SMITH A O CORP (AOS)

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, heat pump and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world.

We continue to seek acquisitions that enable geographic growth, expand our core business, and establish adjacencies. On November 1, 2024, we acquired Pureit from Unilever for approximately $125 million, subject to customary adjustments. Pureit, a leading water purification business in South Asia, offers a broad range of residential water purification solutions and has annual sales of approximately USD $60 million. The acquisition fits squarely in our core capabilities and doubles our market penetration in the South Asia region. In the first quarter of 2024, we acquired Impact Water Products, a privately-held water treatment company. The acquisition supports our geographic expansion and growth strategy by expanding the West Coast presence of our water treatment business.

Also, we continue to look for opportunities to add to our existing product portfolio in high growth regions demonstrated by our previous introductions of kitchen products and connected product technologies in China. We also recently introduced our internally designed and manufactured gas tankless water heaters in North America. In addition, we are expanding our commercial water heater capacity in North America in preparation for the new efficiency rule for commercial water heaters that the Department of Energy (DOE) has adopted that will take effect in 2026.

In 2024, we recognized restructuring and impairment expenses of $17.6 million. In China, severance expenses of $11.3 million related to the right sizing of that business for current market conditions. The remaining $6.3 million related to the restructuring of our water treatment business in North America as a part of a profitability improvement strategy that prioritizes improving our cost structure and emphasizes our more profitable channels.

In our North America segment, we saw soft residential and commercial water heater order demand in the second half of 2024 after a strong first half of the year. We believe that a pre-buy ahead of our March 1st price increase pulled forward some demand into the first half of the year. We also believe our second half order demand was negatively impacted by our improved lead times. Those factors along with caution around softening of end market demand may have driven some customers to reduce their inventory levels. 2024 residential industry unit volumes were flat compared to the prior year and we project 2025 industry residential unit volumes will be flat as well. Proactive replacement has been above historical levels for the last several years and we project that will continue in 2025. We believe that new home construction remains in a deficit and will be flat compared to 2024. We anticipate that commercial water heater industry volumes will be approximately flat in 2025 after minimal growth in 2024 driven by growth in commercial electric water heaters greater than 55 gallons which was offset by lower shipments of commercial gas water heaters. We expect our boilers sales to grow between three and five percent in 2025 compared to 2024 as we continue to benefit from the transition to higher efficiency boilers. We anticipate sales of our North America water treatment products will be between $235 million and $245 million, a year-over-year decrease of approximately five percent as we de-emphasize certain channels and focus on our more profitable channels.

In our Rest of World segment, after sales growth of three percent in the first half of the year, our full-year 2024 third-party sales in China declined six percent due to a further weakening of consumer demand in the second half of the year. In 2025, we project our third-party sales in China to decrease between five to eight percent in local currency compared to 2024 as we expect consumer demand softness will persist in 2025.

Combining all of these factors, we expect our 2025 consolidated sales to be approximately flat to up two percent compared to 2024. Our guidance excludes the impacts from potential future acquisitions.

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RESULTS OF OPERATIONS

In this section, we discuss the results of our operations for 2024 compared with 2023. We discuss our cash flows and current financial condition under “Liquidity and Capital Resources.” For a discussion related to 2023 compared with 2022, please refer to Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the Year Ended December 31, 2023, which was filed with the United States Securities and Exchange Commission (SEC) on February 13, 2024, and is available on the SEC's website at www.sec.gov.

Our sales in 2024 were $3,818.1 million, a decrease of $34.7 million compared to 2023 sales of $3,852.8 million. Our decrease in net sales was primarily driven by lower water heater volumes in North America, lower sales in China, and unfavorable currency translation of approximately $18 million due to the depreciation of foreign currencies compared to the U.S. dollar, which more than offset our higher boiler sales and pricing actions. Our 2024 and 2023 acquisitions of water treatment companies in North America added approximately $18 million of incremental net sales in 2024.

Our 2024 gross profit margin of 38.1 percent decreased compared to 38.5 percent in 2023. The lower gross profit margin in 2024 compared to 2023 was primarily due to higher production costs and operational inefficiencies associated with volume volatility, which outpaced our pricing actions.

Selling, general, and administrative (SG&A) expenses were $739.3 million in 2024, or $11.9 million higher than in 2023. The increase in SG&A expenses in 2024 compared to the prior year was primarily due to higher employee costs from increased wages and higher selling and advertising expenses to support our strategic initiatives.

We recognized $17.6 million of restructuring and impairment expenses during the year ended December 31, 2024. Of these expenses, $6.3 million was related to our water treatment business in the North America segment and was a result of a profitability improvement strategy that prioritizes improving our cost structure and emphasizes our more profitable channels. In the Rest of World segment, restructuring included severance costs in China of $11.3 million and was related to the right sizing of that business for current market conditions. Restructuring and impairment expenses in 2023 were $18.8 million, of which $15.7 million was recorded in the Rest of World segment and $3.1 million was recorded in Corporate Expense and related primarily to the sale of our business in Turkey.

Interest expense was $6.7 million in 2024, compared to $12.0 million in 2023. The decrease in interest expense in 2024 compared to last year was primarily due to lower average debt levels.

Other (income) expense, net was $8.5 million of income in 2024 compared to income of $6.9 million in 2023. The increase in other income was driven by lower foreign currency translation losses compared to last year, partially offset by lower interest income from lower average cash balances.

Our effective income tax rate in 2024 was lower compared to 2023. The change in the effective income tax rate in 2024 compared to the prior year was primarily due to the restructuring and impairment expense recorded in 2023 with no associated tax benefit. We estimate that our annual effective income tax rate for the full year of 2025 will be approximately 24 to 24.5 percent.

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We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted earnings per share (EPS), total segment earnings, adjusted segment earnings, and adjusted corporate expense) that exclude the impact of restructuring and impairment expenses and pension settlement income. Reconciliations from GAAP measures to non-GAAP measures are provided in the Non-GAAP Measures section below. We believe that the measures of adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance or recurring in nature.

North America Segment

Sales in our North America segment were $2,950.1 million in 2024, or $27.2 million higher than sales of $2,922.9 million in 2023. Compared to the prior year, pricing actions, higher boiler sales, and approximately $18 million of incremental net sales from our 2024 and 2023 acquisitions of water treatment companies primarily drove our net sales increase and more than offset lower water heater volumes.

North America segment earnings were $707.5 million in 2024, or $19.2 million lower than segment earnings of $726.7 million in 2023. Segment margins were 24.0 percent and 24.9 percent in 2024 and 2023, respectively. Lower segment earnings and margins in 2024 were primarily due to lower water heater volumes, higher production costs and higher SG&A expenses associated with strategic investments that outpaced our pricing actions and higher boiler volumes. Segment earnings and margin in 2024 also included restructuring and impairment expenses of $6.3 million related to our water treatment business and a result of a profitability improvement strategy that prioritizes improving our cost structure and emphasizes our more profitable channels.

Adjusted segment earnings and adjusted segment margin in 2024 were $713.8 million and 24.2 percent, respectively, which excludes $6.3 million of pre-tax restructuring and impairment expenses. Adjusted segment earnings and adjusted segment margin in 2023 were $726.0 million and 24.8 percent, respectively, and exclude pension settlement income. We estimate our 2025 North America segment margin will be approximately 24.0 to 24.5 percent.

Rest of World Segment

Sales in our Rest of World segment were $918.6 million in 2024, or $38.3 million lower than sales of $956.9 million in 2023. Compared to the prior year, lower net sales in 2024 were primarily driven by decreased sales of our core water heating and water treatment products in China and included approximately $13 million of unfavorable currency translation. The decline in sales in 2024 was partially offset by higher volumes of kitchen products in China and included increased inter-segment sales of approximately $16 million related to our tankless water heaters manufactured in China and shipped to the U.S. market.

Rest of World segment earnings were $64.5 million in 2024 and lower compared to $83.4 million in 2023. Segment margins were 7.0 percent and 8.7 percent in 2024 and 2023, respectively. Lower volumes of our core water heating and water treatment products and an unfavorable product mix and sales promotions in China primarily drove lower segment earnings and segment margin in 2024, partially offset by lower SG&A costs. Segment earnings and margin in 2024 and 2023 included restructuring and impairment expenses of $11.3 million and $15.7 million, respectively. Restructuring and impairment expenses in 2024 were severance costs in China related to the right sizing of that business for current market conditions, and 2023 expenses were primarily associated with the sale of our business in Turkey.

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Adjusted segment earnings and adjusted segment margin in 2024 were $75.8 million and 8.3 percent, respectively. Adjusted segment earnings and adjusted segment margin in 2023 were $99.1 million and 10.4 percent, respectively. Adjusted segment earnings and adjusted segment margin in 2024 and 2023 exclude $11.3 million and $15.7 million of restructuring and impairment expenses, respectively. We estimate our 2025 Rest of World segment margin will be approximately eight to nine percent.

LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $495.7 million at December 31, 2024, compared with $555.0 million at December 31, 2023. The decrease in working capital was primarily related to lower cash and receivable balances, partially offset by higher inventory balances, lower accounts payable and lower payroll-related accruals. As of December 31, 2024, cash balances were negatively impacted by $6.6 million due to changes in foreign currency during the year. Cash and cash equivalents used to fund our operations are primarily generated through operating activities and our existing credit facilities. We believe our available cash and existing credit facilities are sufficient to cover our cash needs for the foreseeable future. We use a global cash pooling arrangement, intercompany borrowing, and some local credit lines to meet funding needs and allocate capital resources among various entities. We have historically made and anticipate future cash repatriations from certain foreign subsidiaries. In 2024, we repatriated approximately $90 million of cash from our foreign subsidiaries and used the proceeds to pay down outstanding debt balances and fund acquisitions.

Cash provided by operations in 2024 was $581.8 million and lower than $670.3 million in 2023, primarily as a result of higher incentive payments associated with record sales and profits earned in 2023, higher inventory balances and lower earnings, which more than offset lower trade receivable balances. Our free cash flow in 2024 and 2023 was $473.8 million and $597.7 million, respectively. We expect cash provided by operating activities to be between $600 million and $650 million in 2025. We expect free cash flow to be between $500 million and $550 million in 2025. Free cash flow is a non-GAAP measure described in more detail in the Non-GAAP Measures section below.

Capital expenditures totaled $108.0 million in 2024 compared with $72.6 million in 2023. Higher capital expenditures compared to the prior year were primarily due to our capacity expansion projects in Juarez, Mexico and McBee, South Carolina and our new engineering facility in Lebanon, Tennessee. We project that 2025 capital expenditures will be between $90 million and $100 million and full-year depreciation and amortization expense will be approximately $80 million.

In 2024, we renewed and amended our $500 million revolving credit facility ("renewed facility") which now expires on August 23, 2029. The renewed facility is with a group of nine banks and has an accordion provision that allows it to be increased up to $1 billion if certain conditions (including lender approval) are satisfied. Borrowing rates under the renewed facility are determined by our leverage ratio. The renewed facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2024, and expect to be in compliance for the foreseeable future. The renewed facility backs up commercial paper and credit line borrowings. At December 31, 2024, we had $30.0 million of borrowings outstanding under the renewed facility and an available borrowing capacity of $470.0 million. We believe the combination of available borrowing capacity and operating cash flows will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt increased by $65.9 million in 2024 primarily due to borrowings associated with our share repurchase program and Pureit acquisition. Our leverage, as measured by the ratio of total debt to total capitalization, was 9.3 percent at December 31, 2024, compared with 6.5 percent at December 31, 2023.

In 2024, our Board of Directors approved adding 2,000,000 shares of common stock to our existing discretionary share repurchase authority. Under our share repurchase program, we may purchase our common stock through a combination of a Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors, which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. During 2024, we repurchased 3,755,337 shares of our stock at a total cost of $305.8 million. As of December 31, 2024, we had 1,746,125 shares remaining on the share repurchase authority. On January 26, 2025, the Board of Directors approved adding 5,000,000 shares of common stock to the existing discretionary share repurchase authority. Including the additional shares, we had 6,476,677 shares

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available for repurchase as of the date of the Board of Directors' approval. We intend to repurchase approximately $400 million of our common stock in 2025 through a combination of 10b5-1 plans and open-market purchases.

We paid dividends of $1.30 per share in 2024 compared with $1.22 per share in 2023. We increased our dividend by six percent in the fourth quarter of 2024, and the five-year compound annual growth rate of our dividend payment is approximately eight percent. We have paid dividends for 85 consecutive years with annual amounts increasing each of the last 33 years.

Recent Accounting Pronouncements

Refer to Recent Accounting Pronouncements in Note 1, “Organization and Significant Accounting Policies” of Notes to the Consolidated Financial Statements.

Critical Accounting Policies

Our accounting policies are described in Note 1, “Organization and Significant Accounting Policies” of Notes to the Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets and significant estimates used in the determination of the liability related to product warranties. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.

Goodwill and Indefinite-lived Intangible Assets

In conformity with GAAP, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct a thorough and competent annual quantitative analysis of goodwill and indefinite-lived intangible assets. Based on the annual goodwill impairment test, we determined there was no impairment of our goodwill as of December 31, 2024. The fair value of each of our reporting units significantly exceeded its carrying value and a 20 percent decrease in the estimated fair value of our reporting units would not have resulted in a different conclusion. Based on the annual indefinite-lived assets impairment test, we determined there was no impairment of our indefinite-lived assets as of December 31, 2024.

Product Warranty

Our products carry warranties that generally range from one to 12 years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based on warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2024 and 2023, our reserve for product warranties was $190.4 million and $188.1 million, respectively.

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Non-GAAP Measures

We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense) that exclude the impact of restructuring and impairment expenses and pension settlement income. Reconciliations from GAAP measures to non-GAAP measures are provided below.

We believe that the measures of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance or recurring in nature.

A. O. SMITH CORPORATION

Adjusted Earnings and Adjusted Earnings Per Share

(dollars in millions, except per share data)

(unaudited)

The following is a reconciliation of net earnings and diluted earnings per share to adjusted earnings (non-GAAP) and adjusted earnings per share (non-GAAP):

(1) Earnings per share amounts are calculated discretely and, therefore, may not add up to the total due to rounding.

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A. O. SMITH CORPORATION

Adjusted Segment Earnings

(dollars in millions)

(unaudited)

The following is a reconciliation of reported earnings before provision for income taxes to total segment earnings (non-GAAP) and adjusted segment earnings (non-GAAP):

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A. O. SMITH CORPORATION

Free Cash Flow

(dollars in millions)

(unaudited)

The following is a reconciliation of reported cash flow from operating activities to free cash flow (non-GAAP):

A. O. SMITH CORPORATION

2025 EPS Guidance and 2024 Adjusted EPS

(unaudited)

The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax):

(1) Includes pre-tax restructuring and impairment expenses of $11.3 million and $6.3 million, within the Rest of World segment and North America segment, respectively.

Outlook

As we begin 2025, we expect our consolidated sales to be approximately flat to up two percent compared to 2024. Our projection is driven by expected flat industry residential and commercial volumes. In our Rest of the World segment, after a challenging 2024, we expect consumer demand softness will persist in 2025 in China and a decline in third-party sales. We expect full-year earnings of between $3.60 and $3.90 per share. Our guidance excludes the impacts of potential future acquisitions.

OTHER MATTERS

Environmental

Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the Company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2024 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage.

Risk Management

We evaluate risk to our business in a number of ways, primarily through our Enterprise Risk Management (ERM) process, which we conduct enterprise-wise on a periodic basis, and seeks to identify and address significant and material risks. Our ERM process assesses, manages, and monitors risks consistent with the integrated risk framework in the Enterprise Risk Management-Integrated Framework (2017) issued by the Committee of Sponsoring Organizations of the Treadway

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Commission (COSO). We believe that risk-taking is an inherent aspect of the pursuit of our strategy. Our goal is to manage risks prudently rather than avoid risks. We can mitigate risks and their impact on our company only to a limited extent.

A team of senior executives prioritizes identified risks, including decarbonization, new technologies and cyber threats among others, and assigns an executive to address each major identified risk area and lead action plans to manage risks. Our Board of Directors provides oversight of the ERM process and reviews significant identified risks. The Audit Committee of the Board of Directors also reviews significant financial risk exposures and the steps management has taken to monitor and manage them. Our other Board committees also play a role in risk management, as set forth in their respective charters.

Our goal is to proactively manage risks using a structured approach in conjunction with strategic planning, with the intent to preserve and enhance shareholder value. However, the risks set forth in Item 1A - Risk Factors and elsewhere in this Annual Report on Form 10-K and other risks and uncertainties could adversely affect us and cause our results to vary materially from recent results or from our anticipated future results.

Market Risk

We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1, “Organization and Significant Accounting Policies” of Notes to Consolidated Financial Statements.

We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2024, we had net foreign currency contracts outstanding with notional values of $70.1 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $7.0 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged.

Forward-Looking Statements

This filing contains statements that the Company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance,” “outlook” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: further softening in U.S. residential and commercial water heater demand; negative impacts to the Company, particularly the demand for its products, resulting from global inflationary pressures or a potential recession in one or more of the markets in which the Company participates; the Company’s ability to continue to obtain commodities, components, parts and accessories on a timely basis through its supply chain and at expected costs; negative impacts to demand for the Company’s products, particularly commercial products, as a result of changes in commercial property usage that followed the COVID-19 pandemic; further weakening in North American residential or commercial construction or instability in the Company's replacement markets; inability of the Company to implement or maintain pricing actions; inconsistent recovery of the Chinese economy or a further decline in the growth rate of consumer spending or housing sales in China; the availability, timing or effects of China stimulus programs; negative impact to the Company’s businesses from international tariffs, trade disputes and geopolitical differences, including the conflicts in Ukraine and the Middle East; potential weakening in the high-efficiency gas boiler segment in the U.S.; substantial defaults in payment by, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer; foreign currency fluctuations; the Company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; failure to realize the expected benefits of acquisitions or expected synergies; failure to realize the expected benefits, timing and extent, of regulatory changes; competitive pressures on the Company’s businesses; including new technologies and new competitors; the impact of potential information technology or data security breaches; negative impact of changes in government regulations or regulatory requirements; the inability to respond to secular trends toward decarbonization and energy efficiency and adverse developments in general economic, political and business conditions in key regions of the world. A more detailed description of these risks is contained under the heading "Risk Factors" in Item 1A above. Forward-looking statements included in this filing are made only as of the date of this filing, and the Company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

Forward-looking and other statements in this Form 10-K regarding our environmental and other sustainability plans and goals are not an indication that these statements are necessarily material to investors or are required to be disclosed in our filings with the SEC. In addition, historical, current, and forward-looking social, environmental and sustainability-related statements

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may be based on standards for measuring progress that are still developing, internal controls and processes that continue to evolve, and assumptions that are subject to change in the future. Any such forward-looking statements made herein are based on information currently available to us as of the date of this Report. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, heat pump and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world.

We saw improvement in our supply chain during 2022, particularly in the second half of the year, which continued through 2023. We remain in close contact with our suppliers and logistics providers to resolve supply chain constraints as they arise.

We continue to seek acquisitions that enable geographic growth, expand our core business, and establish adjacencies. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our previous introductions of water treatment products in India and kitchen products including our recently introduced dishwashers and steam ovens, in China. We also launched our internally designed and manufactured gas tankless water heaters in early 2024. In addition we are expanding our commercial water heater capacity in preparation for the 2026 commercial regulatory change.

In our North America segment, we saw resilient demand in the residential water heater industry in 2023 after three years of uneven growth, primarily related to the impacts of COVID-19-related supply chain constraints. Proactive replacement remained above historical levels in 2023 and we project that will continue in 2024. We believe that new home construction remains in a deficit and we expect it will be flat in 2024 compared to 2023. Considering these factors, we project 2024 industry residential unit volumes will be approximately flat after approximately six percent growth in 2023. We believe that commercial water heater industry volumes will grow low single digits in 2024 compared to 2023 as demand for commercial electric water heaters greater than 55 gallon continues a positive trend toward pre-2022 levels. Sales of our boilers and water treatment products were negatively impacted by elevated channel inventories in 2023. We believe that channel inventories were at near normal levels at the end of 2023 for both product categories. We expect to see an eight to ten percent increase in our sales of boilers in 2024 compared to 2023 as we continue to benefit from the transition to higher efficiency boilers. We anticipate sales of our North America water treatment products will increase approximately ten to 12 percent in 2024, compared to 2023, as we expect our sales to grow at approximately two times the market.

In our Rest of World segment, we saw a return to growth in China as our sales increased four percent in local currency in 2023. We project our sales in China will grow three to five percent in 2024 in local currency compared to 2023 driven by innovative new products and resilient demand for our core products. Our guidance assumes that the currency translation impact on sales will be minimal in 2024.

Combining all of these factors, we expect our 2024 consolidated sales to increase between three and five percent compared to 2023. Our guidance excludes the impacts from potential future acquisitions.

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RESULTS OF OPERATIONS

In this section, we discuss the results of our operations for 2023 compared with 2022. We discuss our cash flows and current financial condition under “Liquidity and Capital Resources.” For a discussion related to 2022 compared with 2021, please refer to Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the Year Ended December 31, 2022, which was filed with the United States Securities and Exchange Commission (SEC) on February 14, 2023, and is available on the SEC's website at www.sec.gov.

Our sales in 2023 were $3,852.8 million, or 2.6 percent higher than 2022 sales of $3,753.9 million. Higher sales in 2023 were driven by higher volumes of residential and commercial water heaters, which more than offset unfavorable foreign currency impacts of approximately $56 million, lower boiler sales and unfavorable pricing in our North America segment.

Our gross profit margin in 2023 of 38.5 percent increased compared to 35.4 percent in 2022. The higher gross profit margin in 2023 was primarily due to lower material costs.

Selling, general, and administrative (SG&A) expenses were $727.4 million in 2023, or $56.5 million higher than in 2022. The increase in SG&A expenses was primarily due to higher employee costs, which includes management incentive expenses related to higher earnings, and compensation increases. In 2022 SG&A included the recognition of an $11.5 million favorable judgment against a competitor related to its infringement of one of our patents, which reduced SG&A expenses, and was partially offset by a $4.3 million expense associated with a terminated acquisition.

Restructuring and impairment expenses in 2023 were $18.8 million, of which $15.6 million related to the sale of our business in Turkey which was included in our Rest of World segment. Of the $18.8 million restructuring and impairment expenses, $15.7 million was recorded in the Rest of World segment and $3.1 million in Corporate Expense.

Interest expense was $12.0 million in 2023, compared to $9.4 million in 2022. The increase in interest expense in 2023 was primarily due to higher debt levels and interest rates.

Other (income) expense, net was income of $6.9 million in 2023 compared to expense of $425.6 million in 2022. The change in Other (income) expense, net was primarily due to a reduction in pension expenses and pension settlement expense associated with the termination of our defined benefit pension plan (the Plan). In 2022, we recorded a $417.3 million pension settlement expense related to the termination of the Plan which represented over 95 percent of our pension plan liability. The service cost component of our pension expense is reflected in cost of products sold and SG&A expenses. All other components of our pension expense (income) are reflected in other (income) expense-net.

Our effective income tax rate in 2023 was higher than our effective income tax rate in 2022 primarily due to the tax effects of the pension settlement expense associated with the termination of the Plan and a change in geographic earnings mix. We estimate that our annual effective income tax rate for the full year of 2024 will be approximately 24 to 24.5 percent.

We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted earnings per share (EPS), total segment earnings, adjusted segment earnings, and adjusted corporate expense) that exclude the impact of restructuring and impairment expenses, pension settlement income and expenses, non-operating pension expenses, income from a legal judgment and expenses associated with a terminated acquisition. Reconciliations from GAAP measures

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to non-GAAP measures are provided in the Non-GAAP Measures section below. We believe that the measures of adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance or recurring in nature.

North America Segment

Sales in our North America segment were $2,922.9 million in 2023, or $103.8 million higher than sales of $2,819.1 million in 2022. The increased sales in 2023 compared to the prior year were primarily driven by higher residential and commercial water heater volumes, partially offset by lower volumes of boilers and unfavorable pricing.

North America segment earnings were $726.7 million in 2023, or $460.7 million higher than segment earnings of $266.0 million in 2022. Segment margins were 24.9 percent and 9.4 percent in 2023 and 2022, respectively. Higher segment earnings and margins in 2023 were primarily due to higher volumes of residential and commercial water heaters and lower material costs that were partially offset by higher SG&A expenses. Additionally in 2022, we realized pre-tax pension settlement expense of $346.8 million.

Adjusted segment earnings and adjusted segment margin in 2023 were $726.0 million and 24.8 percent, respectively which exclude $0.7 million of pension settlement income. Adjusted segment earnings and adjusted segment margin in 2022 were $611.0 million and 21.7 percent, respectively and exclude pension settlement expense of $346.8 million, pension expense of $9.7 million and the recognition of the $11.5 million patent infringement judgment. We estimate our 2024 North America segment margin will be approximately 24.5 to 25 percent.

Rest of World Segment

Sales in our Rest of World segment were $956.9 million in 2023, or $8.9 million lower than sales of $965.8 million in 2022. The decrease in sales in 2023 was primarily driven by the approximately $44 million unfavorable impact of foreign currency translation, partially offset by favorable volumes in China, particularly in our water treatment and kitchen products.

Rest of World segment earnings in 2023 were $83.4 million compared to $96.3 million in 2022. Segment margins were 8.7 percent and 10.0 percent in 2023 and 2022, respectively. Lower segment earnings and segment margin in 2023 were primarily driven by restructuring and impairment expenses of $15.7 million, of which $12.5 million was associated with the sale of our business in Turkey.

Adjusted segment earnings and adjusted segment margin in 2023 were $99.1 million and 10.4 percent, respectively. Adjusted segment earnings and adjusted segment margin in 2023 exclude restructuring and impairment expenses. We estimate our 2024 Rest of World segment margin will be approximately 10 percent.

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LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $555.0 million at December 31, 2023 compared with $699.5 million at December 31, 2022. Movements in working capital consisted of lower Cash and cash equivalents, and Marketable securities due to the paydown of our Long-term debt and Trade payables. In addition, as of December 31, 2023, cash balances were negatively impacted by $12.8 million due to changes in foreign currency. Cash and cash equivalents used to fund our operations are primarily generated through operating activities and provided by our existing credit facilities. We believe our available cash and existing credit facilities are sufficient to cover our cash needs for the foreseeable future. We use a global cash pooling arrangement, intercompany borrowing, and some local credit lines to meet funding needs and allocate capital resources among various entities. We have historically made and anticipate future cash repatriations to the United States from certain foreign subsidiaries. In 2023, we repatriated approximately $100 million of cash from our foreign subsidiaries through dividends and approximately $200 million through our global cash pooling arrangement. We used the proceeds to pay down outstanding debt balances.

Cash provided by operating activities in 2023 was $670.3 million compared with $391.4 million during 2022. The increase in operating cash flows in 2023 compared with the prior year is due to increased earnings and a more favorable working capital contribution primarily related to lower inventory levels and incentive payments. Our free cash flow in 2023 and 2022 was $597.7 million and $321.1 million, respectively. We expect cash provided by operating activities to be between $640 million and $690 million in 2024. We expect free cash flow to be between $525 million to $575 million in 2024. Free cash flow is a non-GAAP measure and is described in more detail in the Non-GAAP Measures section below.

Our capital expenditures were $72.6 million in 2023 and $70.3 million in 2022. We project our 2024 capital expenditures will be between $105 and $115 million and expect depreciation and amortization will be approximately $70 million.

In 2021, we renewed and amended our $500 million revolving credit facility, which now expires on April 1, 2026. The renewed and amended facility, with a group of nine banks, has an accordion provision that allows it to be increased up to $850 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2023, and expect to be in compliance for the foreseeable future. The facility backs up commercial paper and credit line borrowings. At December 31, 2023, we had no borrowings outstanding under the facility and an available borrowing capacity of $500 million. We believe the combination of available borrowing capacity and operating cash flows will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt decreased by $217.2 million in 2023 primarily due to the use of operating cash flows to pay down debt. Our leverage, as measured by the ratio of total debt to total capitalization, was 6.5 percent at December 31, 2023, compared with 16.5 percent at December 31, 2022.

Our remaining U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2023. We forecast that we will not be required to make a contribution to the plan in 2024, and we do not plan to make any voluntary contributions in 2024. For further information on our pension plans, see Note 13, “Pension and Other Post-retirement Benefits” of Notes to the Consolidated Financial Statements.

In 2023, our Board of Directors approved adding 7,500,000 shares of common stock to our existing discretionary share repurchase authority. Under our share repurchase program, we may purchase our common stock through a combination of a Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors, which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. During 2023, we repurchased 4,377,000 shares of our stock at a total cost of $306.5 million. As of December 31, 2023, we had 3,501,462 shares remaining on the share repurchase authority. On January 26, 2024, the Board of Directors approved adding 2,000,000 shares of common stock to the existing discretionary share repurchase authority. Including the additional shares, we have 5,202,462 shares available for repurchase as of the date of the Board of Directors' approval. We intend to repurchase approximately $300 million of our common stock in 2024 through a combination of 10b5-1 plans and open-market purchases.

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We paid dividends of $1.22 per share in 2023 compared with $1.14 per share in 2022. We increased our dividend by seven percent in the fourth quarter of 2023, and the five-year compound annual growth rate of our dividend payment is approximately 10 percent. We have paid dividends for 84 consecutive years with annual amounts increasing each of the last 32 years.

Recent Accounting Pronouncements

Refer to Recent Accounting Pronouncements in Note 1, “Organization and Significant Accounting Policies” of Notes to the Consolidated Financial Statements.

Critical Accounting Policies

Our accounting policies are described in Note 1, “Organization and Significant Accounting Policies” of Notes to the Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets and significant estimates used in the determination of the liability related to product warranties. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.

Goodwill and Indefinite-lived Intangible Assets

In conformity with GAAP, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct a thorough and competent annual quantitative analysis of goodwill and indefinite-lived intangible assets. Based on the annual goodwill impairment test, we determined there was no impairment of our goodwill as of December 31, 2023. The fair value of each of our reporting units significantly exceeded its carrying value and a 20 percent decrease in the estimated fair value of our reporting units would not have resulted in a different conclusion. Based on the annual indefinite-lived assets impairment test, we determined there was no impairment of our indefinite-lived assets as of December 31, 2023.

Product Warranty

Our products carry warranties that generally range from one to 12 years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based on warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2023 and 2022, our reserve for product warranties was $188.1 million and $182.5 million, respectively.

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Non-GAAP Measures

We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, total segment earnings, adjusted segment earnings, and adjusted corporate expense) that exclude the impact of restructuring and impairment expenses, pension settlement income and expenses, non-operating pension expenses, income from a legal judgment and expenses associated with a terminated acquisition. Reconciliations from GAAP measures to non-GAAP measures are provided below.

We believe that the measures of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance or recurring in nature.

A. O. SMITH CORPORATION

Adjusted Earnings and Adjusted Earnings Per Share

(dollars in millions, except per share data)

(unaudited)

The following is a reconciliation of net earnings and diluted earnings per share to adjusted earnings (non-GAAP) and adjusted earnings per share (non-GAAP):

(1) Earnings per share amounts are calculated discretely and, therefore, may not add up to the total due to rounding.

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A. O. SMITH CORPORATION

Adjusted Segment Earnings

(dollars in millions)

(unaudited)

The following is a reconciliation of reported earnings before provision for income taxes to total segment earnings (non-GAAP) and adjusted segment earnings (non-GAAP):

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A. O. SMITH CORPORATION

Free Cash Flow

(dollars in millions)

(unaudited)

The following is a reconciliation of reported cash flow from operating activities to free cash flow (non-GAAP):

A. O. SMITH CORPORATION

2024 EPS Guidance and 2023 Adjusted EPS

(unaudited)

The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax):

(1) Includes pre-tax restructuring and impairment expenses of $15.7 million and $3.1 million, within the Rest of World segment and Corporate expenses, respectively.

Outlook

As we begin 2024, we expect our consolidated sales to increase between three and five percent. Our sales projection is driven by continued end-market demand in water heating and a rebound in boiler and water treatment volumes after 2023 corrections in end-market inventories. In our Rest of the World segment, we see overall growth with stability in China as the economy continues to work through its challenges. We expect to achieve full-year earnings of between $3.90 and $4.15 per share. Our guidance excludes the impacts from potential future acquisitions.

OTHER MATTERS

Environmental

Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the Company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2023 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage.

Risk Management

We evaluate risk to our business in a number of ways, primarily through our Enterprise Risk Management (ERM) process, which we conduct enterprise-wise on a periodic basis, and seeks to identify and address significant and material risks. Our ERM process assesses, manages, and monitors risks consistent with the integrated risk framework in the Enterprise Risk Management-Integrated Framework (2017) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We believe that risk-taking is an inherent aspect of the pursuit of our strategy. Our goal is to manage risks prudently rather than avoid risks. We can mitigate risks and their impact on our company only to a limited extent.

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A team of senior executives prioritizes identified risks, including decarbonization, new technologies and cyber threats among others, and assigns an executive to address each major identified risk area and lead action plans to manage risks. Our Board of Directors provides oversight of the ERM process and reviews significant identified risks. The Audit Committee of the Board of Directors also reviews significant financial risk exposures and the steps management has taken to monitor and manage them. Our other Board committees also play a role in risk management, as set forth in their respective charters.

Our goal is to proactively manage risks using a structured approach in conjunction with strategic planning, with the intent to preserve and enhance shareholder value. However, the risks set forth in Item 1A - Risk Factors and elsewhere in this Annual Report on Form 10-K and other risks and uncertainties could adversely affect us and cause our results to vary materially from recent results or from our anticipated future results.

Market Risk

We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1, “Organization and Significant Accounting Policies” of Notes to Consolidated Financial Statements.

We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2023, we had net foreign currency contracts outstanding with notional values of $118.8 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $11.9 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged.

Forward-Looking Statements

This filing contains statements that the Company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance,” “outlook” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: softening in U.S. residential water heater demand; negative impacts to the Company, particularly the demand for its products, resulting from global inflationary pressures or a potential recession in one or more of the markets in which the Company participates; the Company’s ability to continue to obtain commodities, components, parts and accessories on a timely basis through its supply chain and at expected costs; negative impacts to demand for the Company’s products, particularly commercial products, as a result of changes in commercial property usage that followed the COVID-19 pandemic; further weakening in U.S. residential or commercial construction or instability in the Company's replacement markets; inability of the Company to implement or maintain pricing actions; inconsistent recovery of the Chinese economy or a further decline in the growth rate of consumer spending or housing sales in China; negative impact to the Company’s businesses from international tariffs, trade disputes and geopolitical differences, including the conflicts in Ukraine, the Middle East and attacks on commercial shipping vessels in the Red Sea; potential further weakening in the high-efficiency gas boiler segment in the U.S.; substantial defaults in payment by, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer; foreign currency fluctuations; the Company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on the Company’s businesses, including new technologies and new competitors; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; the inability to respond to secular trends toward decarbonization and energy efficiency; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and the Company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

Forward-looking and other statements in this Form 10-K regarding our environmental and other sustainability plans and goals are not an indication that these statements are necessarily material to investors or are required to be disclosed in our filings with the SEC. In addition, historical, current, and forward-looking social, environmental and sustainability-related statements may be based on standards for measuring progress that are still developing, internal controls and processes that continue to evolve, and assumptions that are subject to change in the future. Any such forward-looking statements made herein are based on information currently available to us as of the date of this Report. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

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ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, heat pump and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world.

Our sales in China in 2022 were impacted by lower consumer demand driven by COVID-19-related lockdowns. Certain COVID-19 restrictions were lifted in China at the end of 2022 and we believe that economic activity there will improve in 2023 as a result.

While supply chain and logistics challenges lingered in 2022, we saw improvement, particularly in the second half of the year. We remain in close contact with our suppliers and logistics providers to resolve supply chain constraints as they arise.

We continue to seek acquisitions that enable geographic growth, expand our core business, and establish adjacencies. Consistent with this strategy, we acquired Giant Factories, Inc. (Giant), a Canada-based manufacturer of residential and commercial water heaters, on October 19, 2021, for $199 million, subject to customary adjustments, using a combination of debt and cash. The acquisition fits squarely in our core capabilities, supplements our presence in Canada and enhances our capacity and distribution in the region. Giant contributed incremental sales of $94.3 million and $22.9 million in 2022 and 2021, respectively. Refer to Note 3, “Acquisitions” for additional information. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our previous introductions of water treatment products in India and range hoods and cooktops in China.

In our North America segment, after approximately eight percent growth each year in 2021 and 2020, we believe that the wholesale residential water heater industry is returning to a more historical growth rate following a channel inventory destocking that occurred primarily in the third quarter of 2022, which resulted in a decrease in industry demand of 12 percent compared to 2021. We believe the majority of our customers exited 2022 with near normal inventory levels. While we believe that new home construction is in a deficit, we project it will be a headwind in 2023 and therefore, we project 2023 industry residential unit volumes will decrease approximately two to five percent from 2022. We believe that commercial water heater industry volumes will be flat to slightly up in 2023 compared to 2022 as supply chain constraints continue to ease. We expect to see a 10 to 12 percent increase in our sales of boilers in 2023 compared to 2022 due to industry growth of approximately three to four percent and our expectation that the transition to higher-efficiency boilers will continue. We anticipate sales of our North America water treatment products will increase approximately five to seven percent in 2023, compared to 2022, primarily driven by pricing and consumer demand.

In our Rest of World segment, we see the recent change to certain COVID-19 restrictions in China as a positive step to an improved economic environment. We project our sales in China will grow three to five percent in 2023 in local currency compared to 2022. Our guidance assumes volume will improve sequentially through out the year. We assume that the currency translation impact on sales will be similar to the 2022 and negatively impact sales by approximately four percent.

Combining all of these factors, we expect our 2023 consolidated sales to be flat to 2022, with a range of plus or minus three percent. Our guidance excludes the impacts from potential future acquisitions and assumes the COVID-19-related impacts in China improve in the second half of the year and do not have a significant impact on our productivity or significantly impact the end markets that we serve.

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RESULTS OF OPERATIONS

In this section, we discuss the results of our operations for 2022 compared with 2021. We discuss our cash flows and current financial condition under “Liquidity and Capital Resources.” For a discussion related to 2021 compared with 2020, please refer to Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the Year Ended December 31, 2021, which was filed with the United States Securities and Exchange Commission (SEC) on February 11, 2022, and is available on the SEC's website at www.sec.gov.

Our sales in 2022 were $3,753.9 million, or 6.1 percent higher than 2021 sales of $3,538.9 million. Higher sales in 2022 were primarily driven by the impacts of inflation-related pricing actions partially offset by lower residential water heater volumes in North America and lower sales in China. In addition, our sales were negatively impacted by approximately $61 million compared to last year due to the depreciation of foreign currencies against the U.S. dollar. Our acquisition of Giant added $94.3 million of incremental sales in 2022.

Our gross profit margin in 2022 of 35.4 percent declined compared to 37.0 percent in 2021. The lower gross margin in 2022 was primarily due to higher steel and other material costs and production inefficiencies, which outpaced the impact of our pricing actions.

Selling, general, and administrative (SG&A) expenses were $670.9 million in 2022, or $30.5 million lower than in 2021. The decrease in SG&A expenses was primarily due to the recognition of a gain from an $11.5 million judgment against a competitor related to its infringement of one of our patents, lower management incentive expenses, and lower engineering costs in China.

Interest expense was $9.4 million in 2022, compared to $4.3 million in 2021. The increase in interest expense in 2022 was primarily due to higher debt levels and interest rates.

In 2021, our Board of Directors approved the termination of our defined benefit pension plan (the Plan) with a termination date of December 31, 2021. The Plan represented over 95 percent of our pension plan liability. In the second quarter of 2022, we received a determination letter from the Internal Revenue Service (IRS) that allowed us to proceed with the termination process. In the fourth quarter of 2022, the settled Plan liabilities resulted in $417.3 million of pretax pension settlement expense, of which, $346.8 million was recorded in the North America segment and $70.5 million in Corporate Expense, and included $167.7 million in related tax benefits. For additional information, refer to the Critical Accounting Policies section under “Pensions” below.

Other expense (income)-net in 2022 was $425.6 million in expense compared to income of $20.4 million in 2021. In 2022, Other expense (income)-net reflected the $417.3 million pension settlement expense related to the termination of the Plan and $13.9 million in pension expenses compared to $12.0 million of pension income in 2021. To protect the Plan's funded status, the Plan transferred a significant portion of its assets to lower-risk investments in 2021. The impact of this transition resulted in a lower expected rate of return on pension investments and, accordingly, higher pension expenses in 2022 compared to the previous year. The service cost component of our pension income is reflected in cost of products sold and SG&A expenses. All other components of our pension expense (income) are reflected in other expense (income)-net.

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Our effective income tax rate in 2022 was lower than our effective income tax rate in 2021 primarily due to the tax effects of the pension settlement expense associated with the termination of the Plan, a non-recurring $4.2 million favorable tax impact recorded in the prior year periods related to amending a previously filed tax return and a change in geographic earnings mix. We estimate that our annual effective income tax rate for the full year of 2023 will be approximately 24 percent.

We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense) that exclude the impact of the pension settlement expense as well as the income from the legal judgment, the expenses associated with a terminated acquisition and non-operating pension income and expenses. Reconciliations from GAAP measures to non-GAAP measures are provided in the Non-GAAP Measures section below. We believe that the measures of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance or recurring in nature.

North America Segment

Sales in our North America segment were $2,819.1 million in 2022, or $289.6 million higher than sales of $2,529.5 million in 2021. The increased sales in 2022 compared to the prior year were primarily driven by the price increases implemented in 2021, largely on water heaters, in response to rising material and other input costs and more than offset lower residential water heater volumes and unfavorable currency translation impact of approximately $12 million. In addition, our acquisition of Giant added $94.3 million of incremental sales in 2022.

North America segment earnings were $266.0 million in 2022, a decrease of 55 percent compared to segment earnings of $590.8 million in 2021. Segment margins were 9.4 percent and 23.4 percent in 2022 and 2021, respectively. Lower segment earnings and margin in 2022 were primarily due to the Plan settlement expense of $346.8 million, lower residential water heater volumes, higher material costs, and production inefficiencies, partially offset by price increases and the $11.5 million patent infringement judgment referenced above. Adjusted segment earnings and adjusted segment margin in 2022 were $611.0 million and 21.7 percent, respectively. Adjusted segment earnings and adjusted segment margin in 2021 were $580.3 million and 22.9 percent, respectively. We estimate our 2023 North America segment margin will be approximately 23 percent.

Adjusted segment earnings and adjusted segment margin in 2022 exclude the pension settlement expense of $346.8 million, pension expense of $9.7 million and the recognition of the $11.5 million patent infringement judgment. Adjusted segment earnings and adjusted segment margin in 2021 exclude pension income of $10.5 million.

Rest of World Segment

Rest of World sales of $965.8 million decreased seven percent year-over-year, including an unfavorable currency translation impact of approximately $49 million, of which $36 million related to sales in China. In local currency, segment sales decreased by approximately two percent year-over-year. The decrease in sales in 2022 was primarily driven by lower consumer demand in China due to COVID-19-related disruptions and lockdowns. Sales in India increased 28 percent in local currency in 2022 due to strong demand for our water heater and water treatment products.

Rest of World segment earnings were $96.3 million in 2022 compared to $91.4 million in 2021. Segment margins were 10.0 percent and 8.8 percent in 2022 and 2021, respectively. Compared to 2021, higher segment earnings and margin were primarily driven by lower engineering, advertising, and selling expenses in China. We expect the full-year segment margin to be approximately 10 percent in 2023.

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LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $699.5 million at December 31, 2022 compared with $633.8 million at December 31, 2021. A majority of the increase in working capital was driven by lower accounts payable and payroll-related accruals and higher inventory balances than at December 31, 2021, due to higher levels of safety stock which were partially offset by lower accounts receivable, and cash balances. In addition, cash balances as of December 31, 2022 were negatively impacted by $20.8 million due to the effects of changes in foreign currency during the year. In 2022, we repatriated approximately $120 million of cash from our foreign subsidiaries to the U.S. We used the proceeds to pay down outstanding debt balances.

Cash provided by operating activities in 2022 was $391.4 million compared with $641.1 million during 2021. The decrease in operating cash flows in 2022 was primarily due to lower customer deposits in China, higher 2021-related incentive payments made in 2022 and additional working capital cash outlays primarily related to higher cost inventories that more than offset lower accounts receivable balances. Our free cash flow in 2022 and 2021 was $321.1 million and $566.0 million, respectively. We expect free cash flow to be between $550 million to $600 million in 2023. Free cash flow is a non-GAAP measure and is described in more detail in the Non-GAAP Measures section below.

Our capital expenditures were $70.3 million in 2022 and $75.1 million in 2021. We project our 2023 capital expenditures will be between $70 and $75 million and expect depreciation and amortization will be approximately $70 million.

In 2021, we renewed and amended our $500 million revolving credit facility, which now expires on April 1, 2026. The renewed and amended facility, with a group of nine banks, has an accordion provision that allows it to be increased up to $850 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2022, and expect to be in compliance for the foreseeable future.

The facility backs up commercial paper and credit line borrowings. At December 31, 2022, we had $208 million outstanding under the facility and an available borrowing capacity of $292 million. We believe the combination of available borrowing capacity and operating cash flows will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt increased by $150.6 million in 2022 and was primarily due to repurchases of our common stock. Our leverage, as measured by the ratio of total debt to total capitalization, was 16.5 percent at December 31, 2022, compared with 9.7 percent at December 31, 2021.

Our remaining U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2022. We forecast that we will not be required to make a contribution to the plan in 2023, and we do not plan to make any voluntary contributions in 2023. For further information on our pension plans, see the Critical Accounting Policies below and Note 13, “Pension and Other Post-retirement Benefits” of Notes to the Consolidated Financial Statements.

In 2022, our Board of Directors approved adding 3,500,000 shares of common stock to our existing discretionary share repurchase authority. Under our share repurchase program, we may purchase our common stock through a combination of a Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors, which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. During 2022, we repurchased 6,647,895 shares of our stock at a total cost of $403.5 million. As of December 31, 2022, we had 378,462 shares remaining on the share repurchase authority. On January 27, 2023, the Board of Directors approved adding 7,500,000 shares of common stock to the existing discretionary share repurchase authority. Including the additional shares, we have approximately 7.6 million shares available for repurchase as of the date of the Board of Directors' approval. We intend to repurchase approximately $200 million of our common stock in 2023 through a combination of 10b5-1 plans and open-market purchases.

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We paid dividends of $1.14 per share in 2022 compared with $1.06 per share in 2021. We increased our dividend by seven percent in the fourth quarter of 2022, and the five-year compound annual growth rate of our dividend payment is approximately 15 percent. We have paid dividends for 83 consecutive years with annual amounts increasing each of the last 31 years.

Recent Accounting Pronouncements

Refer to Recent Accounting Pronouncements in Note 1, “Organization and Significant Accounting Policies” of Notes to the Consolidated Financial Statements.

Critical Accounting Policies

Our accounting policies are described in Note 1, “Organization and Significant Accounting Policies” of Notes to the Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.

Goodwill and Indefinite-lived Intangible Assets

In conformity with GAAP, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct a thorough and competent annual quantitative analysis of goodwill and indefinite-lived intangible assets. Based on the annual goodwill impairment test, we determined there was no impairment of our goodwill as of December 31, 2022. The fair value of each of our reporting units significantly exceeded its carrying value and a 20% decrease in the estimated fair value of our reporting units would not have resulted in a different conclusion. Based on the annual indefinite-lived assets impairment test, we determined there was no impairment of our indefinite-lived assets as of December 31, 2022.

Product Warranty

Our products carry warranties that generally range from one to 12 years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2022 and 2021, our reserve for product warranties was $182.5 million and $184.4 million, respectively.

Pensions

We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions.

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Our assumption for the expected return on plan assets was 3.12 and 6.25 percent in 2022 and 2021, respectively. The discount rate used to determine net periodic pension costs increased to 2.80 percent in 2022 from 2.47 percent in 2021. For 2023, our expected return on plan assets is 5.25 percent and our discount rate is 5.13 percent.

In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to bonds managers is between 60 to 95 percent with the remainder allocated primarily to equities, private equity managers and cash. Our actual asset allocation as of December 31, 2022, was eight percent to equity managers, 27 percent to bond managers, five percent to private equity managers, and the remainder allocated to cash. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 7.1 percent and 6.9 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 5.25 percent expected return on plan assets for 2023 is reasonable.

The discount rate assumptions used to determine future pension obligations at December 31, 2022 and 2021 were based on the Aon AA Only Above Median yield curve, which was designed by Aon to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary.

Lowering the expected return on plan assets by 25 basis points would increase our net pension expense for 2022 by approximately $1.8 million. Lowering the discount rate by 25 basis points would decrease our 2022 net pension expense by approximately $0.8 million.

In 2021, our Board of Directors approved the termination of our defined benefit pension plan (the Plan) with a termination date of December 31, 2021. The Plan represented over 95 percent of our pension plan liability. In the second quarter of 2022, we received a determination letter from the IRS that allowed us to proceed with the termination process. In the fourth quarter of 2022, we settled approximately $169 million of Plan liabilities through lump-sum payments from existing plan assets to eligible participants who elected to receive them and settled approximately $463 million of Plan liabilities by entering into an agreement to purchase annuities from Mass Mutual Life Insurance Company (MML). The irrevocable agreement with MML covers approximately 7,000 active and former employees and their beneficiaries, with MML assuming the future annuity payments for these individuals commencing March 1, 2023. These settlements resulted in approximately $417.3 million of pretax expense in 2022, partially offset by approximately $167.7 million in related tax benefits.

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Non-GAAP Measures

We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense) that exclude the impact of pension settlement expense as well as legal judgment income, expenses associated with a terminated acquisition and non-operating pension income and expenses. Reconciliations from GAAP measures to non-GAAP measures are provided below.

We believe that the measures of adjusted earnings, adjusted EPS, adjusted segment earnings and adjusted corporate expense provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items that we do not consider to be a component of our core operating performance or recurring in nature.

A. O. SMITH CORPORATION

Adjusted Earnings and Adjusted Earnings Per Share

(dollars in millions, except per share data)

(unaudited)

The following is a reconciliation of net earnings and diluted EPS to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP):

(1) Earnings per share amounts are calculated discretely and, therefore, may not add up to the total due to rounding.

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A. O. SMITH CORPORATION

Adjusted Segment Earnings

(dollars in millions)

(unaudited)

The following is a reconciliation of reported segment earnings to adjusted segment earnings (non-GAAP):

A. O. SMITH CORPORATION

Adjusted Corporate Expense

(dollars in millions)

(unaudited)

The following is a reconciliation of reported Corporate Expense to adjusted Corporate Expense (non-GAAP):

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A. O. SMITH CORPORATION

Free Cash Flow

(dollars in millions)

(unaudited)

The following is a reconciliation of reported cash flow from operating activities to free cash flow (non-GAAP):

A. O. SMITH CORPORATION

2023 EPS Guidance and 2022 Adjusted EPS

(unaudited)

The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax):

(1) Includes pre-tax pension settlement expense of $346.8 million and $70.5 million, within the North America segment and Corporate expenses, respectively.

(2) Includes pre-tax pension expense of $9.7 million and $2.0 million, within the North America segment and Corporate expenses, respectively.

Outlook

As we begin 2023, we expect our consolidated sales to be flat to 2022 with a range of plus or minus three percent. Our sales projection is driven by expected lower industry residential unit volumes in North America and offset by anticipated increased boiler and water treatment sales in North America and higher sales in China. We expect to achieve full-year earnings of between $3.15 and $3.45 per share. Our guidance excludes the impacts from potential future acquisitions and assumes the COVID-19-related impacts in China improve in the second half of the year and do not have a significant impact on our productivity or significantly impact the end markets that we serve.

OTHER MATTERS

Environmental

Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the Company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2022 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage.

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Risk Management

We evaluate risk to our business in a number of ways, primarily through our Enterprise Risk Management (ERM) process, which we conduct enterprise-wise on a periodic basis, and seeks to identify and address significant and material risks. Our ERM process assesses, manages, and monitors risks consistent with the integrated risk framework in the Enterprise Risk Management-Integrated Framework (2017) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We believe that risk-taking is an inherent aspect of the pursuit of our strategy. Our goal is to manage risks prudently rather than avoid risks. We can mitigate risks and their impact on our company only to a limited extent.

A team of senior executives prioritizes identified risks, including decarbonization, new technologies and cyber threats among others, and assigns an executive to address each major identified risk area and lead action plans to manage risks. Our Board of Directors provides oversight of the ERM process and reviews significant identified risks. The Audit Committee of the Board of Directors also reviews significant financial risk exposures and the steps management has taken to monitor and manage them. Our other Board committees also play a role in risk management, as set forth in their respective charters.

Our goal is to proactively manage risks using a structured approach in conjunction with strategic planning, with the intent to preserve and enhance shareholder value. However, the risks set forth in Item 1A - Risk Factors and elsewhere in this Annual Report on Form 10-K and other risks and uncertainties could adversely affect us and cause our results to vary materially from recent results or from our anticipated future results.

Market Risk

We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1, “Organization and Significant Accounting Policies” of Notes to Consolidated Financial Statements.

We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2022, we had net foreign currency contracts outstanding with notional values of $122.7 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $12.3 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged.

Forward-Looking Statements

This filing contains statements that the Company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance”, “outlook” or words of similar meaning. Forward-looking statements address uncertain matters and include any statements that: are not historical, such as statements about our strategy, financial plans, outlook, objectives, plans, intentions or goals (including those related to our social, environmental and other sustainability goals); or address possible or future results of operations or financial performance, including statements relating to orders, revenues, operating margins and earnings per share growth. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: further softening in U.S. residential water heater demand; negative impacts to the Company, particularly the demand for its products, resulting from global inflationary pressures or a potential recession in one or more of the markets in which the Company participates; the Company’s ability to continue to obtain commodities, components, parts and accessories on a timely basis through its supply chain and at expected costs; negative impacts to demand for the Company’s products, particularly commercial products, as a result of the severity and duration of the lingering effects of the COVID-19 pandemic; further weakening in U.S. residential or commercial construction or instability in the Company's replacement markets; inability of the Company to implement or maintain pricing actions; an uneven recovery of the Chinese economy or decline in the growth rate of consumer spending or housing sales in China; negative impact to the Company’s business in China as a result of future COVID-19 related disruptions there; negative impact to the Company's businesses from international tariffs, trade disputes and geopolitical differences, including the conflict in Ukraine; potential weakening in the high-efficiency boiler segment in the U.S.; substantial defaults in payment by, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer; foreign currency fluctuations; the Company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on the Company’s businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; the inability to respond to secular trends toward decarbonization and energy efficiency; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and the Company is

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under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

Forward-looking and other statements in this Form 10-K regarding our environmental and other sustainability plans and goals are not an indication that these statements are necessarily material to investors or are required to be disclosed in our filings with the SEC. In addition, historical, current, and forward-looking social, environmental and sustainability-related statements may be based on standards for measuring progress that are still developing, internal controls and processes that continue to evolve, and assumptions that are subject to change in the future. All forward-looking statements made herein are based on information currently available to us as of the date of this Report. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, heat pump and electric water heaters, boilers, tanks, and water treatment products. Both segments primarily manufacture and market in their respective region of the world.

In January 2020, an outbreak of a novel coronavirus (COVID-19) surfaced in Wuhan, China, which by March 2020 had spread throughout the world and was declared a global pandemic. Since March 2020 and continuing into 2021, we experienced impacts to our business and other markets worldwide. As a result of the COVID-19 pandemic and in support of continuing our manufacturing efforts, we have undertaken numerous and meaningful steps to protect our employees, suppliers, and customers. As we continue to receive guidance from governmental authorities, we adjust our safety measures to meet or exceed those guidelines.

Our global supply chain management team continued to navigate through supply chain and logistics challenges in 2021. We have seen supply constraints for certain components and raw materials used in our operations, as well as limited container and trucking capacity, and port congestion and delays. While supply chain issues moderated as we moved into 2022, we remain in close contact with our suppliers and logistics providers to troubleshoot, manage and resolve bottlenecks, as the environment remains unpredictable, particularly with the surge in the Omicron variant of COVID-19.

We seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. This includes focusing on acquisitions that are related to our core business. Consistent with this strategy, we acquired Giant Factories, Inc. (Giant), a Canada-based manufacturer of residential and commercial water heaters, on October 19, 2021, for $199 million, subject to customary adjustments, using a combination of debt and cash. The acquisition fits squarely in our core capabilities, supplements our presence in Canada and enhances our capacity and distribution in the region. Giant contributed $22.9 million of sales and approximately $0.01 in earnings per share (EPS) to our results in 2021 and we expect Giant will contribute approximately $0.06-$0.08 to our EPS in 2022. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our previous introductions of water treatment products in India and range hoods and cooktops in China.

In our North America segment, after approximately eight percent growth each year in 2021 and 2020, we expect residential industry water heater volumes will be down approximately two percent in 2022 compared with 2021 as we believe that industry demand will normalize to more historical growth rates. We believe that commercial water heater industry volumes will be flat to slightly down in 2022 compared to 2021 as new construction and replacement installations level off. We expect sales in 2022 will benefit from our 2021 price increases, which had a cumulative effect on our water heater prices of approximately 50 percent. We expect to see a ten percent increase in our sales of boilers in 2022 compared to 2021 due to industry growth of three to four percent, our expectation that the transition to higher-efficiency boilers will continue as well as our new product introductions. We anticipate sales of our North America water treatment products will increase 13 to 14 percent in 2022, compared to 2021, primarily driven by consumer demand for our point of use and point of entry water treatment systems.

In our Rest of World segment, after strong growth in 2021, we expect 2022 sales in China to increase approximately five percent in local currency compared with 2021 driven by demand for our residential and commercial water treatment products, including our replacement filters, as well as rangehoods and cooktops. We assume China currency rates will stay at levels similar to 2021.

Combining all of these factors, we expect our consolidated sales to increase between 16 and 18 percent in 2022. Our guidance excludes the potential impacts from future acquisitions and assumes the recent surge of the Omicron variant subsides during the first quarter of 2022 and does not have a significant impact on our productivity or significantly impact the end markets that we serve.

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RESULTS OF OPERATIONS

In this section, we discuss the results of our operations for 2021 compared with 2020. We discuss our cash flows and current financial condition under “Liquidity and Capital Resources.” For a discussion related to 2020 compared with 2019, please refer to Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the Year Ended December 31, 2020, which was filed with the United States Securities and Exchange Commission (SEC) on February 12, 2021, and is available on the SEC's website at www.sec.gov.

Our sales in 2021 were $3,538.9 million, or 22.2 percent higher than 2020 sales of $2,895.3 million. Compared to 2020, which was negatively impacted by the COVID-19 pandemic, our sales increase in 2021 was primarily driven by inflation-related pricing actions and higher water heater, boiler, and water treatment volumes in North America as well as higher sales in China. Our acquisition of Giant added $22.9 million of sales in 2021. In addition, our sales in China were favorably impacted by approximately $58 million in 2021 compared to 2020, due to the appreciation of the Chinese currency compared to the U.S. dollar.

Our gross profit margin in 2021 of 37.0 percent declined compared to 38.3 percent in 2020. The lower gross margin in 2021 was primarily due to higher steel and other material costs which outpaced our pricing actions.

Selling, general, and administrative (SG&A) expenses were $701.4 million in 2021 or $41.1 million higher than 2020. The increase in SG&A expenses in 2021 was primarily due to higher advertising, engineering and selling expenses and higher management incentive expenses related to higher earnings compared to 2020. Higher SG&A expenses in 2021 were partially offset by lower spending in China associated with headcount reductions, store closures and other cost-saving measures implemented during 2020.

To align our business to market conditions in 2020, we recognized $7.7 million of pre-tax severance and restructuring expenses. The charges were comprised of $6.8 million severance costs and $0.9 million of other restructuring expenses. These activities are reflected in "severance and restructuring expenses" in the accompanying financial statements.

Interest expense was $4.3 million in 2021, compared to $7.3 million in 2020. The decrease in interest expense in 2021 was primarily due to lower average debt levels.

Other income was $20.4 million in 2021 compared to $11.0 million in 2020. The increase in other income in 2021 was primarily due to higher pension and interest income.

Pension income in 2021 was $12.0 million compared to $5.1 million in 2020. The service cost component of our pension income is reflected in cost of products sold and SG&A expenses. All other components of our pension income are reflected in other income.

Our effective income tax rate was 22.1 percent in 2021, compared with 22.3 percent in 2020. Our lower effective income tax rate in 2021 was primarily due to a change in geographic earnings mix as well as a favorable tax impact related to amending a previously filed tax return. We estimate that our annual effective income tax rate for the full year of 2022 will be between 23.5 and 24 percent.

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North America Segment

Sales in our North America segment were $2,529.5 million in 2021 or $411.2 million higher than sales of $2,118.3 million in 2020. The increased sales in 2021 were driven primarily by price increases, largely on water heaters, which were implemented in response to rising material and transportation costs. Higher sales were also driven by increased volumes across all product lines, including $22.9 million of incremental sales from Giant.

North America segment earnings were $590.8 million in 2021, an increase of 17 percent compared to segment earnings of $503.5 million in 2020. Segment margins were 23.4 percent and 23.8 percent in 2021 and 2020, respectively. Higher segment earnings in 2021 were primarily due to inflation-related price increases and higher volumes, partially offset by higher material and logistics costs. Segment margin was lower in 2021 primarily due to the rise in costs outpacing pricing actions. In 2020 segment earnings and margin were adversely impacted by certain costs related to the pandemic. Those costs included temporarily moving production from Mexico to the U.S., paying employees during temporary plant shutdowns, proactively deep cleaning facilities, paying benefits during employee furloughs, and other costs, which were approximately $6.6 million in 2020. We estimate our 2022 North America segment margin will be between 22.25 and 22.75 percent.

Rest of World Segment

Sales in our Rest of World segment were $1,036.5 million in 2021 or $236.2 million higher than sales of $800.3 million in 2020. Sales in China increased by 32 percent in U.S. dollar terms and 24 percent in local currency in 2021 compared to 2020. In addition, our sales in China were favorably impacted by approximately $58 million in 2021 compared to 2020, due to the appreciation of the Chinese currency compared to the U.S. dollar. The increase in 2021 sales was primarily due to growth in our major product categories in China, including electric and gas tankless water heaters, and residential and commercial water treatment products, including replacement filters. Sales in China were also positively impacted by lower channel inventory reductions in 2021 compared to 2020. Channel inventory levels in China at the end of 2021 were at their lowest level in the last five years. Products with higher selling prices, including super-quiet gas tankless water heaters and water treatment products that deliver filtered water at a faster flow rate, contributed to sales gains. Sales in India increased approximately 31% compared to 2020, which was significantly impacted by the pandemic.

Rest of World segment earnings were $91.4 million in 2021 compared to breakeven in 2020. Segment margin was 8.8 percent in 2021. Compared to 2020, which was significantly impacted by the pandemic, earnings in 2021 increased primarily due to higher volumes in China, which was partially offset by higher employee incentives and brand-building-related advertising costs, as well as the absence of the social insurance waivers received in 2020 that did not repeat in 2021. Higher segment operating margin of 8.8% was primarily a result of increased operating leverage from higher volumes. We expect full-year segment margin to be approximately 10 percent in 2022.

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LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $633.8 million at December 31, 2021 compared with $731.7 million at December 31, 2020. A majority of the change to working capital was driven by higher accounts payable, payroll related accruals and lower cash balances than 2020, which were partially offset by higher inventory and sales related accounts receivable balances. We repatriated approximately $168 million of foreign cash and marketable securities in 2021 and utilized it to repurchase shares of our common stock. We expect to repatriate approximately $100 million in 2022 and use the proceeds for common stock repurchases.

Cash provided by operating activities in 2021 was $641.1 million compared with $562.1 million during 2020. The improvement in operating cash flows in 2021 was primarily due to increased earnings and lower outlays of working capital, including higher accounts payable balances in China, due to receipts of cash deposits in advance of sales from certain customers, and higher incentive related accruals. This was partially offset by higher inventory balances due to increased on hand quantities to ensure product availability and higher accounts receivable balances from higher sales. Our free cash flow in 2021 and 2020 was $566 million and $505 million, respectively. We expect free cash flow to be between $500 million to $525 million in 2022. Free cash flow is a non U.S. Generally Accepted Accounting Principles (GAAP) measure and is described in more detail in the Non-GAAP Measures section below. We continue to monitor developments on an ongoing basis and have taken proactive measures to focus on cash, manage working capital, and reduce costs.

Our capital expenditures were $75.1 million in 2021 and $56.8 million in 2020. Included in 2021 capital expenditures was approximately $11 million related to the purchase of our previously leased Lloyd R. Smith Corporate Technology Center in Milwaukee, WI. We project our 2022 capital expenditures will be between $75 and $80 million and expect depreciation and amortization will be approximately $80 million.

During the second quarter of 2021, we renewed and amended our $500 million revolving credit facility, which now expires on April 1, 2026. The renewed and amended facility, with a group of nine banks, has an accordion provision that allows it to be increased up to $850 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2021 and expect to be in compliance for the foreseeable future.

The facility backs up commercial paper and credit line borrowings. At December 31, 2021, we had $50 million outstanding under the facility and an available borrowing capacity of $450 million. We believe the combination of available borrowing capacity and operating cash flows will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt increased by $83.5 million from $113.2 million at December 31, 2020 to $196.7 million at December 31, 2021. The increase in debt balances was due to our acquisition of Giant and repurchases of our common stock. Our leverage, as measured by the ratio of total debt to total capitalization, calculated excluding operating lease liabilities, was 9.7 percent at December 31, 2021, compared with 5.8 percent at December 31, 2020.

Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2021. We forecast that we will not be required to make a contribution to the plan in 2022, and we do not plan to make any voluntary contributions in 2022. For further information on our pension plans, see the Critical Accounting Policies below and Note 13 of Notes to Consolidated Financial Statements.

In 2021, our Board of Directors approved adding 7,000,000 shares of common stock to our existing discretionary share repurchase authority. Under our share repurchase program, we may purchase our common stock through a combination of a Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors, which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. During 2021, we repurchased 5,087,467 shares of our stock at a total cost of $366.5 million. As of December 31, 2021, we had 3,526,357 shares remaining on the share repurchase authority. After a blackout period on share repurchase activity in the third quarter related to the Giant acquisition, we resumed our repurchases in early November. On January 25, 2022, the Board of Directors approved adding 3,500,000 shares of common stock to the existing discretionary share repurchase authority. Including the additional shares, we have approximately 6.8 million shares available for repurchase as of the date of the Board of Directors' approval. We

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intend to repurchase approximately $400 million of our common stock in 2022 through a combination of 10b5-1 plans and open market purchases.

On October 19, 2021, we acquired Giant, a Canada-based manufacturer of residential and commercial water heaters for approximately $199 million, subject to customary adjustments, using a combination of debt and cash. Giant manufactures water heaters at two facilities in Montreal, Canada and sells water heating products under the Giant brand across Canada. Incremental sales of $23 million were realized in 2021, from the date of acquisition.

We have paid dividends for 82 consecutive years with annual amounts increasing each of the last 30 years. We paid dividends of $1.06 per share in 2021 compared with $0.98 per share in 2020. We increased our dividend by eight percent in the fourth quarter of 2021, and the five-year compound annual growth rate of our dividend payment is approximately 17 percent.

Recent Accounting Pronouncements

Refer to Recent Accounting Pronouncements in Note 1 of Notes to Consolidated Financial Statements.

Critical Accounting Policies

Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements.

The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above.

Goodwill and Indefinite-lived Intangible Assets

In conformity with GAAP, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct a thorough and competent annual quantitative analysis of goodwill and indefinite-lived intangible assets. Based on the annual goodwill impairment test, we determined there was no impairment of our goodwill as of December 31, 2021. The fair value of each of our reporting units significantly exceeded its carrying value and a 10% decrease in the estimated fair value of our reporting units would not have resulted in a different conclusion. Based on the annual indefinite-lived assets impairment test, we determined there was no impairment of our indefinite-lived assets as of December 31, 2021.

Product Warranty

Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2021 and 2020, our reserve for product warranties was $184.4 million and $142.3 million,

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respectively. The increase in our reserve for product warranties in 2021 compared to the prior year was primarily due to increased steel prices and the acquisition of Giant.

Product Liability

Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2021, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also utilize an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2021 and 2020, our reserve for product liability was $35.4 million and $35.3 million, respectively. If the estimated loss reserves as of December 31, 2021 developed adversely by 10%, the impact on earnings would be approximately $2.9 million.

Pensions

We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 6.25 and 6.75 percent in 2021 and 2020, respectively. The discount rate used to determine net periodic pension costs decreased to 2.47 percent in 2021 from 3.18 percent in 2020. For 2022, our expected return on plan assets is 3.00 percent and our discount rate is 2.72 percent.

In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to bonds managers is between 60 to 95 percent with the remainder allocated primarily to equities, private equity managers and cash. Our actual asset allocation as of December 31, 2021, was one percent to equity managers, 75 percent to bond managers, one percent to private equity managers, and the remainder allocated to cash. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 9.3 percent and 8.2 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 3.00 percent expected return on plan assets for 2022 is reasonable.

The discount rate assumptions used to determine future pension obligations at December 31, 2021 and 2020 were based on the Aon AA Only Above Median yield curve, which was designed by Aon to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary.

Lowering the expected return on plan assets by 25 basis points would decrease our net pension income for 2021 by approximately $1.8 million. Lowering the discount rate by 25 basis points would increase our 2021 net pension income by approximately $0.7 million.

Pension Plan Termination

In 2021, our Board of Directors approved the termination of our defined benefit pension plan (the Plan) with a termination date of December 31, 2021. The Plan has filed for a determination letter from the IRS regarding the qualification of the plan termination. The Plan represents over 95 percent of our pension plan liability. In 2022, we expect to annuitize the remaining pension liability. The Plan settlement, which we expect to complete in the fourth quarter of 2022, will accelerate the recognition of approximately $445 million, or $1.73 of EPS, of non-cash, pre-tax pension expenses. In addition, to protect the Plan’s funded status, the Plan transferred a significant portion of its assets to lower risk investments in 2021. The impact of this transition will result in a lower expected rate of return on pension investments and accordingly, higher pension expenses in 2022, compared to previous years.

As part of our strategy to de-risk our defined benefit pension plan, the qualified defined benefit pension plan purchased a group annuity contract whereby an unrelated insurance company assumed $23 million obligation to pay and administer future annuity payments for certain retirees and beneficiaries in 2020.

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We recognized pension income of $12.0 million and $5.1 million in 2021 and 2020, respectively.

To provide improved transparency into the operating results of our business in 2022 we will provide a non-GAAP measure (adjusted earnings per share) that excludes the impact of our estimated pension settlement charge and non-operating pension income and expenses. A reconciliation from GAAP measures to non-GAAP measures is provided in the financial information included in this filing.

Non-GAAP Measures

We provide non-GAAP measures of adjusted free cash flow and adjusted EPS. We define free cash flow as cash provided by operating activities less capital expenditures. Our adjusted EPS excludes the impact of pension settlement expenses and non-operating pension income and expenses.

We believe that free cash flow provides useful additional information concerning cash flow available to meet future debt service obligations and working capital requirements. We believe that the measure of adjusted EPS provides useful information to investors about our performance and allows management and our investors to better understand our performance between periods without regard to items we do not consider to be a component of our core operating performance.

A. O. SMITH CORPORATION

Free Cash Flow

(dollars in millions)

(unaudited)

The following is a reconciliation of reported cash flow from operating activities to free cash flow (non-GAAP):

A. O. SMITH CORPORATION

2022 Adjusted EPS Guidance and 2021 Adjusted EPS

(unaudited)

The following is a reconciliation of diluted EPS to adjusted EPS (non-GAAP) (all items are net of tax):

(1)Includes pre-tax pension settlement charges of $378.3 million and $66.7 million, within the North America segment and Corporate expenses, respectively.

(2)Includes pre-tax pension expense of $10.5 million and $1.3 million, within the North America segment and Corporate expenses, respectively.

(3)Includes pre-tax pension income of $10.5 million and $2.6 million, within the North America segment and Corporate expenses, respectively.

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Outlook

As we begin 2022, we expect our consolidated sales to increase between 16 to 18 percent compared to 2021. Our higher expected sales are driven by pricing actions in North America and increased boiler and water treatment volumes within that region. We expect to achieve full-year earnings of between $1.56 and $1.76 per share and an adjusted EPS in the range of $3.35 and $3.55 per share. Our 2022 guidance excludes the potential impacts from future acquisitions and assumes the recent surge of the Omicron variant subsides during the first quarter of 2022 and does not have a significant impact on our productivity or significantly impact the end markets that we serve.

OTHER MATTERS

Environmental

Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the Company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2021 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage.

Risk Management

Our Enterprise Risk Management (ERM) process seeks to identify and address significant and material risks. Our ERM process assesses, manages, and monitors risks consistent with the integrated risk framework in the Enterprise Risk Management-Integrated Framework (2017) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We believe that risk-taking is an inherent aspect of the pursuit of our strategy. Our goal is to manage risks prudently rather than avoid risks. We can mitigate risks and their impact on our company only to a limited extent.

A team of senior executives prioritizes identified risks, including decarbonization, disruptive technologies and cyber threats among others, and assigns an executive to address each major identified risk area and lead action plans to manage risks. Our Board of Directors provides oversight of the ERM process and reviews significant identified risks. The Audit Committee of the Board of Directors also reviews significant financial risk exposures and the steps management has taken to monitor and manage them. Our other Board committees also play a role in risk management, as set forth in their respective charters.

Our goal is to proactively manage risks using a structured approach in conjunction with strategic planning, with the intent to preserve and enhance shareholder value. However, the risks set forth Item 1A - Risk Factors and elsewhere in this Annual Report on Form 10-K and other risks and uncertainties could adversely affect us and cause our results to vary materially from recent results or from our anticipated future results.

Market Risk

We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements.

We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2021, we had net foreign currency contracts outstanding with notional values of $186.3 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $18.6 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged.

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Forward-Looking Statements

This filing contains statements that we believe are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance,” "outlook," or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: our ability to continue to obtain commodities, components, parts and accessories on a timely basis through its supply chain and at expected costs; negative impacts to demand for our products, particularly commercial products, and its operations and workforce as a result of the severity and duration of the COVID-19 pandemic; our inability to implement or maintain pricing actions; an uneven recovery of the Chinese economy or decline in the growth rate of consumer spending or housing sales in China; negative impact to our businesses from international tariffs, trade disputes and geopolitical differences; potential weakening in the high-efficiency boiler segment in the U.S.; substantial defaults in payment by, material reduction in purchases by or the loss, bankruptcy or insolvency of a major customer; a weakening in U.S. residential or commercial construction or instability in our replacement markets; foreign currency fluctuations; our inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on our businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and we are under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to us, or persons acting on our behalf, are qualified entirely by these cautionary statements.