Good day, and thank you for standing by. Welcome to A. O. Smith Corporation Third Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation there will be a question-and-answer session. 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.

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 Kevin Wheeler, Chairman and Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. In order to provide improved transparency into the operating results of our business, we provide non-GAAP measures. Free cash flow is defined as cash from operations less capital expenditures, adjusted earnings, adjusted earnings per share, adjusted segment earnings and adjusted corporate expenses exclude the impact of pension settlement income and restructuring and impairment expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and on our website. A friendly reminder that some of our comments and answers during this conference call will be forward-looking statements that are subject to risks that could cause actual results to be materially different. Those risks include matters that we described in this morning's press release, among others. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up per turn. If you have multiple questions, please rejoin the queue. We will be using slides as we move through today's call. You can access them on our website at investor.aosmith.com. I will now turn the call over to Kevin to begin our prepared remarks.

Thank you, Helen, and good morning, everyone. I'm on slide four and our third quarter results. As we previously announced, our third quarter sales and earnings decreased compared to last year as consumer demand in China and water heater demand in North America was weaker than expected. China third-party sales declined 17% in local currency. North America water heater sales decreased 4% as pricing actions were more than offset by lower volumes. I am pleased with the double-digit growth we had in the quarter in our North America boiler and water treatment businesses as well as in India. In October, we increased our dividend by 6%. We have increased our dividend annually for the last 32 years. In addition, we are on track to close Pureit by the end of the year. Please turn to slide five. In China, third quarter third-party sales decreased 17% in local currency as a result of weaker than expected consumer demand. We believe our position in the premium portion of the market remains stable. However, we saw increased pricing and promotional pressure, particularly in the mid-price sector of the market. While we expect consumer demand softness to persist through the remainder of the year, government-sponsored appliance trade-in programs and other recently announced government stimulus programs may provide a positive impact beyond 2024. In our North America water heater business, orders were softer than expected in the quarter in both the U.S. and Canada for both residential and commercial water heaters. We believe a price increase related to pre-buy and a reduction in our order lead times led our customers to adjust order patterns and reduce their inventories during the quarter. As we have discussed, we launched our A.O. Smith design and manufactured tankless product in the second quarter, which is currently manufactured in our China facility. Early feedback has been positive on our innovative scale-resistant design. While sales have lagged our expectations, we remain positive about the long-term outlook and we are on track to launch two additional models in early 2025. Our North America boiler sales grew 15% in the quarter compared to last year. As our commercial condensing boilers continue to perform well in the market, we believe we are growing our share in the commercial condensing portion of the market led by our CREST boilers with Hellcat Technology. North America water treatment sales increased 16% year-over-year due to acquisition-related dealer sales and organic growth in our dealer and wholesale channels. I'm now on slide six. As we have discussed earlier this year, we commenced several expansion projects in 2024 to support our long-term growth strategy. We recently celebrated the grand opening of our new facility on our campus in Juárez where we will manufacture gas tankless water heaters for North America. While there is still startup work to be completed, production is expected to begin in early 2025 with the ramp-up through the year. We have also added additional heat pump capacity on the same site in support of increased demand for our residential heat pump water heaters. Also, we have made progress on our new state-of-the-art commercial product development center, which is located on the same site as our Lebanon, Tennessee facility. This expanded facility, which is projected to be completed in mid-2025, will enhance our product development and testing capabilities and knowledge sharing by bringing together our commercial water heater and boiler engineering teams. I'll now turn the call over to Chuck who will provide more details on our third quarter performance.

Thank you, Kevin. Good morning, everyone. I'm on slide seven. Third quarter sales in the North America segment were $703 million, a 1% decline compared with 2023, as higher boiler and water treatment sales and the benefit of year-over-year pricing actions were more than offset by lower residential and commercial water heating volumes. North America segment earnings of $163 million decreased 4% compared with 2023. Segment margin was 23.1%, a decrease of 80 basis points year-over-year. The lower segment earnings and segment margin were primarily driven by lower water heating volumes that were partially offset by higher boiler and water treatment sales and pricing. Moving to slide eight, rest of the world segment sales of $210 million decreased 10% compared to last year. The decline was primarily driven by lower sales of our core water heater and water treatment products in China. India sales increased 12% in local currency in the quarter as our new products continue to be well received in the market. Rest of the world segment earnings of $14 million and segment margin was 6.5% in 2024 compared to segment earnings of $23.2 million and segment margin of 9.9% in the prior year. The lower segment earnings and segment margin were driven by lower sales, partially offset by lower material costs that resulted from cost-saving projects in China. Please turn to slide nine. We generated free cash flow of $283 million during the first nine months of 2024, a decrease from the same period last year, primarily as a result of higher inventory balances as well as higher incentive payments associated with record sales and profits. Last year, they were partially offset by lower accounts receivable balances. Capital expenditures increased $35 million year-over-year due to the growth-focused expansion projects that Kevin just reviewed. Our cash balance totaled $256 million at the end of September and our net cash position was $136 billion. Our leverage ratio was 5.9% as measured by total debt to total capital. Now turn to slide 10. In addition to returning capital to shareholders, we continue to see opportunities for organic growth, innovation and new product development across all of our product lines and geographies. As previously announced, we signed an agreement to acquire Pureit from Unilever for $120 million. The acquisition aligns with our strategy of adding scale and enhancing our premium water treatment product portfolio distribution footprint in the South Asia region, particularly in India. The acquisition of Pureit is on track to close by the end of 2024. Earlier this month, our board approved a 6% increase to our quarterly dividend to $0.34 per share. We repurchased approximately 2.9 million shares of common stock in the first nine months of 2024, for a total of $237 million. Please turn to slide 11 and our updated 2024 earnings guidance and outlook. We reaffirm our recently revised 2024 EPS outlook to an expected range of $3.70 to $3.85 per share. Our outlook is based on a number of key assumptions, including our guidance assumes that material costs in the full year 2024 will be roughly flat to 2023. Our guidance also assumes a relatively stable supply chain environment similar to what we experienced throughout 2023. For the year, CapEx should be between $105 million and $115 million, an increase year-over-year and from the past several years, due to our capacity expansion projects and expanded engineering capabilities. We expect to generate operating cash flow of $525 million and free cash flow of approximately $415 million, a reduction from our previous guidance due to the lower earnings outlook, increased inventories and lower customer deposits in China. Corporate and other expenses are expected to be approximately $70 million. Our effective tax rate is estimated to be approximately 24% and we expect to repurchase approximately $300 million of shares of our stock, resulting in outstanding diluted shares of $147 million at the end of 2024.

I'll now turn the call back over to Kevin who will provide more color on key markets and top line growth outlook and segment expectations, all while staying on slide 11. Kevin? Thank you, Chuck. We reaffirm our recently revised outlook for 2024 sales to be approximately flat to 2023, which includes the following assumptions. In China, we believe that the weakness we experienced in the market in the third quarter will persist through the remainder of the year. While we are encouraged by the recently announced government stimulus programs, we expect minimal impact from the programs in 2024. As a result, we lowered our 2024 China third-party sales guidance to be a decrease of between 6% and 8% local currency. Our forecast assumes a negative currency translation impact of approximately 1% for the year. Our North America residential water heater orders have been weaker than we expected since July when we provided our prior guidance. With our improved lead times, reduced backlog, and some signals of softness in the market, we believe our customers have reduced their inventories and that inventories will remain at current levels for the remainder of the year. Our July outlook assumed we would outperform the market and slightly improve our share year-over-year. On weaker orders, we project our share will remain similar to last year. We maintain our projection that the 2024 U.S. residential industry unit volumes will be relatively flat to last year. We have reduced our projection for the U.S. commercial water heater industry volumes from a low single-digit increase to approximately flat in 2024. There has also been an industry-wide mix shift within the commercial categories where electric unit shipments have increased and gas unit shipments have decreased compared to last year. We are pleased with our share in both categories. However, the change in the mix creates a headwind as the average price of a commercial gas water heater is approximately three times that of a commercial electric heater. The benefits of our previously announced price increases in North America water heating of 4% across most of our water heater products and 8% on heat pumps are included in our outlook. Our outlook assumes proactive replacement will remain at levels similar to last year. However, on signals of end market demand softening, we'll be watching our data closely. We revised our boiler sales growth guidance to be approximately 8% on the lower end of our previous range. We are pleased with our commercial boiler sales. However, we see weakness in our residential order rates. Our sales growth guidance for North America water treatment of an increase of 8% to 10% is unchanged. Based on our revised 2024 assumptions, we expect our North America segment margin to be approximately 24.5% and the rest of the world third-party segment margin to be approximately 8%. Please turn to slide 12. We are pleased with our boiler and North America water treatment sales growth in the quarter. Our China and North American water heater businesses experienced challenges in the third quarter. Although we have some caution around end market demand, we expect quarter-over-quarter improvement in North America water heater volumes, and even though we expect the weak demand in China to continue through the end of the year, our outlook projects quarter-over-quarter sales improvements as fourth-quarter sales are typically seasonally stronger in China due to shopping holidays. We are pleased with our year-to-date sales growth in our North America boiler business, particularly for our high-efficiency commercial products. Market optimism continues. However, we have seen a modest slowdown in coating activity. As we have in the past we are assessing the current environment in China now, reviewing our operations to optimize the business to align with lower volumes and create a solid foundation to leverage profitable growth in the future. In our manufacturing facilities in North America, we have adjusted to operate more efficiently at the current lower volume rates while still maintaining our improved lead times. A.O. Smith has a 150-year history of navigating through all economic cycles. We estimate replacement demand represents approximately 80% to 85% of U.S. water heater and boiler volumes. That stable replacement as well as our strong balance sheet allows us to continue investing for the long term in ourselves and through acquisitions. We are focused on servicing our customers and continue to grow our leadership position in heating and treating water. That concludes our prepared remarks and we are now available for your questions.

Thank you. Our first question comes from the line of Susan Maklari from Goldman Sachs.

Thank you. Good morning, everyone.

Good morning, Susan.

My first question is focusing on the North America residential water heater segment of the business. If I'm doing the math right, I think, considering your guide, that the industry volumes will be flat for the year. And based on what we know in terms of your commentary around price in that part of the business, it would suggest that you trailed the industry fairly significantly in the third quarter, and then you expect that to reverse pretty meaningfully going through the fourth quarter. I guess, first of all, is that right? And second of all, if so, can you just talk to what's driving those big moves that we've been seeing in the last several months?

Yes, I think it's. Let me just step back on that a little bit. The price increase that we had in the second quarter, we talked about generated more than we anticipated a 4% and particularly an 8% increase would generate. That increased our lead times and pushed out some orders. And when that happens, we have ERP systems in our customers that also start to generate more orders, and then we get behind. As we got into the second quarter and then even on our call in July, we had mentioned we saw some softness, and that was us working down our backlogs and really kind of bringing in line our lead times with again causing our distributors to reduce the inventories as they change their ERP systems back to a normal lead time. So there's been some puts and takes moving up and down in the market, but a lot of that deficit is just the inventory imbalance and timing. So when you just look at it from a share perspective, from our customers getting their fair share of the market, we're in pretty good shape. But it's just some lumpiness that we experienced that just happens during some price increases or during some volatile time. So nothing here from our side that I would tell you that we're concerned about. It's just something that we had to work through with our customers. And the only concern we have is maybe some softness that we saw in the market that we still have to work through.

And maybe just a couple of comments in addition. So, as Kevin said, there's a lot of timing that goes on with that. And we haven't changed our full-year outlook. But in July, a flat industry, I would say we were thinking of it as flat being really the floor and probably flat to up. And now as we look at the full year being flat, we'd say that, the flat is probably the ceiling and more flat to down. So just kind of gauge that for the fourth quarter, we feel very good about going into the fourth quarter, at least at the trend rate of what we see in orders, which have increased, really starting from August through September.

Thank you. One moment for our next question. Our next question comes from the line of Jeff Hammond from KeyBank Capital Markets, Inc.

Hey, good morning, guys.

Good morning.

Just wondering about the stickiness of your March price increase. We've seen a lot of deflation in steel, and I'm just wondering if that's making it harder to push price in North America.

Well, you know how much we like to talk about pricing here, but it's a good question. And as we look at it, the increase was executed as we indicated. And I would tell you the markets are always competitive. But as I step back and how we build our business plan and what we expect out of volume and pricing, we're exactly where we thought we would be according to our plan. So it's a competitive market, but nothing from a perspective that we're concerned about. Our goal is always, always come back to. Our goal is always to keep our customers competitive. And I feel we're in a good position as we head into the fourth quarter.

Okay. And then just on China, I mean, the business has been down significantly, then uneven for some time and the returns are much lower than the North America business. Just wondering how you're thinking about that business strategically, long-term, does it make sense in the portfolio? As an analyst, we get an increasing number of questions about that over the last 12, 18 months. Thanks.

Yes, that's a fair question. I mean, let me step back. A. O. Smith is a long-term company, and when we sit back and look at the markets, there are three markets that I think A. O. Smith should participate in and be a part of going forward on a long-term basis. Obviously, the U.S. I would tell you China is right behind that. It's the second largest economy moving potentially to the number one economy in the market still has a lot of upside from urbanization in the middle class. And the third is India. You put those three countries together where we have footprints in those markets, strong brands, and strong organization. So to answer your question more on a holistic standpoint, we're very comfortable in the markets that we're in and we see them have an upside, albeit some markets go through some tough patches and we're going through one in China. But long-term we still feel the demographics and economics make sense for A. O. Smith.

Thank you. One moment for our next question. Our next question comes from the line of Matt Summerville from D.A. Davidson Co.

Maybe just to follow up on China. Obviously, any early read you have on how we should be thinking about that business in 2025 in the context of the stimulus that you mentioned and do you feel like this is the beginning of a longer duration down cycle in China? I'm just getting back to Jeff's comment, which I thought was a fair one. I mean, this business has not been able to sustain, string together a multi-year period of growth since the late 2010s.

Yes, I think it's a little early on the stimulus side. We do think that's a positive outcome that we still need more information about. But again, as you look at it, I think the government of China realizes that they need to do something. They've announced a number of stimulus programs to increase credit for stalled construction projects. They've canceled purchasing restrictions and lowered mortgage rates. They have put out a litany of lists I think are going to have a positive impact. However, we still don't know the size of the stimulus, and that's an important part of it. But again, when you look at the market, you look at our brand, you look at our value proposition there, we still think there's upside. Again, it's been a tougher haul the last few years, particularly coming out of COVID. But again, the stimulus programs, people are talking about our brand positioning, our distributors and so forth. We still feel good about the business. Now when it's going to come out of that? That's a whole different story. We don't forecast that, but we do prepare our business to do business in that environment. We talked about how we're assessing the business today. But overall I think we'll get some good indication of what the stimulus looks like over the next few weeks and then we'll start to tie that back into what it means for our business going forward.

Then just as a follow-up, you mentioned what sounds like it may be more of a sustained pivot in your North America commercial business toward electric away from gas. Are you appropriately capacitated today to address that market trend? Help me kind of understand a little bit more about what's going on there.

Yes, Matt, we're very comfortable with our share in both electric and gas. If you recall, earlier in the year we were talking a bit about being heavier on the gas side of the business, which helped us a bit in Q1 and Q2. And now it's real; what we're really seeing is a little bit of an unwind of that and from a headwind. We'll be facing that in the back half of the year. But we're very comfortable with our capacity and our position in both electric and gas commercial.

Got it. Thank you, guys.

Thank you. One moment for our next question. Our next question comes from the line of Saree Boroditsky from Jefferies.

Hi, good morning. Just as we look towards 2025, can you just walk us through the impact of the tankless water heater factory switch on both the rest of the world and North America segments? Because I think it should be a maybe headwind to rest of world sales, but a margin benefit. It would be helpful to kind of walk through those impacts as we look to next year.

Yes, we will reserve, kind of framing it in a lot of detail as far as what it actually means for 2025. But the headwind that we're talking about this year and we've been talking about is 50 basis points to the full year to launch tankless and Kevin mentioned we're a little behind. Most of the weight will hit the fourth quarter going into next year. We would still expect a headwind. There's some benefit to the rest of the world from the volume perspective. But as we've talked about, we'll be transitioning that product from manufacturing in China to our Juárez facility over the course of 2025. So there will be a continued headwind into 2025, but we'll frame that a little bit closer as we get into the end of January and on our fourth quarter call.

Thank you. And maybe just digging into the residential water heaters in North America a little bit more. It seems like quarter-to-date shipments are up for the industry. So could you just help us understand how you performed in residential water heater volume from a volume perspective in the third quarter? How did this differ from the market, and if there was a difference, why is that the case? Thank you.

Yes. Again, the data you see is always a month or two behind. Based on our September and how we finished the quarter, we look at the industry having a pretty good shift back down in that 10% range. If you will, it's going to come in line with where we thought that the 3% you're talking about; we don't believe it's going to stick. There's going to be further softening in that number. And that's why we've been pretty consistent. We talked about it being flat for the rest of the year, and we're as Chuck just mentioned, we think it's flat to maybe slightly down by the time we exit 2024. So, you know, I just think it's timing in the orders and how things are, are actually going to play out in 2024. But we're very comfortable. We think that the industry is going to be relatively flat.

Thank you. One moment for our next question. Our next question comes from the line of Bryan Blair from Oppenheimer.

Good morning, everyone.

Hey, Bryan. If you can hear us, we can't hear you.

One moment for our next question. Our next question comes from the line of Mike Halloran from Baird.

Good morning, everyone.

Hey, Mike.

So just kind of following up on the last question there, maybe just talk about what sellout dynamics look like from an industry perspective. So I guess kind of twofold, is it more stable from a sellout perspective and then secondarily, when you look at your specific sellout data through your channel, I mean, is that what kind of backs up the stable share side of things from your perspective?

Yes. I would tell you we don't have perfect sell-out information, but we do communicate with our customers on a pretty regular basis. And it varies by market. But we have distributors that are up, say, low single digits up to some that are down. I think some of them are leaning a bit more to kind of even. Overall, the feedback we're getting is things have slowed a little bit. But know, overall, the market's still holding up, and it's going to be in that kind of flattish zone as we go forward and don't see anything changing there right now based on the customer feedback that we have, and that goes for both our residential business and our commercial business.

Yes. And I would just add that, one of the insights we get is we do that proactive replacement survey. And so we did that again this quarter and it's maintained relatively in the same position. So proactive replacement has been fairly strong. So we don't see a concern on proactive replacement movement down as of this quarter.

Right. Thanks for that. And then secondarily, just maybe talk about how you're thinking about steel cost and kind of the price-cost trend from here as we look at the fourth quarter and then kind of loose thoughts on steel curve into the front part of next year.

Yes, I mean, we've gone to the fourth quarter. We had a little bit of help on steel since steel took a tick favorable of about, maybe 15% movement from Q3 to Q4. Some of that also is timing as we slow down kind of volumes, we've got a little bit of a lag and we're going to experience that. But our price, the other costs, I mean, I think we, in our prepared remarks, we said overall material costs are relatively flat. So while steel is a little favorable for the fourth quarter year, fourth quarter and the year other material costs are a little bit unfavorable. So relatively flat. So price costs, we feel pretty stable going into the fourth quarter.

Thank you. One moment for our next question. Our next question comes from the line of David MacGregor from Longbow Research.

Yes. Good morning, everyone. Thanks for taking the questions. You had talked in your prepared remarks about with respect to North American water heater, the de-stock and just softer conditions, slightly slower coating activity, I think is what you said. Is it your sense that this is just replacement demand slowing down? You've indicated proactive is stable, or is it just builder and particularly maybe multifamily starting to impact that? And I guess to what extent you can talk about these factors that you've identified as having a negative influence on North American second half. Are they expected to carry forward as earnings headwinds into 25, where you're largely looking upon these as second half 24 issues?

Yes, I guess I would take it that replacements obviously continue to be stable. As Chuck just mentioned, it's been four years that we've had proactive replacement at the higher level. So I'm almost calling that a trend now. So when we look at the quarter and the lower order rates, we really believe that was primarily driven by inventory and just people rebalancing their inventories for one hour lead times, but also for maybe a bit slower demand over their counter. So that's really, I think the key part of it. It was an inventory correction driven by lead times coming down and I think the rest of the business seems to be pretty stable. Multifamily is down a little bit, but I don't think that's going to be a big driver as we close Q4.

I'll add that, we do get comfort on kind of what we see in trends overall residential order rates. So we said on our last call in July, order rates were down. We saw August also a bit down in order rates and residential, but then September took a tick up in order rates, and October month-to-date is also up a bit. So, that trend is very positive and gives us confidence that it's largely related to the pre-buy as you go into the fourth quarter.

Thank you. One moment for our next question. Our next question comes from the line of Scott Graham from Seaport Research Partners.

Hi. Good morning. Thanks for taking the questions.

Hey, Scott.

I wanted to just talk about China again because you had organic positive in the first half, and the third quarter was a pretty significant turnaround from that. I know you talked about pricing and I guess it would be the upper middle price point, but that's, I thought, less than half of those sales. So could you unbundle that for us a little bit? What do you think caused the significant flip in China sales in the third quarter versus the first half?

Yes, I'm going to give you what we feel are some possible reasons for it. It comes back to consumer confidence. If you look at the Q3, there are two items. GDP doesn't always tell us a whole lot, but one area that we look at constantly is property development and what's happened in that property market; it got significantly worse and hasn't been addressed. If you look at it, if you own property, about 70% of the Chinese consumer’s wealth is in property, so that's continuing to decline. I think that's driven some real poor confidence by the consumer and really holding back their spending. It accelerated in Q3. Employment has also been a challenge there. A lot of that I think happened in Q3, and it just accelerated the lack of consumer confidence where consumers just stepped back and decided they weren't going to spend unless it was absolutely necessary. That's how we feel. The quarter, I mean, it was going along pretty well, as you talked about for the first six months, but there was a change there, particularly in the property sector, that I think got the consumer's attention.

Just one other add-on to that and Kevin's comments cover the majority of the impact for the quarter. We also did launch our kitchen products last year in Q3, so we're anniversarying that, and we didn't have any benefit for kitchen products quarter-over-quarter, year-over-year. As we've come across that anniversary of launching those products.

That makes a lot of sense. Thank you for that color. I guess really the other question is on tankless. I think obviously you had high hopes in that area. What do you think is the drawback here? Is it maybe just that the market has weakened a little bit for, let's say, on the, maybe on the proactive side? It would seem, because the housing stats haven't really gotten worse. Right. So maybe on the proactive side, has that led into that sort of weaker reception to new products and in this case, the tankless?

No, I don't think it's that specific. Remember we launched one product category that was our premium condensed premix product line. That's the upper end of the market as we launched it. Again, there are still two other product lines that we'll be launching in early 2025. It might have gotten caught up a little bit into Q3 and some of the destocking that happened there. But if I step back, it's this is a long-term approach. You have to. My view is we're going to have to take share on a regular basis as we go forward. We think we have the product lines, the features and benefits. Being North America, having our own control, I think is going to be terrific. It's going to reduce lead times for our customers. They'll be able to put it on their trucks with water heaters. So there are several things that come along here, but we're in the early, early stages. We just launched it in May, but we just wanted to give you some color on how things were going forward. As we start to launch the new product and build out, we're still very comfortable and, as we mentioned in our analyst meeting, that we feel there's $100 million incremental sales for us as we get towards 2026. So, Scott, I just think it's just too early to make any assumptions there. The full product line should see a nice tick up as we enter in 2025.

Thank you. One moment for our next question. Our next question comes from the line of Nathan Jones from Stifel.

Good morning, everyone.

Good morning.

I wanted to just ask a question on the shortened lead times. My recollection is that your lead times have gotten back to normal post-COVID, like a couple of years ago. So maybe you can provide just a little bit more color on what you're talking about on lead times. Did they extend out and they've come back in again, or have you reduced them further or just what the details around that comment are?

I think your memory is perfect. But they did get extended out when we did the price increase in Q1 and Q2. So, as we talked about, that increase was a little bit lower. That increase was; we thought would have a minimal impact, but our customers really bought into the maximum amount they could. That raised our lead times up again. If you look at an overall part of our business, our boiler lead times are in good shape. Our water treatment lead times are in good shape. That point in time for North America water heating, that increase did put us out almost double our normal lead times. And that was a reason for it. It was a specific event, and this took us a little longer than we anticipated to work it down. So that's why you're hearing lead times back and forth. But we're really across most of, I'd say all of our businesses; our lead times are pretty much where they need to be, providing there's some kind of event like an increase that would change that.

Okay. And I wanted to ask a question on China from a different angle. It sounds like you don't have enough information to kind of figure out what impact this one will have. But you have been through cycles where China's provided stimulus to the market before, not deliberately for water heater markets, but for consumer spending. Can you maybe just give us a little color on some of the previous stimulus impacts that you've seen from the Chinese government, kind of how long that typically takes to flow through to the consumer? Any kind of magnitude you can put around that just from a historical perspective?

Yes. I would tell you this is probably a bit different than the prior stimulus. There was still a lot of FDI going into the country and people were expanding, and the environment's changed. So if you go back historically on this now it's just a different environment. The market is much more mature. I think the property sector, this issue is one that they have to deal with. They haven't had to deal with in the past. So I would really be cautious about us trying to predict how and when China will come out of this. I do think, though, the steps that they're talking about taking and it seems to be serious where they were doing more incremental stimulus and they're leaning in on a bit more larger stimulus package to move the economy. I think it's a good thing, but I couldn't really give you a prediction of when we think will come out of it. We know what they'll come out of it in some form or fashion down the road. We just, and again, I think what we're going to do is we're going to manage our business on the current environment, make the adjustments we need to make. We still have a strong brand there, and then as it starts to come out, we'll be in position to really benefit from that as things start to get better in China from an economic standpoint.

I would add that we have in the past heard of appliance programs specific to appliances that have not really gained much traction. But I would say the most recent program that they've announced, a trade-in program, at least appears at early stages to be a little more specific, a little more qualified type of a program. So we'll see where that goes. But historically, the appliance programs have not been as specific as this last program, and again, it's in early stages for that program.

Thank you. One moment for our next question. Our next question comes from the line of Damian Karas from UBS.

Hey, good morning, everybody. A couple follow-up questions on China. When you were talking about the water heater business there, it sounded like you're seeing varying trends in the premium side of the market versus the mid-tier price portion of your business. Could you maybe just break out the numbers to help us better understand kind of like what the difference was in the year-over-year trends for those two pieces?

Well, I would say overall, we're feeling that the entire market is a bit down. So, we're feeling that. I think we're down about 17% in local currency. I'd say it's fairly, fairly even. We feel like we've protected the premium position that we had. So our share from how we can measure it. It's always a challenge to measure share in China that we predicted our premium position, but the whole market, we feel, is a bit down, probably down a little bit more on the upper mid-price of the market because we did not fully participate in all the promotional programs. Overall, we just feel the whole market is a bit depressed based on some of the factors that Kevin mentioned earlier.

And I would just add to that again, we've been very selective. You got to remember, we sell one water heater at a time to a consumer. If we don't participate in a promotion, someone's going to maybe lean towards a competitive brand. But overall, our brand is strong, and we're going to continue to take our targeted approach to promotions and think about the long-term value of the A.O. Smith brand and our premium position, which I think has held up really well in this difficult environment.

Got it. Okay. And then just thinking about that 17% core sales decline, how much of that was purely kind of volume pressures versus maybe negative price and mix impacts?

Mostly all volume, Damian.

Yes, it's substantially all volume. You know, there's pricing pressure, and again, we didn't participate in all of that pricing pressure, but there's a little pressure on mix. But the majority of that decline is in volume.

Thank you. One moment for our next question. Our next question comes from the line of David MacGregor from Longbow Research.

Yes. Thanks for taking the follow up. I guess. Just again, on China, where are unit volumes today on your premium segment, water heaters versus or maybe as a percentage of pre-COVID levels?

Well, if you go back, and if you go back pre-2019, 2018, the majority of our sales were falling into the premium category and keeping the same baseline measurement on how we define premium. In the third quarter, quarter-over-quarter, year-over-year, we actually saw an increase in the premium portion of our market that we sold. So a little over 60% on the water heating side is in the premium category. And I would say on the water treatment side, it's a little bit less. We're kind of hovering the 40% to 30% premium.

Great. I guess I was just trying to get a sense of a comparison versus where you were pre-COVID.

Pre-COVID, before we saw a downturn a bit in the market, we were above 90% premium. The majority of our product was premium, particularly on the water heating side at that time.

Thank you. One moment for our next question. Our next question comes from the line of Bryan Blair from Oppenheimer.

Good morning, everyone.

Good morning.

Unfortunately, it's a technical issue, so I cut out from the call for a bit. I apologize if I'm repeating any questions there. You mentioned optimizing costs both in China and North America in response to demand conditions. Are there structural cost actions that are in flight right now? If so, can you quantify the anticipated savings or are these more variable moves for the timing?

Well, I'll cover China separately from North America. I mean, I'll say in North America we've made a few moves by realigning production between plants. We've reduced some headcount through attrition. We've balanced production and headcount at our largest facility. So taking some actions in the manufacturing facility to adjust to the volumes in the third quarter, which did cause a headwind to our margin in Q3, but feel like we're in a decent position going out of Q3 into Q4 in North America. In China, when we're looking at China, we have really two pieces. One is we're always looking at cost reduction. It's part of our process, and it's part of our process through looking at product innovation, redesigning product to take cost out, process improvement in the plant. So that's an ongoing process along with that ongoing process, particularly since COVID is looking at the efficiencies of our store footprint, looking to streamline and improve the efficiencies and what we support for retail outlets. Those things continue. In the current environment, as we did going into COVID, we're challenging ourselves to evaluate structurally. Is this the right foundation? And we want to have the best foundation. So we're taking a look at kind of our cost in China to be in a stronger position for profitable growth in the future. We don't have a quantification of what that may or may not cost, but we'll be looking at that through the course of the quarter and be back talking about kind of where we're at on China when we get into January.

Understood. And perhaps offer a smart color on your pending Pureit acquisition. I think high level and strategically makes a lot of sense. Just hoping you offer some detail on how the asset helps to accelerate profitable growth in South Asia and India in particular. The low to mid-single-digit margin profile you have right now, the levers to the upside, is that as simple as scale channel presence? How else will that make your business that much stronger in the region?

Yes, those are two pretty important items that you just mentioned, scale and footprint, along with complementary brands in the markets. Pureit has some strengths. Certain markets like e-commerce that we don't. You look at bringing the scale together and leveraging the various functions and so forth as we go forward, having access to different markets that maybe one side didn't then putting the combination together to, bring a package to some type of dealer or retailer. So the scale really matters. We're going to double our business in India, which is a big deal. We're going to move to the number three market share position, which again, gives us that foundation that we're looking for. It's been a goal for us. India is doing quite well, but organically, we just can't grow fast enough to get where we want to be. Strategic acquisitions like Pureit are going to make a big difference as we scale that business up. I believe it's a perfect time coming up the election and where India is going to go. Having two strong water treatment brands in the market, being able to leverage the synergies between the two companies over the next year or two. When you put that all together, I think it's going to drive certainly incremental margins. We're still in the early stages. We haven't closed, but I look forward to not only top-line growth but profitable growth and margin enhancement as we get into the first couple of years.

Thank you. One moment for our next question. Our next question comes from the line of Andy Kaplowitz from Citigroup.

Good morning, everyone.

Hey, Andy. Good morning.

Could you give us a little more color into how you're thinking about North American commercial water heaters? Obviously, you revised industry forecasts down a little bit, and you mentioned the move toward electric versus gas, but what's the risk that commercial could still get a little worse before it gets better, given it does tend to lag what happens in U.S. residential water heaters?

It does lag a bit. But as we look at, again, we start with our coating, we look at our distributors' inventory, our replacement market. I think we don't really see a significant shift down coating seems to be holding up pretty well. Again, remember, boilers plus water heating is 85%, 80%, 85% is replacement. But there is a shift going on. We have a nice heat pump product line that is in the commercial space as well. Of course, we have the premier condensing commercial gas product line. We just think there are different solutions we're going to have to work through. What I like about our position is we have a full portfolio from gas electric to heat pump technology to condensing high-efficiency gas product that we can provide that solution going forward. So again, we see it being relatively flat, but don't see a further downside to the business as we exit 2024.

That's helpful. And obviously boiler is still strong. I think you said you saw a modest slowdown in coating activity in boilers despite the overall strong growth. You mentioned the weaker residential boiler market. Are you at all concerned regarding slower slowdown in that market or generally still good outlook there?

Well, we're kind of pointing out where we're at, what's happening here. Our commercial, our conditioned commercial boilers have outperformed the market this year. We've gained some share feel really good about the pepper products, particularly some of the benefits that we have, like Hellcat technology. There's still a lot of activity out there. We just said we saw some softness there. But again, I go back to 80%, 85% of this business is still replacement. We're heading into the cold season, which is always a good time for us. Just wanted to maybe just put that on the table. Overall, the business is going well, our backlog is where we expect it to be. So overall performing really well. I do want to make one caution; we were up significantly, as we talked about, for the quarter, but if you go back, that was a pretty easy comp. We look going into Q4 as kind of a normalized run rate for our commercial boilers.

Thank you. One moment for our next question. Our next question comes from the line of Jeff Hammond from KeyBank Capital Markets, Inc.

Hey, guys, just a quick follow up. Free cash flow. You cut it pretty significantly, clearly the lower earnings, but just walk through the moving pieces.

Yes, it's really two moving pieces there. One is inventory. Our inventory forecast is up. You heard a little bit about us slowing a bit on our tankless plans. We still are very positive about tankless, but it's going to be a little slower out of the gate. And so we of our inventory, that's gone up a meaningful piece of that. Probably about 40% of the increase is due to carrying more tankless inventory than we would have at the end of last year. Some of that is planned. Some of that is just a little heavier than what we would have expected in July. The other piece is in China. We receive customer deposits in advance of shipments. As we've seen, China slow, our projection on year-end customer deposits just come down. So those are really the two major pieces.

Okay, thank you. At this time, I would now like to turn the conference back over to Helen Gurholt for closing remarks.

Thank you for joining us today. Let me conclude by reminding you that our Global A. O. Smith team delivered solid execution while navigating many challenges in the third 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 four conferences this quarter. Baird on November 12, North Coast on November 13, UBS on December 3, and Goldman Sachs on December 4. Thank you and enjoy the rest of your day.

This concludes today's conference call. Thank you for participating. You may now disconnect.