Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

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

In January 2020, an outbreak of a novel coronavirus (COVID-19) surfaced in Wuhan, China. As a result of the outbreak, the Chinese government required businesses to close and restricted certain travel within the country. In cooperation with the government authorities, our operations in China closed for approximately four weeks before resuming production before the end of the first quarter. In March 2020, COVID-19 was declared a global pandemic and we experienced impacts to our business and other markets worldwide. To date, our global manufacturing operations of essential water heating and water treatment products continue without material disruption to our operations. As a result of the COVID-19 pandemic and in support of continuing our manufacturing efforts, we have undertaken numerous and meaningful steps to protect our employees, suppliers, and customers. These important steps, which in certain cases reduce efficiency, include continuous communication and training to our employees on living and working safely in a COVID-19 environment, plant accommodations and reconfigurations to maintain social distancing, masks for all employees, implementation of sanitizing stations, temperature taking and regular, proactive deep cleaning and sanitization of our facilities, among others. As we receive guidance from governmental authorities, we adjust our safety measures to meet or exceed those guidelines. The majority of our customers in the U.S. are also deemed essential under Cybersecurity and Infrastructure Security Agency (CISA) guidance and are operating their businesses under varying state and local governmental guidance.

Our global supply chain management team continues to monitor and manage our ability to operate effectively during the COVID-19 pandemic. To date, we have not seen any material disruptions to our supply chain, although we have seen an increase in logistics costs and shipment times as a result of pandemic-related capacity reductions. Ongoing communications with our suppliers to identify and mitigate risk of potential disruptions and to manage inventory levels continue. Our U.S. water heater manufacturing lead times, which were extended in the second and third quarters due to self-quarantine absenteeism mandated by our COVID-19 prevention measures, stabilized in the fourth quarter of 2020 as a result of adding manufacturing shifts, hiring temporary workers and shifting some production.

While we believe our balance sheet and capital position are strong, proactive management of discretionary spending and cost structure will continue. On May 1, 2020, the members of our Board of Directors voluntarily reduced the cash component of their board compensation by 25 percent and our chairman and chief executive officer (CEO) voluntarily reduced his base salary by 25 percent. Our CEO’s staff, which includes our other named executive officers, also volunteered a 15 percent reduction in base salary. Full compensation of our Board of Directors, our CEO and our CEO’s staff was reinstated on October 1, 2020.

We estimate that between 80 to 85 percent of our water heater and boiler units sold in the U.S. relate to replacement business. While we expect that our replacement business in both water heating and boilers will provide a buffer in any economic downturn resulting from COVID-19 in a similar manner to what we have seen historically, the impacts of the pandemic on consumer spending are difficult to predict.

In our North America segment, we expect industry residential water heater volumes will be down approximately two percent in 2021 compared with 2020, which is driven by our belief that customers may have added inventory in 2020 due to industry extended lead times. We believe that some de-stocking by our customers will occur in early 2021 as our lead times have improved and continue to improve. We believe that commercial water heater industry volumes will further decline approximately four percent in 2021 as COVID-19 pandemic-impacted businesses delay or defer new construction and discretionary replacement installations. We expect to see a mid-single digit increase to our boiler sales in 2021 compared to 2020 due to industry growth of three to four percent driven by pandemic-related pent up demand as well as our new product introductions. We expect sales of our North America water treatment products to increase by 13 to 14 percent in 2021, compared to 2020, primarily driven by consumer demand for our point of use and point of entry water treatment systems.

In our Rest of World segment, we expect China sales in 2021 to increase 14 to 15 percent in local currency compared with 2020 due to increased consumer demand. We assume China currency rates will stay at current levels and which would add approximately $47 million and $3 million to sales and earnings in 2021, respectively. In addition, we project that our mix of products sold in China is shifting to more mid-price range products from our historical mix of higher priced products. We also continue to focus on aligning our cost structure in China through headcount reductions, store closures, cuts in advertising

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and other cost saving measures. Our 2020 headcount reductions and restructuring actions we took were largely completed as of the end of the third quarter of 2020.

Combining all of these factors, we expect our consolidated sales to increase approximately ten percent in 2021. Our guidance excludes the potential impacts from future acquisitions and assumes the conditions of our business environment and that of our suppliers and customers are similar in 2021 to what we are experienced in recent months and does not deteriorate as a result of further restrictions or shutdowns due to the COVID-19 pandemic.

Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction of water treatment products in India and Vietnam and range hoods and cooktops in China.

RESULTS OF OPERATIONS

Our sales in 2020 were $2,895 million, a decline of 3.3 percent compared to our 2019 sales of $2,993 million. Compared to 2019, our sales decline in 2020 was primarily driven by lower sales in China and lower commercial water heater volumes, and reduced boiler sales in North America. The decreased sales in 2020 compared to the prior year more than offset higher water treatment volumes including incremental sales of $16 million from Water-Right, acquired on April 8, 2019 and higher residential water heater volumes in North America. In addition, our sales in China were favorably impacted by currency translation of approximately $9 million in 2020 compared to 2019, due to the appreciation of the Chinese currency compared to the U.S. dollar. Our sales in 2019 were $2,993 million, a decline of 6.1 percent compared to our 2018 sales of $3,188 million. The decrease in 2019 sales was primarily due to a 23 percent decline in China sales in U.S. dollar terms, which was largely a result of weaker end-market demand in the region, year over year channel inventory shifts, and a higher mix of sales of mid-price products versus premium price products than in the prior year. Excluding the unfavorable impact from currency translation, China sales declined 19 percent in 2019. The sales reduction in China in 2019 compared to 2018, more than offset the benefits of higher sales in North America, which were primarily a result of higher sales of water treatment products, including incremental sales from our Water-Right acquisition, and water heater pricing actions related to steel and freight cost increases. The increase in North America sales in 2019 compared to 2018, was partially offset by lower residential water heater volumes.

Our gross profit margin in 2020 of 38.3 percent declined compared to our gross profit margin of 39.5 percent in 2019 primarily due to the lower sales volumes. Our gross profit margin in 2019 of 39.5 percent declined compared to our gross profit margin of 41.0 percent in 2018, primarily due to the lower sales volumes in China and a higher mix of mid-price products, which have lower margins, in that region.

Selling, general, and administrative (SG&A) expenses were $660.3 million in 2020 or $55.3 million lower than 2019. SG&A expenses were $715.6 million in 2019 or $38.2 million lower than in 2018. The decrease in SG&A expenses in both 2020 and 2019 was primarily due to lower selling and advertising expenses in China.

To align our business to current market conditions, we recognized $7.7 million of pre-tax severance and restructuring expenses in 2020. Charges recognized were comprised of $6.8 million severance costs and $0.9 million of other restructuring expenses. On March 21, 2018, we announced a plan to transfer water heater, boiler and storage tank production from our Renton, Washington plant to our other U.S. plants. The majority of the consolidation of operations occurred in the second quarter of 2018. As a result of the relocation of production, we incurred pre-tax restructuring and impairment expenses of $6.7 million in the first quarter of 2018, primarily related to employee severance, building lease exit costs, and the impairment of assets. These activities are reflected in "severance, restructuring, and impairment expenses" in the accompanying financial statements.

We provide non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted earnings per share, and adjusted segment earnings) that exclude severance, restructuring, and impairment expenses. Reconciliations to measures on a GAAP basis are provided later in this section. We believe that the measures of adjusted earnings, adjusted EPS, and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items we do not consider to be a component of our core operating performance.

Interest expense was $7.3 million in 2020, compared to $11.0 million in 2019 and $8.4 million in 2018. The decrease in interest expense in 2020 was primarily due to lower debt levels and lower interest rates than the prior year. The increase in interest expense in 2019 compared to 2018 was primarily due to higher debt levels utilized to fund the acquisition of Water-Right and share repurchase activity.

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Other income was $11.0 million in 2020 compared to $18.0 million in 2019 and $21.2 million in 2018. The decrease in other income in 2020 compared to 2019 was primarily due to lower interest income. The decrease in other income in 2019 compared to 2018 was primarily due to lower non-service cost-related pension income and lower interest income.

Pension income in 2020 was $5.1 million compared to $6.2 million in 2019 and $8.7 million in 2018. The service cost component of our pension income is reflected in cost of products sold and SG&A expenses. All other components of our pension income are reflected in other income.

Our effective income tax rate was 22.3 percent in 2020, compared with 21.6 percent in 2019 and 20.4 percent in 2018. Our effective income tax rate in 2020 and 2019 was higher compared to the prior years primarily due to a change in geographic earnings mix.

North America

Sales in our North America segment were $2,118 million in 2020 or $34 million higher than sales of $2,084 million in 2019. Compared to 2019, the increased 2020 sales were primarily due to higher volumes of residential water heaters and a 25 percent increase in water treatment product sales, including $16 million of incremental sales from Water-Right. This increase was partially offset by lower U.S. commercial water heater volumes, lower boiler sales and a water heater sales mix composed of more electric models which have a lower selling price. Sales in our North America segment were $2,084 million in 2019 or $39 million higher than sales of $2,045 million in 2018. The increase in sales in 2019 compared to 2018 was primarily due to the incremental Water-Right sales of $44 million, water heater pricing actions related to steel and freight cost increases, and higher sales of water treatment products, which were partially offset by lower residential water heater volumes.

North America segment earnings were $503.5 million in 2020 compared to segment earnings of $488.9 million and $464.1 million in 2019 and 2018, respectively. Segment margins were 23.8 percent, 23.5 percent and 22.7 percent in 2020, 2019 and 2018, respectively. Adjusted segment earnings and adjusted segment margin, which exclude severance, restructuring, and impairment expenses, were $506.2 million and 23.9 percent, respectively, in 2020, and $470.8 million and 23.0 percent, respectively, in 2018. The higher adjusted segment earnings and adjusted segment margin in 2020 compared to 2019 segment earnings and segment margin were primarily driven by higher residential water heater volumes, higher water treatment product sales, which included incremental profit from Water-Right, and lower material costs. This was partially offset by lower volumes of commercial water heaters and lower boiler sales. During 2020, segment earnings and margin were adversely impacted by certain costs related to the pandemic. These costs included temporarily moving production from Mexico to the U.S., paying employees during temporary plant shutdowns, proactively deep cleaning facilities, paying benefits during employee furloughs, and other costs, which were approximately $6.6 million in 2020. The higher segment earnings and segment margin in 2019 compared to 2018 adjusted segment earnings and adjusted segment margin were primarily a result of pricing actions, lower steel costs, and higher sales of water treatment products, including incremental volumes from our acquisition, Water-Right. These increases were partially offset by the unfavorable impact from lower residential water heater volumes. We estimate our 2021 North America segment margin will be between 23 and 23.5 percent.

Adjusted segment earnings and adjusted segment margin in 2020 exclude $2.7 million of pre-tax severance and restructuring and impairment expenses. These expenses were associated with an initiative to align our business to current market conditions. Adjusted segment earnings and adjusted segment margin in 2018 exclude $6.7 million of pre-tax severance, restructuring and impairment expenses. These expenses were associated with our transfer of our water heater, boiler and storage tank production from our Renton, Washington plant to our other U.S. plants.

Rest of World

Sales in our Rest of World segment were $800 million in 2020 or $136 million lower than sales of $936 million in 2019. Compared to 2019, our sales in China decreased by 15 percent in U.S. dollar terms and 16 percent in local currency in 2020. In addition, our 2020 sales in China were favorably impacted by currency translation of approximately $9 million compared to 2019, due to the appreciation of the Chinese currency compared to the U.S. dollar. The decrease in Rest of World sales in 2020 was primarily due to COVID-19 pandemic-related lockdowns, weak end-market demand in China, primarily in the first half of 2020, a higher mix of mid-price products which have a lower selling price and year over year channel inventory shifts. Sales in our Rest of World segment in 2019 were $936 million or $238 million lower than sales of $1,174 million in 2018. Lower sales in 2019 compared to 2018 were largely a result of decreased China sales, which declined 23 percent in U.S. dollar terms and 19 percent in local currency terms. The decline in China sales was primarily due to weaker end-market demand, elevated channel inventory levels for the first three quarters of 2019 that returned to a more normal range of two to three months by the end of 2019, and a higher mix of mid-price products versus premium-priced products. In addition, the weaker Chinese currency unfavorably impacted translated sales by approximately $39 million. Sales in India grew approximately 13 percent in 2019 compared to 2018.

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The Rest of World segment was breakeven in 2020 compared to segment earnings of $40.2 million and $149.3 million in 2019 and 2018, respectively. Segment margins were 4.3 percent and 12.7 percent in 2019 and 2018, respectively. Adjusted segment earnings and segment margin, which exclude severance, restructuring, and impairment expenses, were $5.0 million and one percent, respectively, in 2020. Compared to 2019, the absence of segment earnings in 2020 was driven by the unfavorable impact from lower sales in China and a higher mix of mid-price products, which have lower margins than our historical mix of higher-priced products, and which were partially offset by the benefits from lower selling, advertising, and administrative costs and temporary social insurance exemptions. Currency translation increased segment earnings by approximately $3.6 million in 2020 compared to 2019. The decline in 2019 segment earnings and margin compared to 2018 was primarily due to lower sales in China and a higher mix of mid-price products, which have lower margins, that when combined, more than offset benefits to profits from lower SG&A expenses and material costs in that region. Currency translation reduced segment earnings by approximately $3.0 million in 2019 compared to 2018. We expect full-year segment margin to be between seven percent and eight percent in 2021.

Adjusted segment earnings and adjusted segment margin in 2020 exclude $5.0 million of pre-tax severance and restructuring and impairment expenses. These expenses were associated with an initiative to align our business to current market conditions.

LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $731.7 million at December 31, 2020 compared with $733.9 million and $853.2 million at December 31, 2019 and December 31, 2018, respectively. An increase in cash, cash equivalents and marketable securities was offset by higher accounts payable balances and payroll accruals in 2020 compared to 2019. We repatriated approximately $190 million in foreign cash and marketable securities in 2020 and utilized it to repay floating rate debt. The decline in cash, cash equivalents and marketable securities and sales related decreases in accounts receivable partially offset by lower accounts payable balances led to the majority of the decline in working capital in 2019. Approximately $165 million in foreign cash, cash equivalents and marketable securities was repatriated in 2019 and utilized to repay floating rate debt, pay dividends and repurchase shares. We expect to repatriate approximately $190 million in 2021 and use the proceeds for common stock repurchases.

Cash provided by operating activities in 2020 was $562.1 million compared with $456.2 million during 2019 and $448.9 million during 2018. The improvement in operating cash flows in 2020 was primarily due to lower outlays of working capital including higher accounts payable balances in China, which include receipts of cash deposits in advance of sales from certain customers, that more than offset lower earnings. The increase in cash flows in 2019 compared with 2018 was primarily due to lower outlays for working capital which offset lower earnings in 2019. We expect cash provided by operating activities to be $450 million to $475 million in 2021. We continue to monitor developments on an on-going basis and have taken proactive measures to focus on cash, manage working capital, and reduce costs.

Our capital expenditures were $56.8 million in 2020, $64.4 million in 2019 and $85.2 million in 2018. Included in 2018 capital expenditures were approximately $13 million related to capacity expansion in China. We project our 2021 capital expenditures to be between $85 and $90 million and expect depreciation and amortization will be approximately $80 million.

We have a $500 million multi-currency credit facility with a group of nine banks, which expires in December 2021. The facility has an accordion provision, which allows us to increase it up to $700 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2020. We expect to complete a renewal of our credit facility in the first half of 2021.

The facility backs up commercial paper and credit line borrowings. As a result of the long-term nature of this facility, our commercial paper and credit line borrowings, as well as drawings under the facility, are classified as long-term debt as of December 31, 2019. At December 31, 2020, we had no borrowings under the facility and an available borrowing capacity of $500 million. We believe the combination of available borrowing capacity and operating cash flows will provide sufficient funds to finance our existing operations for the foreseeable future.

Our total debt declined from $284.0 million at December 31, 2019, to $113.2 million at December 31, 2020. Our leverage, as measured by the ratio of total debt to total capitalization, calculated excluding operating lease liabilities, was 5.8 percent at the end of 2020, compared with 14.6 percent at the end of 2019.

Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2020. We forecast that we will not be required to make a contribution to the plan in 2021, and we do not plan to make any voluntary contributions in 2021. For further information on our pension plans, see Note 13 of Notes to Consolidated Financial Statements.

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In the second quarter of 2019, our Board of Directors approved adding 3,000,000 shares of Common Stock to an existing discretionary share repurchase authority. Under the share repurchase program, our common stock may be purchased through a combination of a Rule 10b5-1 automatic trading plan and discretionary purchases in accordance with applicable securities laws. The stock repurchase authorization remains effective until terminated by our Board of Directors, which may occur at any time, subject to the parameters of any Rule 10b5-1 automatic trading plan that we may then have in effect. Due to the uncertainty surrounding the impact of the global COVID-19 pandemic, we suspended our share repurchases on March 18, 2020. During 2020, we repurchased 1,348,391 shares of our stock at a total cost of $56.7 million. At December 31, 2020, we had 1,613,824 million shares remaining on the board share repurchase authority. On January 27, 2021, the Board of Directors approved adding 7,000,000 shares of common stock to the existing discretionary share repurchase authority. Including the additional shares, we have approximately 8.6 million shares available for repurchase. We currently intend to spend approximately $400 million to repurchase common stock in 2021 through a combination of 10b5-1 plans and open market purchases.

We have paid dividends for 81 consecutive years with annual amounts increasing each of the last 29 years. We paid dividends of $0.98 per share in 2020 compared with $0.90 per share in 2019. We increased our dividend by eight percent in the fourth quarter of 2020, and the five-year compound annual growth rate of our dividend payment is approximately 22 percent.

Recent Accounting Pronouncements

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

Critical Accounting Policies

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

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

Goodwill and Indefinite-lived Intangible Assets

In conformity with U.S. Generally Accepted Accounting Principles (GAAP), goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct thorough and competent annual valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2020.

Product warranty

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

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long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2020 and 2019, our reserve for product warranties was $142.3 million and $134.3 million, respectively.

Product liability

Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2020, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million.

We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also utilize an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2020 and 2019, our reserve for product liability was $35.3 million and $33.1 million, respectively.

Pensions

We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 6.75 and 7.15 percent in 2020 and 2019, respectively. The discount rate used to determine net periodic pension costs decreased to 3.18 percent in 2020 from 4.32 percent in 2019. For 2021, our expected return on plan assets is 6.25 percent and our discount rate is 2.44 percent.

In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 30 to 60 percent, with the remainder allocated primarily to bond managers, private equity managers and real estate managers. Our actual asset allocation as of December 31, 2020, was 44 percent to equity managers, 46 percent to bond managers, nine percent to real estate managers, and one percent to private equity managers. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 9.3 percent and 8.7 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 6.25 percent expected return on plan assets for 2021 is reasonable.

The discount rate assumptions used to determine future pension obligations at December 31, 2020 and 2019 were based on the Aon AA Only Above Median yield curve, which was designed by Aon to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary.

We recognized pension income of $5.1 million, $6.2 million, and $8.7 million in 2020, 2019, and 2018, respectively.

We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014. Lowering the expected return on plan assets by 25 basis points would decrease our net pension income for 2020 by approximately $1.9 million. Lowering the discount rate by 25 basis points would increase our 2020 net pension income by approximately $0.4 million.

As part of our strategy to de-risk our defined benefit pension plan, the qualified defined benefit pension plan purchased a group annuity contract whereby an unrelated insurance company assumed a $23 million and $31 million obligation to pay and administer future annuity payments for certain retirees and beneficiaries in 2020 and 2019, respectively.

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Non-GAAP Measures

We provide non-GAAP measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted segment earnings) that exclude severance, restructuring and impairment expenses in 2020 and 2018.

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

A. O. SMITH CORPORATION

Adjusted Earnings and Adjusted EPS

(dollars in millions, except per share data)

(unaudited)

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

			Years ended December 31,
			2020						2019						2018
Net Earnings (GAAP)			$	344.9					$	370.0					$	444.2
Severance, restructuring and impairment expenses, before tax (1)(2)(3)			7.7						—						6.7
Tax effect of severance, restructuring and impairment expenses			(1.4)						—						(1.7)
Adjusted Earnings			$	351.2					$	370.0					$	449.2
Diluted EPS (GAAP)			$	2.12					$	2.22					$	2.58
Severance, restructuring and impairment expenses per diluted share(1)(2)(3)			0.05						—						0.04
Tax effect of severance, restructuring and impairment expenses per diluted share			(0.01)						—						(0.01)
Adjusted EPS			$	2.16					$	2.22					$	2.61

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

			Years ended December 31,
			2020						2019						2018
Segment Earnings (GAAP)
North America			$	503.5					$	488.9					$	464.1
Rest of World			—						40.2						149.3
Inter-Segment earnings eliminations			(0.3)						—						—
Total Segment Earnings (GAAP)			$	503.2					$	529.1					$	613.4
Adjustments
North America(1) (2)			$	2.7					$	—					$	6.7
Rest of World(3)			5.0						—						—
Inter-Segment earnings eliminations			—						—						—
Total Adjustments			$	7.7					$	—					$	6.7
Adjusted Segment Earnings
North America			$	506.2					$	488.9					$	470.8
Rest of World			5.0						40.2						149.3
Inter-Segment earnings eliminations			(0.3)						—						—
Total Adjusted Segment Earnings			$	510.9					$	529.1					$	620.1

(1)In 2020, we recognized $2.7 million of severance and restructuring expenses in connection with our alignment of the business to current market conditions. For additional information, see Note 5 of Notes to Consolidated Financial Statements.

(2)In 2018, we recognized $6.7 million of restructuring and impairment expenses in connection with the move of manufacturing operations from our Renton, Washington facility to other U.S. facilities. For additional information, see Note 5 of Notes to Consolidated Financial Statements.

(3)In 2020, we recognized $5.0 million of severance and restructuring expenses in connection with our alignment of the business to current market conditions. For additional information, see Note 5 of Notes to Consolidated Financial Statements.

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Outlook

We expect our consolidated sales to increase approximately ten percent in 2021. We believe the Chinese economy will improve in 2021 and expect that sales in China will increase by 20 to 21 percent in U.S. dollar terms and 14 to 15 percent in local currency terms. We expect to achieve full-year earnings of between $2.40 and $2.50 per share. Our 2021 guidance excludes the potential impacts from future acquisitions and assumes that the conditions of our business environment and that of our suppliers and customers are similar for the remainder of the year to what we have experienced in recent months and do not deteriorate as a result of further restrictions or shutdowns due to the COVID-19 pandemic.

OTHER MATTERS

Environmental

Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2020 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage.

Risk Management

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

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

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

Market Risk

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

We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2020, we had net foreign currency contracts outstanding with notional values of $229.9 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $23.0 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged.

Forward-Looking Statements

This filing contains statements that the Company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: negative impacts to the Company's businesses, including demand for its products, particularly commercial products, operations and work-force dislocation and disruption,

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supply chain disruption and liquidity as a result of the severity and duration of the COVID-19 pandemic; a failure to recover or a further weakening of the Chinese economy and/or a failure to recover or a further decline in the growth rate of consumer spending or housing sales in China; negative impact to the Company’s businesses from international tariffs and trade disputes; potential further weakening in the high-efficiency boiler segment in the U.S.; significant volatility in raw material availability and prices; inability of the Company to implement or maintain pricing actions; a failure to recover or further weakening in U.S. residential or commercial construction or instability in the Company’s replacement markets; foreign currency fluctuations; the Company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on the Company’s businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and the Company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on its behalf, are qualified entirely by these cautionary statements.