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AO Smith Corp. (NYSE:AOS)
Q2 2020 Earnings Call
Jul 30, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Second Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Now, I would like to hand the conference over to your first speaker for today, Ms. Patricia Ackerman, Senior Vice President of Investor Relations, Corporate Responsibility and Sustainability and Treasurer. Thank you. Please go ahead, madam.

Patricia Ackerman -- Senior Vice President, Investor Relations, Treasurer & Corporate Responsibility and Sustainability

Thank you, Mikey. Good morning, ladies and gentlemen and welcome to A. O. Smith's second quarter 2020 results conference call. Joining me today are Kevin Wheeler, Chairman and Chief Executive Officer; and Chuck Lauber, Chief Financial Officer. Before we begin with Kevin's remarks, I would like to remind you that some of the comments that will be made during this conference call, including answers to your questions will constitute forward-looking statements. These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in this morning's press release and on Slide 2.

On Slide 3, in order to provide improved transparency into the operating results of our business, we provided non-GAAP measures adjusted net earnings, adjusted earnings per share, and adjusted segment earnings that exclude the severance and restructuring charges related to aligning our business to current market conditions. Reconciliations from GAAP measures to non-GAAP measures are provided in the appendix at the end of this presentation and also on our website. Also, as a courtesy to others in the question queue, please limit yourself to one question and one follow-up question per turn. If you have multiple questions, please rejoin the queue. I will now turn the call over to Kevin, who will begin our prepared remarks on Slide 4.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Thank you, Pat. Before I summarize the quarter and Chuck goes through the results, I want to express how proud I am of our global team. We faced challenges and complexities to our business that we have never faced before. Our number one goal was and remains to keep our employees safe while delivering our essential products to our customers. I say confidently that our team met and often exceeded my expectations. Thank you to the men and women in the A. O. Smith family around the world for your dedication and your spirit. You truly make A. O. Smith a remarkable company.

The business performed in the second quarter is largely in line with what we saw in April. Continuing the pace of growth we saw in the first quarter, our North America water treatment business organically grew 19%. Direct-to-consumer and retail sales were particularly strong as consumers became more health conscious during the pandemic and the shelter-in-place orders confined many of us to our homes. As expected, industry volumes of residential water heaters in the U.S. held up notably well. Based on our June shipments, we estimate industry volumes were flat to slightly up [Phonetic] in the quarter compared to last year.

Due to construction project delays and postponements in North America, we saw commercial water heater and boiler volumes decline, in line with our estimates of the industry declines of 20% to 25% in the quarter compared with last year. Consumer demand for our products in China was flat to slightly positive compared to the second quarter of 2019 as restaurants and shopping malls reopened and retail foot traffic increased. We remained operational with no significant disruptions. Our Juarez, Mexico plant, which we voluntarily closed in April, reopened in May and ramped up production over the latter portion of the quarter.

We have taken numerous and meaningful steps to protect our employees, suppliers, and customers in the pandemic. These important steps, in many cases reduced efficiencies, and include continuous communication and training to our employees on living and working safely in a COVID-19 world, client [Phonetic] accommodations and reconfiguration to maintain social distancing, masks for all employees, implementation of sanitizing stations, temperature taking, and regular proactive deep cleaning and sanitization of our facilities.

Our global supply chain remain operational. We continue to monitor and manage our ability to operate effectively as tariffs and the evolving nature of the COVID-19 pandemic and the related stresses on the supply chain and periodic marketplace disruptions impact our operation. To align our business with current market conditions, primarily in China and to a lesser extent in North America, we reduced headcount and incurred other restructuring costs totaling $6 million in the second quarter. I will now turn the call over to Chuck, who will provide more details on the quarter, beginning on Slide 5.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Thank you, Kevin. Second quarter 2020 sales of $664 million declined 13% compared to the second quarter of 2019. The decline in sales was largely due to lower water heater volumes in China and lower commercial water heater and boiler volumes in North America driven by the COVID-19 pandemic. As a result of lower sales, second quarter 2020 adjusted earnings of $73 million and adjusted earnings per share of $0.45 declined significantly compared with the same period in 2019.

Please turn to Slide 6. Sales in our North America segment of $481 million declined 8% compared to the second quarter of 2019. Organic growth of approximately 19% in North America water treatment sales was more than offset by lower commercial water heater volumes, lower boiler volumes, and a water heater sales mix composed of more electric models which have a lower selling price. Rest of the World segment sales of $190 million declined 24% compared to the same quarter of 2019. China sales declined 20% in local currency related to higher mix of mid-price products and further reductions in customer inventory levels.

Consumer demand for our products in China was flat to slightly positive compared with the second quarter of 2019. China currency translation negatively impacted sales by approximately $6 million. Our sequential sales in China improved through the quarter and China was profitable in May and June. India sales declined significantly as the economy was shut down during a majority of the quarter to minimize the spread of the virus.

On Slide 7, North America adjusted segment earnings of $108 million were 12% lower than segment earnings in the same quarter in 2019. The decline in earnings was driven by lower volumes of commercial water heaters, lower boiler volumes, and a mix skew to electric water heaters. Certain costs directly related to the pandemic including temporarily moving production from Mexico to the U.S., paying employees during temporary plant shutdowns, facility cleaning, paying benefits for furloughed employees and other costs were $5.5 million in the second quarter. Adjusted earnings exclude $2.2 million in pre-tax severance costs. As a result, second quarter 2020 segment -- adjusted segment margin of 22.4% declined from 23.5% achieved in the same period last year.

Rest of the World adjusted segment loss of $2 million declined significantly compared with 2019 second quarter segment earnings of $22 million. The unfavorable impact to profits were lower China sales and a higher mix of mid-price products which have lower margins more than offset the benefits to profits from lower SG&A expenses. These results exclude $3.9 million in pre-tax severance and restructuring costs. As a result of these factors, adjusted segment margin was negative compared with 9% in the same quarter of 2019. Our corporate expenses of $10 million and interest expense of $3 million were similar to last year.

Please turn to Slide 8. Cash provided by operations of $179 million during the first half of 2020 was higher than $144 million in the same period of 2019 as a result of lower investment in working capital, including deferral of our April estimated federal income tax payment to July, which was partially offset by lower earnings compared with the year ago period. Our liquidity and balance sheet remained strong. We had cash balances totaling $569 million and our net cash position was $288 million at the end of June.

Our leverage ratio at the end of the second quarter was 14.5% as measured by total debt to total capital. We had $332 million of undrawn borrowing capacity on our $500 million revolver. [Technical Issues] the second quarter and our share repurchase activity continues to be suspended. During the first half of 2020, we repurchased approximately 1.3 million shares of common stock for a total of $57 million.

Please advance to Slide 9, we reintroduced our 2020 adjusted EPS guidance this morning with a range of between $1.72 to $1.86 per share. Our 2020 adjusted EPS guidance excludes $0.03 per share in severance and restructuring costs included that were incurred in the second quarter. Our adjusted guidance assumes the conditions of our business environment and that of our suppliers and customers is similar for the remainder of the year to what we are currently experiencing and does not deteriorate as a result of further restrictions or shutdown due to the COVID-19 pandemic.

We expect our cash flow from operations in 2020 to be approximately $350 million compared with $456 million in 2019, primarily due to lower earnings. Our 2020 capital spending plans are between $60 million and $70 million and our depreciation and amortization expense is expected to be approximately $80 million. Our corporate and other expenses are expected to be approximately $47 million in 2020, slightly higher than 2019 primarily due to lower interest income on investments. We expect our interest expense to be $9 million in 2020 compared with $11 million in 2019. Our effective income tax rate is expected to be between 23% and 23.5% in 2020. Our assumptions assume no additional share repurchase resulting in an average diluted outstanding shares in 2020 of approximately 162.5 million. I'll now turn the call over to Kevin, who will summarize our guidance assumptions beginning on Slide 10.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Okay, thank you, Chuck. Our outlook for 2020 includes the following assumptions. We project U.S. residential water heater industry volumes will be flat in 2020 driven by resilient replacement demand and similar levels of new home constructions as last year. We expect commercial industry water heater volumes will decline approximately 10% as job sites and business closures due to the pandemic delay or defer new construction and discretionary replacement installation.

It is encouraging to see consumer demand for our China product similar, if not a little higher than last year over the last four months. We are also seeing sequentially quarterly improvement in market share both online and offline for water heater and water treatment products driven by our mid-price range products. We took additional charges in Q2 for further restructuring of the business. We believe these restructuring charges are largely behind us.

We continue to target closure of 1,000 existing stores while targeting to open 500 small store relationships in Tier 4 through 6 cities. Cost actions and restructuring activity are projected to result in $35 million of savings in 2020 over 2019, $15 million of which will be realized in the second half of 2020. We expect year-over-year declines in local currency sales of 18% to 20% and protract sequential quarter-over-quarter growth in the second half of the year as China appears to be making sustainable progress in reopening their economy and keeping the virus in check.

We expect our North America boiler sales will decline approximately 10% for the full year. Commercial boilers represent 65% to 70% of our boiler sales. With many job sites temporarily closed during the second quarter, we believe as job sites reopen, the orders will sequentially improve in the second half of the year. We project 20% to 22% sales growth in our North America water treatment products which include incremental Water-Right sales. We ended 2019 with a $2.6 million loss in India and expect a similar loss in 2020 as a result of the pandemic.

Please advance to Slide 11. We project revenue will decline by 7% to 8% in 2020 as strong organic North America water treatment sales and resilient North America residential water heater volumes are more than offset by weaker North America commercial water heater and boiler volumes and lower China sales, largely due to the pandemic. We expect North America segment margin to be between 22.5% and 23% and Rest of World segment margins to be negative 1% to negative 2.5%.

Please turn to Slide 12. We believe particularly in these uncertain times A. O, Smith is a compelling investment for a number of reasons. We have leading share positions in our major product categories. We estimate replacement demand represents approximately 80% to 85% of U.S. water heater and boiler volumes. We have a strong premium brand in China, a broad product offering in our key product categories, broad distribution, and a reputation for quality and innovation in that region. Over time, we are well positioned to maximize favorable demographics in both China and India to enhance shareholder value. We have strong cash flow and balance sheet supporting the ability to continue to invest for the long-term with investments in automation, innovation, and new products as well as acquisitions and returning cash to shareholders.

We will continue to proactively manage our business in this uncertain environment. We see improving consumer demand trends emerge in China where we were first impacted by the pandemic and see China operations pivot to profitability for the remainder of the year. In North America, as the economy begins to reemerge after [Phonetic] the economic shut down, persistent COVID-19 cases and related potential implications to returning to a more stable environment in the market, workplace and supply chain will continue to be challenging throughout the remainder of the year. We have a strong and dedicated team, which has navigated successfully through prior downturns and I'm confident in our ability to execute similarly through COVID-19. That concludes our prepared remarks and then we are now available for your questions.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from the line of Jeff Hammond of KeyBanc. Your line is open.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Hi, good morning everyone.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Good morning, Jeff.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Good morning, Jeff.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Just want to dig in on this China dynamic, sales down 20% and I think you said consumer demand was flat. So just help me square those two things. I know you mentioned mix and destock. Just maybe parse those out and what's the expectation for this mix dynamic and kind of inventory destocking to continue into the second half?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Okay, so we're down, you're right, it's about 20% when you take out the FX. So right, for the quarter, we're down 20%. There is two main pieces, one is mix and the other, you're right, is the destock. If you just kind of look at the mix, of that 20%, roughly a third, less than a half is related to sales mix. So you kind of -- you just get into that category of a little [Phonetic] less than half to maybe a third of that 20%. The rest is really destock in consumer demand. So it's -- inventories came down again in the channel inventory in China. So we were a little bit surprised they came down as much as they did. We don't project them to continue to decrease. They are now in the two to three month range when we recalibrate to kind of what we see 2020 to be at. So in our forward looking, we think they are about as low as they're going to go, they could go lower, but that's what our projection has.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

And the mix dynamic in the second half, should that continue?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

You know, the mix dynamic is a little unique I think in Q2, right. So we've got our online sales were strong. So if you look at our online sales, they were 30% of our total revenue in Q2 and actually up quarter-over-quarter slightly. So online sales put a little bit more pressure on the mid-price products as you know, they kind of -- there is more mid-priced -- upper mid-price products on the online than there is in the offline. We would expect that there continue to be pressure on mix going forward, but we would also hope and we expect sequential improvement in volumes and would hope that the offline market would grow a bit and it might be a little bit improved over that, but we'll have to kind of see how that plays out.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Okay and then just, it looks like you got to do $30 million to $35 million in op profit in the second half in China to kind of get to your margin target. Is that strictly volume improvement from here or is there something else that's driving that profit improvement?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Well, it's two things. There is some volume improvement. So we've seen sequentially China improve month-over-month and we expect it to continue quarter-over-quarter. So we do expect growth in the back half of the year where if you kind of parse out the math, we expect China to grow year-over-year in low-single digits maybe in that 5% range. And then on top of that, as Kevin mentioned, we've got cost reduction programs that we put in place. It's about $35 million for the year and we expect $15 million of that to drop into the back half. Probably pretty even per quarter, the savings.

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Okay, great.

Operator

Your next question is from the line of Scott Graham of Rosenblatt. Your line is open.

Scott Graham -- Rosenblatt Securities, Inc. -- Analyst

Yes, hi, good morning Kevin, Chuck.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Good morning, Scott.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Good morning.

Scott Graham -- Rosenblatt Securities, Inc. -- Analyst

So I just wanted to make sure just sort of like a housekeeper, the COVID $5.5 million, you did not pull that out. That is in your North America 22.4% [Phonetic]. Right?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

You are correct. It is in our numbers. The only thing we adjusted out was $0.03 on severance and restructuring.

Scott Graham -- Rosenblatt Securities, Inc. -- Analyst

Yep. Got it. I'm hoping you could maybe tell us a little bit more about the China sort of percent of sales to premium in water heaters versus the percent to upper price point. I'm just kind of wondering what that pie chart looks like right now?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Sure, let me frame it. And as I mentioned just to Jeff, I mean it's a little unusual quarter because we got a little heavier mix than [Phonetic] online, but just to kind of frame it, let me go with the definition first. So at mid-price as we're defining it for this information is on the electric, it would be less than RMB3,000 and then on a gas, it would be less than RMB5,000. So that's what we're considering in this kind of calculation of mid-price.

If you go back two years ago, the percent of our sales that would fall into that category below those two thresholds is in that 25% to 40% range. If you kind of walk it forward to a year ago, it is in that 35% to 55% and then if you go to Q2 which again a little bit heavier online percentage than normal, it's in the 55% to 70% range. So it's grown because we've reintroduced products into that category, which we feel now we've got the full range of products kind of filled in there.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Scott, I would just want to dovetail on what Chuck said is we've been working over a year plus to fill those mid-price categories and now we're there. So as we go forward, we look for our mix to hopefully move more toward our premium sector, but it was important for us from an overall perspective to compete both online and offline to have those mid-price products which by the way are in the upper mid-part of the range in our product offering. So again, going forward, I think as Chuck mentioned, this is probably a low point when it comes to how many mid-price or a high point for mid-price products and we look forward to see our mix shifting back maybe not to where it was in the past but mixing higher to premium products.

Operator

Your next question is from the line of Susan Maklari of Goldman Sachs. Your line is open.

Susan Maklari -- Goldman Sachs -- Analyst

Thank you. Good morning.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Good morning.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Good morning.

Patricia Ackerman -- Senior Vice President, Investor Relations, Treasurer & Corporate Responsibility and Sustainability

Hi.

Susan Maklari -- Goldman Sachs -- Analyst

My first question is just can you give us some color on the mix shift in the U.S.? I noticed in your press release, you commented that, that's kind of turned a bit negative more toward the electric side of things on the consumer business. Can you just give us some comments on how that has been coming together and your thoughts on the back half for mix?

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yeah, this is Kevin. If you look at our industry, we do have periodically some mix shifts for various reasons. The way we would look at this is from our perspective, the Northeast has been one of the hardest hit. You go to New York, New Jersey, Boston, those areas -- Massachusetts have probably been the hardest hit when it comes to COVID and shut downs. That just so happens to be one of our strongest gas markets. So that could be part of it. We've also had strong growth in the -- with our customer base in a stronger electric markets. So the two kind of caused the shift, the temporary shift. If I look at it though and look forward, yeah, I don't see any real systemic changes in the market. And over time I would expect that our mix would normalize over the year or into next year.

Susan Maklari -- Goldman Sachs -- Analyst

Okay. That's helpful. And then just following up, can you give us some color on raw material inputs? Steel prices seem to be a slight advantage for you in the quarter, but how should we think about that going out over the next few quarters as well?

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Well, I mean if you look at steel and 70% of our steel is a cold rolled, 30% is hot rolled and we see kind of a delay in the cost of that 90 days to 120 days. So if we kind of just take a data point of spot prices today and compare them to a year ago second quarter, we're down about 5%. So that kind of frames how to think about it. Steel's been lower I guess for a couple of quarters now, but it has edged down a bit.

Operator

Next question is from the line of Bryan Blair of Oppenheimer. Your line is open.

Bryan Blair -- Oppenheimer & Co. -- Analyst

Good morning, everyone. Hope you're doing well.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Hey, Bryan. Same to you.

Bryan Blair -- Oppenheimer & Co. -- Analyst

Chuck, I believe you've mentioned breakeven revenue for China in the $55 million, $60 million per month range in the recent past and being profitable in May and June would kind of validate that. Is that still the right range to think about? And then as we look forward beyond the structural savings that will come through in the back half, how should we think about incrementals as China revenue moves higher?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, you're exactly right. That breakeven point is in that $55 million to $60 million. We're pleased that we saw it in May and June. We would expect we're going to be profitable going forward. So we still see that as the range. We're going to continue to look at the structure and we have taken a look at the structure and the restructuring charge we took of about -- it's about $4 million in China will result in some savings going forward. So incrementals are probably in that 45% to -- 40% to 45% range I would say.

Bryan Blair -- Oppenheimer & Co. -- Analyst

Okay, I appreciate that. And really nice growth in water treatment. Can you remind us sort of run rate profitability there and structurally where you think margins can climb as that business continues to scale?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, run rate profitability, Q1 we were at 9%, Q2 we're about 8%. We see it continuing to be that for the rest of the year. We're still looking at cost reduction. We've got a little SAP implementation happening this quarter. So there's some costs that are going to burden it a little bit in the back half, but we still see that just approaching 10% this year. So we're pleased with water treatment. The order rate has been strong. I mean we were up 20% -- 19% to 20% for the quarter. And when we look into July, we see the same strength in orders, It's at that same rate.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yeah, I would just make another comment on that as far as the growth has been strong and it looks to be continuing. And then, just keep in mind, there is a consumable part of this that as we go forward and continue to put our [Indecipherable] entry type of products, that seeds the consumables as we go forward over the next few years. So there is a lot of positive trends in our water treatment business and even as you look at it today, even softeners are starting to come back as our dealers are learning how to sell in a environment and using digital and how they're installing and so forth. They've made a remarkable shift in their selling methods and it's proven to be effective so far through July.

Operator

Your next question is from the line of Matt Summerville of D.A. Davidson. Your line is open.

Matt Summerville -- D.A. Davidson & Company -- Analyst

Thanks. Couple of questions, I want to get back to the electric impact. Can you -- North America was down 8%. Can you sort of parse out what the impact of that shift was on revenue and what the operating margin impact may have been there as well?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, we're just tracking down the impact on revenue. The percentage is really the same for gas or electric. So, I mean the percentage runs roughly the same, it's really just a step function as far as sales dollars and then margin dollars. Don't have a good answer on mix, but I mean it's probably in that 10% to 15% of the total decrease. When you look at the decrease in margin of the 8%, it's probably 10% to 15% of that.

Matt Summerville -- D.A. Davidson & Company -- Analyst

And then have you begun to see in your order book as of late looking into June, July, any evidence that these delayed construction projects are indeed coming back online. Have you actually seen that take place in our order book?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

You know, I think it's too early to see that. When we look at -- I'm thinking about Lochinvar boilers at this point, but when you look at kind of the order -- our quoting rate out in the marketplace, it is down a bit. The quoting rate is lower than what it has been, but there is still activity out there and orders coming back online, I think it's a little early. And when we look at though just commercial water heating, Kevin talked about the decline in the second quarter, we have seen some uptick in order rates on commercial water heating.

So if you look at Q2 compared to Q -- compared to what we saw in July, we see July up about 4% to 5% on commercial orders. So that -- probably is some delayed replacement that's coming back online and we would expect that to continue. So I mean when we kind of think about commercial -- and it's both commercial water heater and boilers. You know the front half of the year looks a lot like the back half of the year, we're down roughly 10% with a lot of disruption, a lot of disruption on boilers in the second quarter, but we expect some of that to come back online particularly since our boiler season is a little stronger in the fourth quarter.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yeah, I think that's the key takeaway here is as we get closer to the colder months and so forth, that's where we see again schools and businesses start to fire up their boilers. So it's a little early. We do have a reasonably strong backlog that we're still working through and we'll probably have a better view, but if you talk to our reps who are on the ground, they'll tell you that they expect the sites to reopen, they expect to see some projects move forward and that's kind of our assumption as we go forward the rest of the year.

Operator

Your next question is from the line of Ryan Connors of Boenning & Scattergood. Your line is open.

Ryan Connors -- Boenning & Scattergood, Inc. -- Analyst

Hey, great, thanks for taking my question. I wanted to actually talk a little bit about the sort of channel impact channel situation given everything that's going on. Obviously, many of your distributors are relatively smaller businesses. So in some cases, presumably, there could be some balance sheet pressures and other issues. How has that impacted your wholesale business in terms of your own need to hold inventory, payment terms etc. And any impact there? Anything that's evolving as this goes on with the channel?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Well, most of our customers, if not all of our customers in the channel are essential businesses remained open like we did and continue to operate maybe with curbside pickup and other activities. So we've been fortunate that most of our customers have fared pretty well -- well from the perspective that they've been able to operate in a difficult time. We haven't seen significant impact on payment terms or any other ability of our customers to pay. Some of the smaller ones can qualify for loans. So there are opportunities for them to do that.

So at this point, we've fared pretty well. Our customers have fared pretty well. We have seen particularly on the commercial side some destocking. So we've seen our customers work on maybe taking a little bit of their balance sheet down, cutting a little bit on the inventory side, particularly with higher cost commercial product. I mean we believe some of what we've seen in order rates and maybe it has been impacted by that, maybe in the industry too, just some adjustments within inventory within the channel.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yeah, I would just add on to that, I mean you talked about construction, talked about reopening and of course, all of our distributors are also good at business and balancing their inventories. So I would tell you that all of our distributors for the most part are managing through it. They've been through the financial crisis and they've come out of it and at the same time, they're going to adjust our inventories to the current demand. And so as we go forward and demand does pick up, I would expect them to adjust those inventories appropriately going forward. So overall, we have a tremendous customer base with legacies of 20 years, 30 years, 40 years strong, good positions in the market and they are navigating through fairly well based on the information we're getting from our sales organization.

Ryan Connors -- Boenning & Scattergood, Inc. -- Analyst

Got it. And then my follow-up was just really following up on the earlier discussion of water treatment. Really seems like you are building some pretty strong momentum there at this point in terms of the organic growth. Can you talk about just what is driving that. Is that more the market growth given all the PFOS concerns and lead and all that or is that share gain with your big box channel. I mean where is that growth coming from, if you can kind of give us some flavor there?

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Well, you actually outlined it pretty well. I think it's coming from all the things that you mentioned. Certainly the pandemic has heightened people's awareness, but I would tell you at the same time, I believe our water treatment team is executing very well. Through the process, we've updated websites. Our consumer engagement process is much better. We have a telesales activity. So there is a number of foundational things that we put in to improve e-commerce, to improve our dealer network. On top of the consumer becoming more aware of some health issues and particularly on water treatment, we're also executing I think at a higher level than we were last year, which I think is critical for us to go forward and our close rates are up and that kind of ties in with our sales as well.

So overall, the water treatment business is doing well, but it's not just a combination of the market. It's a combination of execution as well. In water treatment, we don't have the data that we have say in water heaters, but if you look at -- we do get some information from our water quality association that tracks softener valves and tanks. That is a little old because of the pandemic, they haven't been able to update it, but we're up 20% plus in the market at the time that we had the data, which is I believe in February was flat. So we are taking -- I believe we're taking some share. We'll need some more time to validate that, but yes, it's going well, but it's a combination of market and our team executing at a much higher level than we had in the past. Yeah and this is Chuck. I mentioned earlier that we've seen July demand continue strong and we've seen a better mix of some of our install products as people are more comfortable with installers dealers getting into homes. So if you kind of look through kind of the end of June or July time frame, the softener mix and some of the larger products, we've just seen that come back a bit.

Operator

Your next question is from the line of David MacGregor of Longbow Research. Your line is open.

David MacGregor -- Longbow Research -- Analyst

Hey, good morning everyone.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Good morning.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Good morning.

David MacGregor -- Longbow Research -- Analyst

Wanted to ask about Lochinvar. And you mentioned that quoting activity was down a little at this point although there is still some uncertainty I suppose with where that's going according to your comments but under that situation or that scenario, one might sort of expect a higher level of competitive pricing pressure and just a more vigorous level of competition from some of the other players in the space. So I wonder if you could just talk a little about what you're seeing on that side of the Lochinvar story and also to the extent you could talk about what you're seeing in terms of the mix of units sold within Lochinvar and what might be changing there?

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Well, as far as from a competition standpoint, we deal with that on a regular basis. We haven't seen much change from how we quote and how we can go to market. You have to get a little creative about how we do sales calls and engineering calls on Zoom, but overall, not much change there. We've had a nice mix toward some of our crest boilers, which are the higher BTU type products, which are in large application. So you saw that come back this year quite well. So yeah, overall, again I go back to the business, we're heading into our stronger half of the year.

There is still some uncertainties there that we've outlined, but we are in position and to capitalize as the markets do open up. I think it's really important as we've been working our way through the pandemic, we've kept our operations ready to be prepared to come out of it as sales grow and as the markets reopen. So overall, operational, we're in position to take care of our customers and normally, there is a little bit of emergency activity that happens in the second half of the year where people need things right away and we're positioning ourselves to take care of that as well.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Maybe just a little more color on mix too and Kevin's exactly right, We've seen some of the larger boilers a little heavier in the mix in the second quarter and we talked before about residential being light. So when we look at residential in Q1, it was a warmer winter and it was pretty light for us in the industry. Second, July activity is really kind of hard to read. We've typically and we've done it this year again is we've got a early buy program. So early buy program is specifically for residential boilers and that's running -- we're seeing orders come in pretty well. We're fairly pleased with how that is typically playing out. So hard to read what's happening in July, but the residential orders on the early buy program might be running slightly less than last year, but it's not done yet and we're pretty pleased with how that's playing out.

David MacGregor -- Longbow Research -- Analyst

Okay, thanks for that color. Just second question on China and you had mentioned the shift toward more medium price points. So thanks very much for providing the detail on that mix. I know it's something we've discussed in the past. I guess the question is with regard to capacity utilization rates, which I'm guessing right now you've got plenty of headroom, but as you shift more to medium price point, what impact does that have on capacity and your need to invest capex in those facilities.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

I would tell you right now there is -- we do have plenty of capacity and operating leverage going forward. As you probably know, we have three large facilities in China and being where we're at today from our top line sales where we were, say a couple of years ago, we'd be a plenty of capacity to handle it. So there -- we see no need for really additional capital from the production side of the business going forward for several years.

Operator

Your next question is from the line of Nathan Jones of Stifel. Your line is open.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Good morning, everyone.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Good morning, Nate.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Good morning.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

I just wanted to follow-up a little bit on Ryan's questions on water quality. That's a pretty fragmented market here in the U.S. Can you talk about where you think your market share is? What kind of market share targets you would have? And strategically thinking, is this more of a build versus buy, an organic growth versus roll off the market? Or do you see opportunities here to go about consolidating this market? And are there big advantages to that scale?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Well, I mean it's tough for us to get a detailed handle on share, right and you're right, it is a fragmented market. I mean, we think the addressable market and when we kind of look at it in a couple of different ways it's about a $2 billion market. So clearly there is opportunity for us to continue to expand our position. It's both when you say, is it a build versus versus buy. I think there is opportunities on both. We've entered -- our strategy is we've gotten into leveraging the channels that we're in. So we've got the direct-to-consumer channel through Aquasana and the Amazon channel through Aquasana.

We've also got the dealer channel through the Water-Right acquisition along with the Hague acquisition. We've introduced product into wholesale and we're in retail through Lowe's. So we've entered all the channels and we would expect to continue to grow that out on channel -- within those channels over the next several years. M&A, it's certainly an area that we've got our eyes open and we're looking at. So we think there is opportunities in both.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yeah, I'd just add a little bit more on to that, it's Kevin here. Certainly on the M&A front, I think there's plenty of opportunity out there. Again, it's got to fit to where we're taking our strategy, but if you look out, I've always said on any call or any Investor meeting that the opportunity on the water treatment front is I think an area that we're going to spend a lot of time in. There is opportunity there and there's ways for us to leverage and consolidate over the long haul and again A. O. Smith is always looking to make the industry better and raise it up and we think there's going to be opportunity over time to continue to find those right fits for our business.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Okay. Another question on China. I mean you guys have talked about the mid-tier priced products being lower margin than the premium tier product. That's a relatively new introduction for you into China. Is there opportunities through operational improvement and ramping up the productivity of those lines for you to close that margin gap between the mid-tier and premium tier price products without just leveraging volume?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, there is opportunity, but we're working on cost reduction programs within the product. We also work on cost reduction programs within the manufacturing process. So certainly, you're right, volume would help us, but we're coming at it from multiple angles.

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

And just one quick one on capital allocation. You guys had started this year with a $200 million target for share repurchase. Based on your projections for the back half of the year cash flow, you're probably going to have about $500 million of cash on the balance sheet. So the balance sheet is going to be a little inefficient. Can you talk about when you think it would be appropriate to reinstate the share repurchase program? If that's next year, would you look to kind of catch-up a little bit of the 2020 spending to go along with the 2021 program, if we assume that the markets are in reasonable condition?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, I mean, it's a little early for us to reach out and make that call right now. I mean we're watching -- well, we typically frame that program historically to not grow cash now and then in this environment, we do have a cash projection and you're right, we're pleased with projecting $350 million for the year and we feel that right now though there is enough uncertainty out there that we want to just watch it for the next quarter and we'll be back probably talking about it next quarter.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yeah, I would just add on to that is we still believe there is better opportunities in the market. Acquisition is always our preferred method to invest and I would like to see how things come out of the pandemic and we're going to keep an eye on that and again we expect there'll be some opportunities and we want to be prepared from a cash position to capitalize if they arise.

Operator

Your next question is from the line of Scott Graham of Rosenblatt. Your line is open.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Hey, Scott. Hello, Scott, are you there?

Scott Graham -- Rosenblatt Securities, Inc. -- Analyst

Yes, I'm sorry about that. I was on -- I muted myself. So just a follow-up question on China. So we are shrinking the number of sites there I think by about a 1,000 this year and here we are with the channel destocking unexpectedly. Could one be the cause of the other. How is that -- and how are you managing that site reduction, how is that going?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Well, I don't think they're related Scott to be honest with you. One, the 1,000 stores that we keep referring to has to do with unproductive stores and we've done that over the years, but we've had to close some stores, reopen other stores and so forth. So that to me is a productivity market issue because there is a heck of a lot of cost into offline sales and with promoters and so forth. So because of the economic environment there, certainly it's enhanced this, but -- so that's an independent thing that we do on a regular basis, evaluate our stores and close and open appropriately.

As far as the stocking, it's really up to our distributors to determine what they need in their inventory. And again, I don't think a quarter or a month is something we should really be surprised of some shift. It wasn't a big shift, we're still in that two to three month range of inventory and what's important is that they have the right products in stock and that we're driving business to the consumer to sell it. We're in great position. I think our distributors are in significantly better position than they were, say six months to a year ago and our sales are growing. The opportunity to sell more products as the economy reopens is positive. We have the capacity and the lead times to take care of that. So again, I think the inventories are just more of a separate business management by our distributors and we're taking care of the retail stores because it's the right way to manage our cost of sales.

Scott Graham -- Rosenblatt Securities, Inc. -- Analyst

Got you. And then last one on -- back to the North American business with commercial, which includes restaurant, lodging, It does look like lodging certainly in spots is coming back fairly strongly, but I think you have to emerge from this with -- we're going to emerge with a smaller restaurant footprint at least for the time being, they always seem to grow back in the out years but is there a need year to maybe come back to North America and cut some costs on the commercial side both water heaters and boilers given that on our post COVID basis, how are you looking at that?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, I mean, we think a lot of that demand that we're seeing in the second quarter and into July is postponement of some replacement going forward. I think it's a little early for us to predict if there is a great deal of change in the footprint of those types of customers. That's a portion of where our water heaters and boilers do go, but we'll continue to watch that. So we'll continue to watch it as it goes forward and see what happens. Right now we expect that it is just delayed and there'll be replacement as those businesses start up.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Yes, Scott. I think it's a fair point and a fair question, but I think it's a little bit early and so if you look at where our sweet spots are, you hit restaurants and hotels, and so forth. Certainly the closures have delayed some of that, but again, going forward depending how we reopen, we'll have to see how that plays out, but again the replacement market will be there and we'll have to see what size it is as we come out the other end.

Operator

Your next question is from the line of Kevin Hocevar of Northcoast Research. Your line is open.

Kevin Hocevar -- Northcoast Research -- Analyst

Hey, good morning everybody.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Good morning, Kevin.

Kevin Hocevar -- Northcoast Research -- Analyst

On the water treatment guidance. I guess I want to understand a little more for the full year, 20% to 22% sales growth. It seems to imply a fairly sizable slowing in the growth rate in the back half of the year, but it sounds like the DIY, well the organic growth in the second quarter seems to be carrying forward into July and a lot of the companies that have seen DIY strength have seemingly said that, that's slowing, but still quite robust and carrying forward and it sounds like the contractor based products seem to be getting a bit better. So I guess I just want to understand what -- is there a reason to assume that there should be a sizable slowing. Is there some conservatism in there. Just trying to connect the dots there and understand the guidance there going forward for water treatment?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, no, it's a good question. I mean we saw some fair strength coming into the second quarter. We think a lot of that or some of that and we talked a little bit -- Kevin talked a little bit before about the strength in the businesses is consumer awareness and maybe the shutdown people thinking about their water a little bit more. The DIY channel, you're right, it's been very, very strong. So the second quarter and into July, we see a lot of activity on water treatment, a lot of strength. Will that continue as people kind of get -- hopefully get back to a little bit more normal and back to work, we'll have to see how that plays out. So you're right, I mean if you kind of do the math, we're expecting it to soften a bit in the back half and not be exactly that 20% to high order rates that we're seeing in the current environment.

Kevin Hocevar -- Northcoast Research -- Analyst

Okay, got you. And then I guess I just want to clarify, in the opening comments, I think you guys mentioned that based on where you see your water heater shipments in June that you think the industry is flat to slightly up. Was that just a month of June comment or was that the full quarter because I guess if it's the full quarter, it would imply June was quite a robust month to offset the slowness in April and May's HRI shipments and curious how you felt A. O. Smith has done versus the industry in the second quarter and into July?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Yeah, that comment implies the full quarter. And again, we did see a strong June. So that's the impetus going forward. And then as you look at it, we've always felt people will do without a water heater for 24 hours. That's about it. So that replacement market is still going to be there and then we've seen decent new construction still holding up over the various markets. So you put those two together, that's where we came up with a forecast of residential volume being relatively the same as last year, but you're right, it comes off a strong June.

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Strong June and just orders carried forward into July. We still see that playing out similarly. So residential orders have been healthy. And market share -- market share is the same. There is really no shift in market share.

Operator

Your next question is from the line of Susan Maklari of Goldman Sachs. Your line is open.

Susan Maklari -- Goldman Sachs -- Analyst

I just have a few follow-up questions. The first is you mentioned in your commentary that you're in the process of establishing 500 new relationships -- store relationships in China. Can you just give us a little more color on that? It sounds like it's in the Tier 3 to Tier 6 cities. And then how does that kind of balance against the 1,000 store closures that you've done there?

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Well, it's Tier 4 to 6 cities and that's where a lot of the growth is and we have -- those are much smaller stores, but they are in the areas that are growing. So we're working with our customers to establish those relationships, to make sure they have the right selling tools and products for that particular environment and we see the 4 and 6 Tier cities playing a bigger role particularly in the new construction part of the business and housing. So that's moving. Comparing the 1,000 to the 500 is difficult. Again, there is really not a comparison. The 1,000 are under-productive stores, not performing, not recovering their costs and so forth. So we're just leaning up that part of our business where the 500 stores, which we've been expanding in Tier 4 and 6 cities for a while now are additional opportunities. There will be certainly less sales volume going through a Tier 4, 6 [Phonetic] city store than obviously in a Tier 1, Tier 2 specialty store or retail store. So they're really two separate actions on our part, one is more growth and one is more cost control.

Susan Maklari -- Goldman Sachs -- Analyst

And so, should we expect that they'll come online over the course of 2020 or is that more of a 2021 impact in terms of the revenues coming through and some of the benefits.

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

We expect those to come on throughout 2020.

Operator

I am showing no further questions at this time. I would now like to turn the conference back to Ms. Patricia Ackerman.

Patricia Ackerman -- Senior Vice President, Investor Relations, Treasurer & Corporate Responsibility and Sustainability

Thank you for joining us today. We plan to participate in two virtual conferences in the third quarter, Jefferies on August 5th and D.A. Davidson's conference on September 22nd. Have a great day.

Operator

[Operator Closing Remarks]

Duration: 57 minutes

Call participants:

Patricia Ackerman -- Senior Vice President, Investor Relations, Treasurer & Corporate Responsibility and Sustainability

Kevin J. Wheeler -- Chairman, President and Chief Executive Officer

Charles T. Lauber -- Executive Vice President and Chief Financial Officer

Jeff Hammond -- KeyBanc Capital Markets -- Analyst

Scott Graham -- Rosenblatt Securities, Inc. -- Analyst

Susan Maklari -- Goldman Sachs -- Analyst

Bryan Blair -- Oppenheimer & Co. -- Analyst

Matt Summerville -- D.A. Davidson & Company -- Analyst

Ryan Connors -- Boenning & Scattergood, Inc. -- Analyst

David MacGregor -- Longbow Research -- Analyst

Nathan Jones -- Stifel, Nicolaus & Company -- Analyst

Kevin Hocevar -- Northcoast Research -- Analyst

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