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AO Smith Corp. (NYSE:AOS)
Q4 2020 Earnings Call
Jan 28, 2021, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to the A. O. Smith 2020 Results Conference Call. [Operator Instructions]

I would now like to turn the conference over to your host, Ms, Patricia Ackerman, Senior Vice President, Investor Relations, CRS and Treasurer. You may begin.

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

Thank you, Julie. Good morning, ladies and gentlemen, and welcome to the A. O. Smith's full-year 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.

Please advance to 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 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

Okay. Thank you, Pat. Before we begin discussing our results and outlook, I want to send my deepest gratitude to the thousands of A. O. Smith employees who've been working under less than ideal conditions and we continue to keep our operations running, offices open and customers in hot and treated water. To recap 2020, better than expected fourth quarter results drove our 2020 performance above our expectations. North America water treatment grew 14% organically, driven by continued consumer demand for products promoting a safe home.

The direct-to-consumer channels with our Aquasana brand, retail outlets with their A.O Smith brand and the dealer channel all contributed to solid 2020 growth. We believe industry shipments of U.S. residential water heaters, including tankless surge to a record, exceeding 10 million units or 8% growth over the prior year. This assessment is based on our strong December shipments. We believe the overall positive tone to new residential and safe at home remodel construction activity, including an increase in proactive replacement demand and channel inventories stocking related to extended lead times resulted in above trend growth in 2020.

Due to construction project delays and postponements in North America as well as pandemic-related weakness in restaurant and hospitality, new construction and replacement demand, we saw commercial water heater and boiler industry volumes declined by 8% to 10%. We maintained our market share in both of these categories. Progressive year-over-year improvement in consumer demand for our products in China continued in the fourth quarter. As a result of higher volumes and diligent efforts by our team to reduce cost and reorganize, high single-digit margins were achieved in the second half of the year.

In North America, aside from the voluntary closure of our Mexican facility for several weeks in the second quarter, we remained operational throughout 2020 with no significant disruptions within our plants and our supply chain. Pandemic-related safety protocols have been in place in our facilities and our offices. Due to strong residential water heater demand coupled with soft quarantine-related absenteeism, our lead times remained above normal. We continue to use temporary workers, swing shifts and expedited logistics in some cases to take care of our customers.

Operator

Good day, ladies and gentlemen, and welcome to the A.O. Smith 2020 Results Conference Call. [Operator Instructions]

I would now like to turn the conference over to your host, Ms. Patricia Ackerman, Senior Vice President, Investor Relations, CRS and Treasurer. You may begin again.

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

Thank you, Julie. And I apologize to everyone on this call this morning. We had telephone problems and so we will start over from the beginning so that you can hear all of our prepared remarks and then we will go into questions-and-answers. I believe you heard the introduction that I gave. So, we will -- I will turn the call over directly to Kevin Wheeler.

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

Okay. Again, thank you, Pat, and our apologies for some technical difficulties here. This may be redundant, but we think it's important to start from the beginning.

Before we begin discussing our results and outlook, I want to send my deepest gratitude to thousands of A.O. Smith employees who have been working under less than ideal conditions and we continue to keep our operations running, offices open and customers in hot and treated water. To recap 2020, better than expected fourth quarter results drove our 2020 performance above our expectations. North America water treatment grew 14% organically, driven by continued consumer demand for products promoting a safe home.

The direct-to-consumer channel with our Aquasana brand, retail outlets with our A.O. Smith brand and the dealer channel all contributed to solid 2020 growth. We believe industry shipments of U.S. residential water heaters, including tankless, surge to a record, exceeding 10 million units or 8% growth over the prior year. This assessment is based on our strong December shipments. We believe the overall positive tone to new residential and safe at home remodel construction activity, including an increase in proactive replacement demand in channel inventory stocking related to extended industry lead times resulted in above trend growth in 2020.

Due to construction project delays and postponements in North America as well as pandemic-related weakness in restaurant and hospitality, new construction and replacement demand, we saw commercial water heater and boiler industry volumes declined by 8% to 10%. We maintained our market share in both of these categories. Progressive year-over-year improvement in consumer demand for our products in China continued in the fourth quarter. As a result of higher volumes and diligent efforts by our team to reduce costs and reorganize, high single-digit margins were achieved in the second half of the year.

In North America, aside from the voluntary closure of our Mexican facility for several weeks in the second quarter, we remained operational throughout 2020 with no significant disruptions within our plants and our supply chain. Pandemic-related to safety protocols remain in place in our facilities and offices. Due to strong residential water heater demand coupled with self quarantine-related absenteeism, our lead times remain above normal. We continue to use temporary workers, swing shifts and expedite logistics in some cases to take care of our customers. All of these efforts result in inefficiencies and incremental costs.

To align our business with current global market conditions, we reduced headcount and incurred other restructuring costs, totaling approximately $6 million after tax in 2020. The majority of these actions took place in China. We published our second Corporate Responsibility and Sustainability Report in January and great proud of our accomplishments since our first report, particularly in employee engagement, safety, research reduction in our facilities and a product portfolio that both some of the most efficient products in their respective categories. We introduced our first ever public greenhouse gas emission goal. We strive to reduce GHG emissions by 10% by 2025.

I will now turn the call over to Chuck, who will provide more details on the full year and the fourth quarter beginning on Slide 5.

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

Thank you, Kevin. Full year sales of $2.9 billion declined 3% compared with 2019, largely due to significant weakness in the China business in the first half of 2020. As a result of lower sales, adjusted earnings declined 3% to $351 million or $2.16 per share compared with $370 million or $2.22 per share in 2019.

Please turn to Slide 6. Sales in our North America segment of $2.1 billion increased 2% compared with 2019. Higher residential water heater volumes, growth in water treatment as well as full year of Water-Right sales were partially offset by lower U.S. commercial water heater volumes, lower boiler sales and our water heater sales mix composed of more electric models, which have a lower selling price. Rest of the world segment sales of $800 million declined 14% from 2019. Pandemic-related lock downs and weak end market demand primarily in China in the first half of the year and a higher mix of mid-priced products resulted in lower sales. Currency translation of China sales favorably impacted sales by approximately $9 million. Indian sales were also negatively impacted by the pandemic-related economic disruption and declined to $31 million compared with $39 million in 2019.

On Slide 7, North America segment adjusted earnings of $506 million increased 4% compared to 2019. The increase in earnings was driven by favorable impact to earnings from higher residential water heater volumes, growth in water treatment sales, full year of Water-Right sales and lower material costs. The impact to earnings from lower volumes of boilers and commercial water heaters and the mix skew to electric water heaters partially offset these factors. Adjusted segment earnings exclude $2.7 million in pre-tax severance costs. As a result, adjusted operating margin of 23% is slightly higher than in 2019.

Rest of the world adjusted segment earnings of $5 million declined significantly compared with 2019. In China, the unfavorable impact from lower sales and the higher mix of mid-priced products which have lower margins than higher-priced products more than offset reductions in SG&A costs and temporary waivers for required social insurance contributions. As a result of these factors, adjusted segment operating margin of 0.6% decline from 4.3% in 2019. Our corporate expenses of $52 million were higher than in 2019, primarily driven by lower interest income.

Turning to Slide 8. Record fourth quarter sales of $835 million increased 11% compared with the fourth quarter of 2019. The increase in sales was largely due to higher residential water heater volumes in North America and higher sales in China. As a result of higher sales and cost reduction initiatives earlier this year, fourth quarter earnings of $120 million or $0.74 per share increased significantly compared with 2019.

Please advance to Slide 9. Record fourth quarter sales in North America segment of $561 million increased 7% compared with the same period in 2019, primarily driven by higher residential water heater volumes. Rest of the world fourth quarter segment sales of $279 million improved 19% compared with the fourth quarter of 2019. Currency translation of China sales favorably impacted sales by approximately $14 million. Constant currency China sales improved 15% driven by mid single-digit growth in end market demand led by water treatment, replacement water treatment filters and gas tankless water heaters and a favorable mix between product categories compared with the fourth quarter of 2019.

On Slide 10, record fourth quarter North America segment earnings of $138 million increased 7% from the same period in 2019. The increase in earnings was primarily driven by higher residential water heater volumes in North America and lower steel costs. These factors were partially offset by logistic costs. As a result, fourth quarter segment margin of 24.6% was slightly higher than 24.5% in 2019. Rest of the World segment earnings of $31 million improved significantly from $1.5 million in the same quarter in 2019. In China, higher volumes, reductions in SG&A costs and lower material costs drove higher earnings. As a result of these factors, fourth quarter segment margin improved to 11.2% compared with 0.6% in 2019. Our corporate expenses of $16 million in the fourth quarter were higher than the same period of 2019, primarily due to an increase in long-term incentives and lower interest income in the 2020 fourth quarter.

Advancing to Slide 11. Cash provided by operations of $562 million during 2020 was higher than 2019. Lower investments in working capital in 2020 were partially offset by lower earnings compared with the prior year. Our liquidity and balance sheet remained strong. Our cash balances totaled $690 million at the end of 2020 and our net cash position was $576 million. At the end of 2020, our leverage ratio was 6% as measured by total debt to total capital. We are in the process of refinancing our $500 million revolving credit facility, which expires at the end of the year. We currently have no borrowings on this facility. We expect to repurchase $400 million worth of share in 2021 through a combination of 10b5-1 program and open market purchases. Recently, our Board increased the authorized shares on our share repurchase authority by 7 million shares.

Turning to Slide 12. We introduced our 2021 EPS guidance this morning with the range of between $2.40 and $2.50 per share. The midpoint of our range represents an increase of 13% compared with our 2020 results. Our guidance assumes the conditions of our business environment and that of our suppliers and customers are similar in 2021 to what we have experienced in recent months and does not deteriorate as a result of further restrictions or potential shutdowns due to the COVID-19 pandemic. We expect cash flow from operations in 2021 to be between $450 million and $475 million compared with $560 million in 2020, primarily due to higher earnings offset by higher investments in working capital than in prior year. In 2021, capital spending plans are between $85 million and $90 million and our depreciation and amortization expense is expected to be approximately $80 million. Our corporate and other expenses are expected to be approximately $51 million, slightly lower than in 2020. Our effective tax rate is assumed to be between 22.5% and 23% in 2021. Average outstanding diluted shares of 160 million assumes $400 million worth of shares are repurchased in 2021.

I'll now turn the call back over to Kevin, who will summarize our guidance assumptions beginning on Slide 13. Kevin?

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

Thank you, Chuck. Our businesses and the countries in which we do business continue to navigate through pandemic-related challenges, particularly in supply chain and logistics. Our outlook for 2021 includes the following assumptions. We project U.S. residential water heater industry volumes will be down 2% or 200,000 units in 2021. We are encouraged by the positive tone in the new construction market. Although, we believe some destocking will occur during 2021 as we expect industry lead times to improve throughout the year. The timing of the destocking is difficult to predict as we have two price increases announced, one effective in February and the second one in April. Destocking activity could be delayed until mid-year due to the pre-buy orders in advance of the price increases.

Further note on the 2021 price increases. We have seen inflation our cost of supply chain, particularly steel and logistic costs. Steel has increased nearly 50% since we announced our February 1 water heater price increase of 5% to 9%. We announced a second price increase last week on water heaters effective April 1st, also between 5% to 9% depending on the type of water heater. We expect commercial industry water heater volumes will further decline approximately 4% as pandemic impacted business delay, order for new construction and discretionary replacement installations.

In China, it is encouraging to see consumer demand for our China products progressively improve in 2020 and into January of 2021. We accomplished much in China in 2020, which will allow us to profitably grow in 2021. Those accomplishments include closing of 1,000 stores in Tier 1 and 2 cities, while efficiently expanding in Tier 4 through 6 cities, implementing programs to save $30 million in SG&A, which will carry over into 2021. We've lapped a negative impact to earnings from mid-priced products. We expect positive mix in 2021 from new products. And we execute programs to result in a stronger and more nimble distributors. We expect year-over-year increases in local currency sales between 14% and 15%.

We assume China currency rates remain at current levels, adding approximately $45 million and $3 million to sales and profits over the prior year respectively. We expect our North America boiler sales will increase by mid single-digits in 2021. Our expectations are based on several growth drivers. First, industry growth of 3% to 4%. We assume some pent-up demand after the industry decline in the low-teens levels in 2020. The CAGR for commercial condensing boilers, which is over 50% of the boiler revenue, was 5% to 6% prior to 2020. We believe replacement demand is still 85%. A potential government stimulus package targeting infrastructure investment may free up some jobs that were postponed or halted in 2020. The transition to a higher energy efficient boilers will continue, particularly as commercial buildings improve their overall carbon footprint.

In 2020, condensing boilers were 39% of the commercial boiler industry that represents our addressable market, which provides continued opportunity for our leading market share commercial condensing boilers. New product launches including improvements to our flagship CREST commercial condensing boiler with a market differentiating oxygen sensor which continuing measures and optimizes boiler performance and the introduction of be 1 million BTU light duty commercial night FTXL boiler. We project 13% to 14% sales growth in our North America water treatment products. We believe the mega trends of health and safe drinking water as well as a reduction of single use plastic bottles will continue to drive consumer demand for our point of use and our point of entry water treatment systems. We believe margins in this business could grow by 100 to 200 basis points, higher than the nearly 10% margin achieved in 2020. And in India, fourth quarter sales were similar to the prior year. We project 2021 full year sales to increase over 20% compared with 2020 and to incur a small loss of $1 million to $2 million.

Advance to Slide 14. We project revenue will increase by approximately 10% in 2021 as strong North America water treatment and China sales enhanced by growth in boiler sales more than offset expected weaker North America water heater volumes. Our 10% growth rate projection includes approximately $45 million of benefit from China currency translation. We expect North America segment margins to be between 23% and 23.5% and Rest of World segment margins to be between 7% and 8%.

To Slide 15 please. 2020 was a challenging year. We are pleased with our performance through the pandemic. Particularly in these uncertain times, we believe A. O. Smith is a compelling investment for numerous 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 key product categories, broad distribution, 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 are very excited for the opportunity we see in our North America water treatment platform. 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 return cash to shareholders.

That concludes our prepared remarks and we are now available for your questions.

Questions and Answers:

Operator

[Operator Instructions] Your first question comes from Jeff Hammond with KeyBanc.

Jeff Hammond -- KeyBanc Capital Markets, Inc. -- Analyst

Hey, good morning.

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 Hammond -- KeyBanc Capital Markets, Inc. -- Analyst

So just on the China business. Clearly you have a really easy comp in the first quarter. Just trying to get a sense of how you're thinking about seasonality, is it back to normal? And then just on the margin cadence in rest of world, you kind of were putting up high single-digits even above your guidance. So maybe just talk about margin cadence through the year for rest of world?

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

Yeah, sure, I can do that. We were really pleased with the fourth quarter, back to double digits in Q4, had a really nice favorable category mix, had some decent online volume in China. So we were pleased with the fourth quarter. When we look at 2021, I think we're back to a more normal cadence. Always Q1 is a challenge for us. So, Q1 will be the lowest quarter. I would expect that we're going to progress progressively through the year like we have in the back -- in the past. Maybe 2021 might be 45% of the revenue in the first half of the year, 55% in the back and our best quarter will be Q4 again in 2021. So probably starting out the year. You're right. Last year is not a -- is pretty easy comp, right. So we would expect revenues in the first quarter to potentially double last year's revenues, low single-digit margins and progress from there throughout the year.

Jeff Hammond -- KeyBanc Capital Markets, Inc. -- Analyst

Okay. That's helpful. And then just on North America. I guess your unit volume expectation is down in both commercial and res. I think your guidance maybe implies mid single-digit growth. Is that largely a function of price or are you baking in any kind of share gains or mix within North America? Thanks.

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

What we're really baking in is that there'll be some destocking in the 2021. So we came up a record year for the industry. And as we look forward, as we said in our comments, we're very excited about the new home construction market. We think -- we still think there's going to be quite a bit of proactive activity at the DIY level. But embedded in there is some inventory that as industry lead times us kind of move back to normal. We see that declining and bringing the industry dampen this last year by about a couple of hundred thousand units.

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

Yeah. I mean, the kind of the offset to that a little bit of headwind on the destocking is, we do have boilers projected to be favorable next year. In Kevin's comments earlier talked a little bit about some of the new products coming out, potential some help on infrastructure. We do see the industry with replacement being somewhat resilient, maybe some of the work pushed back last year rolls into 2021 water treatment. We project kind of a back-to-back for 13% to 14% increase in water treatment over topping that in. And yes, we do expect price rolling into next year. So we've got our steel costs, particularly leading our costs for 2021 and we've got the two price increases, one February 1st effective and one April 1st growing into next year.

Jeff Hammond -- KeyBanc Capital Markets, Inc. -- Analyst

Thank you.

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

Yeah.

Operator

Your next question comes from Matt Summerville with D.A. Davidson.

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

Thanks. Good morning. With respect to China, can you talk about the outgrowth you achieved in the fourth quarter relative to the market? I think you said you're up kind of mid-teens constant currency, the market up mid single-digits, maybe parse out that gap to the upside in your business.

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

Yeah. I mean, yes, there is a couple of things. So, if you look at kind of industry data and look at share and some of the other metrics out there, what they're not capturing is what's happening in our specialty stores and and we're really pleased with what kind of performance we had in our specialty stores in Q4. So that was strong. Consumer demand overall we saw in the mid single-digits, in a strong mid single-digits. But the product category mix that we saw in Q4 was really helpful. So we had a higher product -- you did higher sales cost on gas tankless, our water treatment products have higher sales price, decent commercial business in the quarter. So the mix between categories was very helpful to our growth. So that's probably the biggest pieces. I mean, we're really pleased about the fact that our mix, we've talked in the past about some headwind on mix and we're really kind of lap that as we said in our comments, where we really wouldn't expect a negative headwind on mix in China. Going forward, we would expect it to be neutral or slightly positive. So, we're kind of at a stabilized point we believe on the mid-priced products and positive to neutral going forward.

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

You said a couple of things under that. We've done a lot of work on our mid-priced products and our cost structure and so forth. And quite frankly, we have some really terrific products that are going to be launching or have launched a high input in our electric water heater category. We're going to be the only brand out there with a category of grade one noise level on our tankless which is a huge factor for consumers in China. Noise is always an issue because it's inside their home. And our water treatment products have to do quite well and we have a number of new ones coming up that will continue to expand our higher flow rates and along with having -- providing hot water. So great work on the mid-priced, but we haven't lost sight on our premium products. That's all three that I just mentioned are in the premium category.

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

And then with respect to, for my follow-up, with respect to the price increases you're putting in place, Kevin, does that cover you guys relative to where spot prices are today? Or I mean, given -- if you just look at steel prices have gone like parabolic I'm sure you're well aware of that. So with this second increase you're putting in, are you effectively covered it today at today's spot prices or do you need to contemplate later in the year maybe a third increase? Thank you.

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

Well, let me start and Chuck is going to give you some of the details. But as you know, we tend to trail cost, but we always take action and we have demonstrated that we can do that over time. Well, we are going to be trailing for a while and maybe Chuck can give us some comments on how we see the price increases working the way through the market.

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

Yeah. I mean our outlook and our guidance assumes that steel pricing stays kind of that where it is for the index right now and carries throughout the end of the year. And then of course, we talked about our price increases. So when we look at next year, we would see that those price increases are probably going to lag a little bit and what we're going to see in the cost, we get a little bit of a runway of 90 to 120 days. But to your point, steel pricing has gone up so dramatically, so quickly that we're probably going to be chasing the margin a little bit as we go forward. Without commenting specifically on particular achievement of price, I would just say, historically, over time, we've been able to switch to cover that.

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

Great. Thank you.

Operator

Your next question comes from Eitan Buchbinder with Citi.

Eitan Buchbinder -- Citi Research -- Analyst

Hi. Good morning, and thank you for taking my question.

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

Good morning.

Eitan Buchbinder -- Citi Research -- Analyst

You mentioned stability in North America water heater manufacturing lead times. Can you talk about your visibility to the level of residential water heater customer inventory levels due to the impact of lead times and potential pre-buy ahead of price increases and how should we think about that affecting seasonality in '21?

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

Let me take that. I mean at the industry on residential is up about 8% over 2019. I think you really kind of have to think about or I think about the jumping off point in 2019, which is down about 2% from the trend line. So, I mean, the industry up in 2020 is really 6% to 8%. When we look at inventories, we think about the fact that it's probably half of that might be inventories that have built up. So if you're in that 3% to 4% of that increase is inventories in the channel, not all of that's going to come out of 2021. We don't think. So, if it's 4% and a portion of that comes out of 2021, we're may be down to that 2% headwind that we see. Helped a little bit by what we think will be encouragement in the housing offset of that and we still see proactive demand on water heaters being pretty strong. So we kind of right at that 2%. When you think about kind of the cadence for the year, we don't believe the price increases that have been announced pulled much if any into sales into 2020. But the first quarter, effective February 1st and effective April 1st, we would expect some increased demand on the price increase driving some volume in the Q1.

Eitan Buchbinder -- Citi Research -- Analyst

That's helpful. Thank you. And in Q4 China saw healthy growth 15% constant currency. Can you give us an update about how the expected 500 store openings in Tier 4 to 6 cities are performing? And what are your expectations for store openings or closings in China during '21?

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

Well, let me touch on that and then Chuck will give you some figures. One, when you start to look out in Tier 4 through 6 Tier cities, I want to caution and make sure that we described, these are small counters if you will. They are really not -- the type of stores that you're talking about in city Tier 1 and Tier 2 cities. So I just want to calibrate as we open up those stores there, they are really kind of counters with limited volume, but the ability to sell our product across those growing cities. From a standpoint, Chuck, our forecast is...

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

Yeah,. So the Tier 4 to Tier 6 cities and we're kind of parsing their stores a little different than what we have in the past. So we've talked historically about 9,000 or 9,500 stores and we're pricing it really Tier 1 and Tier 2 and then back to a Kevin said Tier 4 through 6. In the Tier 1 and Tier 2 cities, if you go back to '19 that have been a little over 7,000 stores in those categories and in the Tier 4 to 6 is around 2,000. So you kind of split it up into those two categories and you get to the 9,000 and 9,500 stores. On the Tier 1 to Tier 2 our focus is really efficiency, looking at store efficiencies, and we talked about closing a 1,000 stores and we have. So we went from about 7,400 stores at the end of 2019 to at the end of this year about 6,400 stores. So we've accomplished kind of where we are set out to do the closing of the 1,000 stores. When we look into next year, not much change. We probably have a little bit. We're continue to look at evaluate efficiencies, but we did not expect much change in the Tier 1 to Tier 2 cities. Tier 3, or I'm sorry, Tier 4 through 6, as Kevin said, it's a different selling model and our expectations are different. And how we're really measuring that is less about how many counters or footprints we have and more about the volume of sales going through there. So that's what we'll probably be talking about more going forward. We've opened up more than that 500 stores that our target. And when I say opened up, we've got relationships and counters and significantly more than the 500 stores and we're going to be just kind of looking at volumes through those stores going forward.

Eitan Buchbinder -- Citi Research -- Analyst

Thank you very much. I'll pass it along.

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

Thanks.

Operator

And your next question comes from Damian Karas with UBS.

Damian Karas -- UBS Securities -- Analyst

Hi, 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.

Damian Karas -- UBS Securities -- Analyst

Wanted to ask you a follow-up question on the China business and rest of world margin in particular. Obviously, making some really nice progress there and you talked about some of the factors with mix staring to come back. Just wondering kind of thinking longer term where you are in the business? I mean, are there any structural reasons why you think you wouldn't be able to get back to kind of those low double-digit margins on a consistent basis or is that achievable over time and if so, kind of what they're going to take you to get there?

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

Well, I would tell you, I believe and we've talked about getting back to those mid-to-low teen margins and certainly we think we can get there. Structural changes, no. If you look at our strategy, our strategy is going to stay consistent. We are a premium brand. We use innovation to drive products into the consumers' market. We invest in high service levels for a high quality company. That foundational part of our business is not going to change. In fact, it will continue to be enhanced. However, the market is changing. You have some online going, getting larger. You have some changes in the retail sector in Tier 1, Tier 2. And what we're going to do is we're going to remain nimble like we have, adjusting our model as far as store openings and how we go to market.

You will see a big part of digital a big driver for us as we engage customers going forward. The day of having somebody in every store as a promoter we'd be talked about are probably going to be limited. And we'll use digital more and will continue to expand into the other markets those 4 and 6 Tier cities, one day are going to be Tier 1, Tier 2, Tier 3 cities and we need to have a position there. So, overall, I mean, our strategy where we're at getting to those type of margins, we think are doable over time and we've been taking the steps in 2020. We will continue to take those steps in 2021 and beyond.

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

Yeah. I was just add that the volume really does matter. Q4 we had decent volume and we get that kind of volume. We've got a double-digit margin in Q4. So over time, we would expect that we will continue to see consumer confidence driving demand and looking at kind of hopefully we get back to the point where we've got more trading up to more high premium products, which by the way this year, we saw some positive trading up in water treatment and the water heating side was stable to up slightly. So, we're optimistic about getting back to double-digit margins. Probably, we are not -- we don't have it in our outlook for next year, but we see that.

Damian Karas -- UBS Securities -- Analyst

Okay, got it. Thanks. And then you did a nice job of kind of walking through your expectations for the U.S. residential market. I was wondering if you could perhaps give us a sense on how we should think about the cadence for the commercial market this year. I mean that down 4%, are you sort of expecting declines through the year or maybe growth returning at some point? How should we think about that?

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

I think about the way we think about it is, we still need to see economy is opening up. We need restaurants, capacities and open up in hotels and travel. So we have a 4% decline built into our model. We hope as the vaccine comes out and heard immunity starts getting closer and closer, we see the restrictions in those type of restaurants and hotels to be less and less. Company start to open it up and traveling. So if anything, we seen more improvement maybe in the back half of the year than we do in the first half as we continue to work through the pandemic, and of course, the vaccines to being transmitted to the number of people that needs to be.

Damian Karas -- UBS Securities -- Analyst

Okay. Thanks so much. Good luck with it. I will pass it along.

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

Hey, thanks.

Operator

Your next question comes from David MacGregor with Longbow Research.

David MacGregor -- Longbow Research -- Analyst

Yes. Good morning, everyone.

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

Good morning, David.

David MacGregor -- Longbow Research -- Analyst

Question on the, good morning, just a question on the inventories in North America and you've provided quite a bit of color around that, so that's greatly appreciated, but what's the opportunity to sort of throttle up downstream kind of demand creation in 2021 as a way of kind of burn through that inventory surplus a little faster?

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

Well, I would tell you that the way the inventories are going to be burned through faster is really just when the economy open up. And again I -- we could see more improvement in the DIY side of the market where people were doing more to their homes as we saw in 2020. And of course, in new construction depending on labor in the market, there is a lot of things that can happen that can drive demand. One of the biggest challenge for the construction business has been labor. So those are two things. As things progress, and again, I keep going back, if the economy opens up and as -- we even have sales people traveling for a year other than under emergency conditions where we're not spending time in the market as much as we like to, all that's going to matter for us to drive demand both from just the economic side, but also from us looking at gain some share. So it's -- there is more action to have to happen, but they also have to be some economic in some opening up of the economy for us to move that forward and bring the inventories down.

David MacGregor -- Longbow Research -- Analyst

Okay, understood. Okay, thanks for that. And then secondly, just on the boiler business. Can you walked through quite a bit of detail on why you're feeling confident in that mid-single-digit growth number for next year, so that as well as is it is appreciated, but I just wonder if you could talk a little bit about what you're seeing in the backlog for that business that may be giving you a confidence or is this more just kind of assembling all these drivers in a theoretical construct and this has got a lead to a better growth? Are you seeing hard evidence in terms of orders and backlog now that's giving you that confidence?

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

Well, what I can tell you what we're seeing today, we didn't see the delay and postponement of our projects as we saw back in last year. That's number one.

David MacGregor -- Longbow Research -- Analyst

Okay.

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

The number two, the activity in the market is lower, but there is still activity going on there. And so again, as we go forward, it's not just about some of the projects being released and the economy growing. There is a component of new product launches that we have that are going to be important to our growth. So it's a combination of those. But I would tell you, I mean, we're excited about the cross boiler with the O2 sensing is an important part of what we're going to do. And we actually introduced several new products in 2020 that kind of got lost in the mix of the pandemic that I believe are going to help our business as we go forward.

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

Yeah. I would say with regard to your specific question on backlog, our backlog is pretty similar to what it was at the end of last year before the pandemic. So backlog is pretty solid.

David MacGregor -- Longbow Research -- Analyst

Okay. And is there anything incremental to the distribution story of boilers that would be helping you next year?

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

Nothing specific. We have still strong distribution. Of course, we have our rep-network, but I would say nothing that would be material to talk about today.

David MacGregor -- Longbow Research -- Analyst

Right, right. Okay. Thanks very much, gentlemen.

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

Thanks.

Operator

Your next question comes from Susan Maklari from Goldman Sachs.

Susan Maklari -- Goldman Sachs & Co. -- 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.

Susan Maklari -- Goldman Sachs & Co. -- Analyst

My first question is on the water treatment side of things. You highlighted that you expect some continued really elevated sales there over the course of '21. Can you talk a little bit about the margins? I know that you've made some progress there over the last couple of quarters, but how you're thinking about that on a go-forward basis and any kind of pressures or benefits that we should be aware of in that?

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

No, we were pleased with the expansion of about 200 basis points of margin this year. So we're just under 10% in 2020. Going forward, with the help of leverage on some growth, so next year we kind of see the growth being 13% to 14% again and continued work on costs. We would expect margins to expand over the -- actually over the next couple of years in that 100 to 200 basis points. So we do expect forward progress on that as we continue to grow the base and continue to look at cost out.

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

I would just add, Susan, volume matters there too. So as that business continues to grow, we get the leverage or facilities, the operating leverage within them, which will also help us to improve margins on a long-term basis.

Susan Maklari -- Goldman Sachs & Co. -- Analyst

Okay, that's helpful. And then my second question is just you mentioned that you are restarting your share buyback program this year, I think you kind of earmarked $400 million or so for that. Any color in terms of the kind of cadence of that. How we should be expecting it to come through? And then kind of any appetite at the higher or the lower end of that $400 million?

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

No, I mean I would peg it at $400 million right now. I wouldn't really go higher or lower and we're probably looking at throughout the years what we're kind of thinking of this. So the cadence would be pretty evenly throughout the year.

Operator

And your next question comes from Bryan Blair with Oppenheimer.

Bryan Blair -- Oppenheimer & Co. -- Analyst

Thanks. Good morning, everyone.

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

Hey, Brian. Good morning.

Bryan Blair -- Oppenheimer & Co. -- Analyst

Chuck, I apologize if you've provided this detail. I have offered a lot. But if we keep other variables constant for the year, what's the margin impact of normalizing residential volumes in 2021? Just trying to parse that out that relative hit knowing there are some offsets elsewhere.

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

Yeah. I mean there are so many. I mean, I -- it's hard to say that it's going to be stable, right. There're so many moving parts. Our costs have gone up so dramatically in the last short period of time. And when you look at those costs going up, if you look at -- you're right, there is a little bit of the detrimental margin impact when you've got a couple of hundred thousand units coming out of the industry. So, yeah, there is some headwind there, but there are so many moving parts. It's hard to say. I think we're going to -- we're just going to -- we're going to be chasing our cost a bit next year. As you said, the costs have gone up so dramatically that there's going to be at least in the first half of the year a little headwind on North American margins.

Bryan Blair -- Oppenheimer & Co. -- Analyst

Okay, understood. And great to see the momentum in your North American water treatment business,. How is your M&A pipeline looking particularly when it comes to targets to continue to scale that platform?

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

I would tell you that as we always do, we try to be active and we have certainly targets that we continue to stay close to in contact with. The pandemic has made that a little bit more challenging, but we remain active in reaching out the appropriate people. And as this pandemic, I think there is going to be some opportunity, but we're as active as we have always been and looking for opportunities that make sense to our core business.

Operator

And your next question comes from Nathan Jones with Stifel.

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

Good morning, everyone.

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

Hi, Nathan. Good morning.

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

I just wanted to follow-up a little bit on the rest of world margins. Comment that you don't have double-digit margins built into the model for 2022. I know in conversations we've had that you targeted getting the mid-priced tiered product margins in China up to the premium tier margins by the end of 2021 with volume returning pretty nicely in RW, why isn't that you could get to double-digit margins in 2022 and what are the top one or two things that would need to happen for you to achieve that double-digit margin in 2022?

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

Yeah. The fourth quarter is always the strongest quarter in China. So if you kind of look at the fourth quarter, you take out currency, you multiply it by four. We're back to a $1 billion business in the year just doesn't play out that way. Q1 is always weaker and so Q1 is just is just going to be challenged on that. So if you look at kind of the quarters building through the year, we're just not quite there yet on the volumes and on the cost out. Now, the margins, you're absolutely right. Our goal is to get the contribution margins back up to a similar percentage to the premium side of the product. That's going to take a little time. It takes a couple of things. It takes cost out, which we're working on over time. We won't be in that position in 2021, but we are working on it. And it's going to take volume to help us kind of leverage that through the footprint in China.

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

And just a question on 4Q '20 North America, you guys had anticipated some channel destocking in 4Q 2020. It doesn't look like that happened. Can you talk about what led to that happening? Was it just customers deferring destocking that because the new price increases were coming, fundamental demand picked up, sell through picked up, just any commentary you can provide on what changed between your assumptions when you were giving 4Q '20 guidance?

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

Yeah. I'm not sure I could describe it better than you just did. It is also done, when we were talking about destocking, we didn't have a price increase coming up and quite frankly demand stay there. And I think as we look back on it, our distributors probably want to be a bit heavy right now on their inventories just to make sure they can take care of their customer demand. So there is a few things that happened that you described them. We expect that sometime in 2021 probably in the latter half of the year you start to see what we had said in the prior quarter actually happen.

Operator

Your next question comes from Scott Graham of Rosenblatt Securities.

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

Good morning, Scott.

Operator

Scott, your line is open.

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

Scott, are you there.

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

Hello. I'm here. Can you hear me?

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

We can hear you now.

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

Okay. I don't know what happened there. Okay, well congrats on the quarter.

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

Thank you.

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

So, first question is on China. Could you just give us that percent of sales for the business which I know you load up everything in there with water treatment and everything, premium versus upper middle in the quarter?

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

Yeah. It really hasn't changed much. It's pretty consistent with what we've been talking about. So we still see the majority in the upper mid-priced part of the segment of the market and not a lot has change since prior quarters.

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

Got it. Thank you. And then on back to the North American business. I want to just try to square away some comments to understand on them. I think you said that last year residential was units industry were up about 8%, but you kind of call that a normalized 6% to 8% and that the inventory build was maybe half of that, but that not all of that will come out this year. So, it sounds to me like 2 minus, that's a 2% headwind, does that fair?

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

Yeah. That's fair. I mean, we think we'll get a little bit of help on new construction potentially in that category too. So we -- that's exactly where we're thinking about in our outlook.

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

But well I only repeat just want to make sure I got it right, Chuck. So those are very, very clear comment, but I mean the full out question from that is, if I may is, if you're thinking that the industry is down too and it's essentially because of that reason. I guess I'm just wondering why you wouldn't expect sort of let's call it normalized, why would you expect it to be on the flat? Residential conditions are quite strong this year. I know you answered David's question earlier about labor and what have you, I mean I think we try to get a contract or in your house, I know you have to pay currency. The defense kind of thing. I understand that. But is it a labor thing or are you just maybe being a bit conservative on that number?

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

I guess I think of it, Scott, is we would continue to expect to see some pretty decent consumer demand next year and proactive demand to be only down 2%. So we mean this year being up 6% to 8%, next year being down to 2%. You still have that kind of baseline proactive replacement, strong residential replacement, some potential growth year-over-year, I think in our numbers. So we do still expect it to be consumer demand pretty fairly strong, relatively strong, similar to what we saw this year on an underlying proactive replacement.

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

Scott, I would also tell you we're coming off a record. Even what we're forecasting is going to be one of the strongest years in the past decade. So there is still a lot of optimism out there, but optimism out there, but we just believe there is some stock that's going to come out that's going to make a difference.

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

Yeah. I mean really the big variable on how we look at next year is that 2% destocking or 200,000 units destocking.

Operator

Your next question comes from Saree Boroditsky with Jefferies.

Saree Boroditsky -- Jefferies -- Analyst

Hi, good morning. Thanks for fitting me in.

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

Good morning.

Saree Boroditsky -- Jefferies -- Analyst

Could you talked through what you're seeing in tankless market in North America. And if you're seeing any other areas introduce legislation somewhere to California limiting gas, Houston residential homes and how could that impact tankless sales going forward?

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

Well, tankless had a good year. We believe it's going to be up low double-digits. So it kind of in line with the tank and so forth. So, it's kind of what we expecting in the tankless market and so forth. Now as far as -- we have our California, you talking about decarbonization and so forth and I'm not going to talk specifically about tankless, I would just talk about our position with regards to that. When you look at it for us, it's important that we are part of the conversation. We believe that GHG emissions in residential and commercial buildings, we want to be part of reducing those. We're constantly talking to policymakers just to make sure that they're keeping in mind the technologies and there is no one size fit all. You hear like California that they want to just go completely electric. We don't think a one size policy fit all, is the right way to go. We think multiple paths are there.

So that's going to navigate its way through and we're going to be part of the conversation to make sure that technologies are including, performance of the products included and cost to the consumers included. And from an A.O. Smith perspective, I think we are positioned well. We have a full line of residential electric and commercial products in the market today. We have a full line of heat comp residential and commercial, which are the highest efficient electric water heaters out on the market and never want to forget that we have leading positions in condensing products, gas condensing, which can make a big difference in lowering GHG emissions just by going from a standard to a high efficiency model. So wherever the market is going to go, we're in position. Again, I would tell you, we're part of the conversation, but we're also positioned well. So we can be nimble and where the market goes we have the products that can meet the demand for the consumer, and of course, the commercial market as well.

Saree Boroditsky -- Jefferies -- Analyst

Thanks for that color. Then on the commercial, you talked about some uncertainty around that business obviously forecasting it down for this year, but could you help us understand from historical perspective, have there been many times where demand has declined two years in a row and could this forecast prove conservative?

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

I don't have taken a look on whether -- and the answer is no. I mean, there probably hasn't been down 2 times year in a row. But I think that the pandemic and the impact to, I call it, restaurants, hotels, some of the higher end -- the higher usage categories that we participate in, it's really spreading across two years, right. So it started Q2 and it's still going. So I think that down year-over-year is more related to pandemic than anything. And we may see in the Kevin's comments earlier about how that might play out. I think we're going to have to wait and see what the back half of the year shows and where we're at in the pandemic disruption.

Operator

And your last question comes from Larry De Maria with William Blair.

Larry De Maria -- William Blair & Co. -- Analyst

Hey, thanks.

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

Hey, Larry.

Larry De Maria -- William Blair & Co. -- Analyst

Hey, guys. Nice job. I know you talked about there kind of almost a noise about the inventory destocking. But just to be clear and then the potential pre-buy, are we expecting sales to comp up first half, comp down second half or could we sort of get close to flat because of the price increases? Can you just kind of clarify that a little bit?

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

I guess it's kind of hard to parse it out that way. I'll say we expect unit volume to be up in Q1 and that's because we do have the two price increases out there and typically there is a pre-buy before that. And then historically, the back half of the year is stronger than the front half of the year. So when you kind of look at it that way, I think maybe that will help kind of frame the model.

Larry De Maria -- William Blair & Co. -- Analyst

Okay. I guess perhaps and then maybe that's mostly obviously residential, but it plays into North America, commercial had some headwinds there obvious. Is there -- how do you think about that market getting toward a bottom? Is that potentially bottoming on a -- just because if nothing else easier comps later this year and start to think about we've comping up off a low base or do we expect that to be down over year?

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

I think it's going to come down to how the economy opens up. There's been a lot of positive feedback of some governors that had been shutting down economies in realizing now that they have to open them up. But again, it comes down to restaurants have to be open up. They have to be more than 25% capacity. Hotels have to have people who are traveling. So I do think the pandemic is going to be a factor in how the commercial market returns and we'll have to wait and see how that plays out throughout the year.

Operator

And I'm showing no further questions at this time. I would now like to turn the call back over to the host.

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

Thank you everyone for joining us today. We plan to participate in two virtual conferences in the first quarter, Citibank on February 18th and Robert W. Baird on February 23rd. Have a great day.

Operator

[Operator Closing Remarks]

Duration: 69 minutes

Call participants:

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

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

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

Jeff Hammond -- KeyBanc Capital Markets, Inc. -- Analyst

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

Eitan Buchbinder -- Citi Research -- Analyst

Damian Karas -- UBS Securities -- Analyst

David MacGregor -- Longbow Research -- Analyst

Susan Maklari -- Goldman Sachs & Co. -- Analyst

Bryan Blair -- Oppenheimer & Co. -- Analyst

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

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

Saree Boroditsky -- Jefferies -- Analyst

Larry De Maria -- William Blair & Co. -- Analyst

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