300 million of shares this year. So we're going to continue to do that. So we're on track to repurchase more than we did last year.

To add on to that about China a little bit. Certainly, we are in a challenging environment. I won't categorize it a fight of a lifetime. We have an excellent management team that's going to work our way through these challenging times and we'll come out the other end as a strong organization. Positively, we have some great mid-price point products that are gaining share. Our share in Q2 was higher than Q1. So there is -- and there has been

No meaningful trading down, there has been really no noticeable effect to our brand. And as we look out, we still look at China as a long-term growth part of our business. We won't want to be any other place than China when it comes to the growth. And when you look at it, the urbanization, I would still believe it has a long runway, the move into the middle class. So yes, we have some short-term challenges here. We have the team in place. We're making the moves we believe are the right moves in the current environment and we'll continue to do that. We know how to do that. And then as we come out the other side, the company will be stronger. We'll probably be a bit leaner and we'll be in position to take advantage of one of the best growth markets in the world. So it's important for us to do the things we're doing. But again, I believe our management team has it under control and we have a line of sight of what we're going to do to manage our way through this challenging environment.

Last question. Given what you see in the U.S. in terms of slightly negative organic growth and obviously this could just be just timing and price increases and still, you still feel good about the fundamental long-term outlook for U.S. and obviously that could impact obviously margins because you got great margins there, you have for some time and that's I've been skeptical of it, you've been -- you've delivered, which has been great. But do you see anything on the horizon that would give you pause that the market is changing or the cycle is changing where you think that the organic growth there is going to be more challenging going forward than it has been over the past several years where you've had very solid stable organic growth in North America?

Yes. The answer to your question first, we still believe there is stable organic growth there. What's going on in our opinion and what we believe is, if you look at the market through May residential water heaters; the shipments in the industry were down about a 150,000 units. And as we look at our June sales in our sales when we look out, we think it's going to be down another 100,000 units. And as we look at it, there has certainly been an impact of a wet spring that's limited new construction. There continues to be a labor shortage with most of the builders and so forth. So as we go forward, the reason we have a decline is we just don't think with the labor shortages out there that the industry can make up the full 250,000 units. We think it's going to be somewhere in the 150,000 range. But what's important, and we said in our opening comments, we still see a very stable replacement market. And again, as we go forward, we have no change to our North American growth pattern. Water heaters are at 4%. We believe a lot more will continue to grow at that 8% to 10% range. So no, that was a long answer, but no, the answer is, we feel really good about North America. We think this is just some weather-related issues. And hopefully as the labor shortages in the market start to become less that the new construction will continue to move forward. So, no change in our outlook on either of our North American businesses.

Well gentlemen, good luck. The market seems to be believing you today.

Thank you.

Thank you. And our next question comes from Matt Summerville with D.A. Davidson. Your line is open.

Thanks. Couple of questions. Why do you think it's taking either the channel or A. O. Smith so long to react to the inventory situation in China?

We've had prolonged slowdown in China. So it's been a number of quarters that we've been talking about the elevated level and the prolonged slowdown. June typically is a favorable month for the appliance channel. It's a high promotion month. I think there is some disappointment perhaps in June, maybe wasn't as high as what expectations were in the customer base. And as we came out of June and the prolonged -- the prolonged level of what the downturn is, I believe our customers just said, it's time to de-lever a bit. So I would say those data points, and you know last year we went into Q4 with pretty high inventory levels and wanted and expected that the channel would flush those out and it was a little disappointing. So when they start looking -- when our customers start looking back historically and look at the data points of last fourth quarter June and maybe what they see in front of them, they've decided to take action in the third quarter.

So maybe if you can flush out in Q2 then and what your expectation is for the year between the water heater business, the water treatment business and air purification in China. Can you give a little bit more granularity as to actual performance in Q2 and full year expectation for those three buckets?

Well, let me kind of carve out water heating and water treatment. So water treatment, for the quarter, water treatment was down about 12%, largely channel flushing or you know reduction of the channel inventory impacted. When we look at our water treatment business over the course of the year, we would expect to be down about 12% on our sales. If you look at kind of the consumer demand, the customer demand and what we're seeing on sell-out, it's probably up about 8% to 10%. So we're seeing a little bit positive there. The water heater, you got to kind of look at the mix, right. So we've introduced some mid-range priced products. We've introduced new products. We do have headwind on the water heater side. Our outlook for the back half of the year is to be similar to the first half of the year as far as consumer demand. We see -- we saw last year 2018 slightly downtick on consumer demand from 2017. But we've seen the first half of 2018 be fairly similar to last year and that's what we're assuming for the rest of the year.

Thank you. And our next question comes from Mike Halloran with Baird. Your line is open.

Hey, good morning, everyone. So just continuing on that, there's a lot of inventory machinations [ph], as well as just the timing of when you guys are manufacturing this year versus last year. Performance relative to the market in the core China product categories, how do you think that's track lately? And what's the assumption moving forward from here?

Knowing that the best tracking for us is market share. And so, if you look at our product categories, we have -- we started the year at a couple of points down overall, but as we go forward, our market share in Q2 exceeded Q1. We're getting really good acceptance of our new products, mid-price point products in the market. So -- and as far as the premium channel is continuing to hold, it's down a couple of points overall, the channel, but the overall it's holding. So as we go forward, we believe we're getting our fair share and we're continuing to gain momentum on the online side of the business as well as with our offline. So overall, we think we're getting our fair share and we look for a back half on a sellout perspective, not so much as sell-in because that's the inventory side of it. We feel we'll continue to get our fair share and possibly move our market share up in couple of categories that we were down a point or so.

So Kevin, was that commentary exclusive to the water heater business or did that include treatment as well?

It includes both. It includes both. As we talk, we have so many different categories, but the three main categories that Chuck outlined, I feel comfortable that we'll be getting our fair share in all three of those categories.

Thank you. And our next question comes from Jeff Hammond with KeyBanc Capital. Your line is open. Jeff Hammond`: Good morning. Can you just talk about market share, how your market share is holding in North America on the res, commercial water heater side? And then just how are things progressing relative to plan within North America water treatment?

Well, let me take the North America water heater residential share question. We had a very good Q2. And our market share on all of our key categories, particularly residential and commercial were back in line with our 2018 levels, actually slightly up. So we've -- we had a soft first quarter and we recovered in the second quarter and we don't see any reason that's going to change. On the water treatment front, we've -- Chuck will outline, but we've had a very good Q2.

Yes. We talked on the last call that we expect to be incrementally better in Q2 versus Q1 and that's -- that is happening. So the business is performing well. For the quarter, our sales were about $37 million, $14 million of that again was Water-Right, which is integrating well as Kevin -- it's on track as Kevin mentioned. So the kind of the customer acquisition in core growth is low-teens for us on the rest of the business. Operating margins were high-single digits for the quarter. So we're pleased with the way water treatment North America is progressing. Jeff Hammond`: Okay. And then just on China, can you give us kind of early read or feedback you're getting on this new price point product and when do you think it will start to really gain traction? Thanks.

Well, the mid-price point products have gone in, in various phases; it does take time to certify. And I think what we've mentioned in the past, we just don't take a product and discount it and make it a bit price point. We will actually design the product for the right category with the right cost structure. So as you go across our residential water heating, it's continuing to do well and we're gaining share on the online side of the business. Gas tankless, we still have a bit of work to do to introduce a few new products to fill those gaps and those will happen by the second half of the year. And our water treatment continues to do well. So overall, the acceptance has been good. But more importantly, the products have been designed for the right price points with the right cost structure so that we could maintain margins. So overall, we've been accepted well. And we look at introducing just a few more to balance out our product portfolio in each of those categories.

Thank you. And our next question comes from the line of David MacGregor with Longbow Research. Your line is open.

Yes, good morning, everyone. Just while we're on the topic of the medium price point, can you give us some sense of what the mix is now in terms of premium versus mid-price point and where you think that might be a year from now?

Yes. Right now, we're probably got a little heavier mix of the mid-price point as we work through the back half of the year. A lot of those products are new. As Kevin said, they're pretty well accepted. The channel -- as they work down the channel inventory, there is product that is not as new. So those price points are different. But we would expect this to normalize next year, more normalized next year. And we're always -- as we grow e-commerce and as we grow the mid-to-mid-price point product, it will be slightly less margin, but we would expect this to normalize. We get just pressure on our margins in Q3, particularly because the lower volume. So it's from gross margin to be a little pressure on us.

So when you say normalized, just from a proportional standpoint are we talking 50-50 or I'm just trying to get some sense of proportion?

Off the top of our head, I don't have that information. I'll be more than happy to dig into it and get it for you. But there is -- what I would tell you it's going to change by product category. And so what we're going to have to -- it's a great question, we will be sure to take a note of that and make sure that we get back to you.

Thank you. And our next question comes from Nick [ph] with William Blair. Your line is now open.

Good morning, guys. I was hoping to ask about a cash repatriation and maybe get a sense for how much of this currently disclosed cash number is in the U.S. and outside the U.S. and if you repatriated any cash from China in the first half or in the quarter?

Yes, we have, we've repatriated. We did it in and out of China about $150 million or $150 million for the first half of the year. So all of the cash that we mentioned is offshore, just to be clear on that. We did in and out of $150 million out of China and we've repatriated about $85 million of that back to the U.S.

So you said the $150 million is from China and the $85 million is back in the U.S.?

Back to the U.S., yes.

Great. Thanks for that.

Thank you. And our last question comes from the line of David MacGregor with Longbow Research.

Yes. Thanks for taking the follow-up. It's two quarters a row I've been cut off. I guess I'm not going to get a Christmas card.

It's is not intentional. Sorry.

I'd just like [indiscernible] we got here, I guess there was an earlier question about raw materials and price cost, and you noted that raw material prices were still high or maybe up year-over-year and obviously spot market has been coming down, you guys are contract buyers, I understand that part. But one would think that by now you're starting to see some leakage on the indirect component as well as maybe some supplemental spot purchases. So I guess the question is, notwithstanding, I know the mills have sent out letters asking for price increases a few weeks back, but when do we start seeing the benefit of lower steel prices coming through? Do we see some here in the third quarter or just can you help us with the timing?

Yes. We see a lag in 90 to 120 days to what you're kind of seeing in the marketplace. So we would expect to see a little bit of that benefit come through in the third and fourth quarter.

Okay. Is there any way to quantify that for us or think about it quantitatively?

No, we'll just kind of go from the benchmark, which is quarter-over-quarter improvement.

Okay. Okay, that's good. And then it's something we picked up on our checks was just talk of moving to kind of a national pricing model. And people are in distribution I guess now that distributors are acting more on a national scale, they're pressing for more of a national price as opposed to the disparities where I guess the southern markets were usually a discount to the northern markets. How does that play out for you in terms of price realization? Do your ASPs move up or down as you kind of normalize to a national level and how does the timing also play out?

Matt, pricing we're the only public company, okay? And so we just do not get into much detail on pricing with regards to strategy implement or expected implementation those type of things. And so, I just would prefer to keep that as kind of our policy. And again, what we've demonstrated over the years is being able to at the appropriate time, given time to address cost and inflation issues going forward. And I'm just going to leave it at that.

Thank you. And we have another follow-up from Matt Summerville with D.A. Davidson. Your line is open.

Thanks. A couple of follow-ups; first, can you talk about what you're doing in the wholesale channel with respect to water treatment. I know when you launched in the Lowe's, you threw a revenue target out there. Do you have a revenue target for this wholesale initiative if you will?

What we have in for other revenue target for -- we just launched into that. We want -- it's right aligned with our channel strategy. So we're excited to have product into the wholesale market effective in May. What we will kind of talk about is because of our channel strategy, we are looking at growing water treatment year-over-year in that 10% to 15% range. So if you look at our whole portfolio of businesses, not guiding just for water -- wholesale, but we would look to grow year-over-year in that 10% to 15% range throughout kind of our, all of our channels.

If you aggregate your global water treatment business, what's your revenue objective for 2019, I believe that's a number you've shared in the past?

Yes. It's about 440 to 450.

Okay. And then lastly just with respect to Lochinvar on the boiler side of the business, can you talk about what you saw in Q2 and maybe what gives you a little bit of pause with the 7% growth target versus the 8% to 10% sort of longer term objective you have there?

Yes, that's -- let me just start with that. The backlog in the activity in the market remains -- it remains pretty active. But what I was talking about the wet weather and the labor shortages on the residential side of our business, water heating side, it's also spilling over into the boiler side and commercial side of the Lochinvar business. So the business remains solid. It's just -- we just don't think because of the wet weather and the labor shortages on either our water heater or our boiler side of the business that we'll be able to make up the complete ground in the second half of the year. So that's why we brought it down a bit to 7%. But the market is active and our coating is active. So the overall business is in -- it continues to move forward in the U.S.

Thank you. And I'm showing no further questions at this time. I would now like to turn the call back to Patricia Ackerman for closing remarks.

Thank you for joining us on our call today. We will participate in several conferences in the third quarter. We will attend the Oppenheimer Conference in Chicago on August 15th, the Longbow Conference in New York on August 21st, and the Davidson Conference in Chicago on September 18th. Enjoy your day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.