In my end of the month summary I told you I had taken a little position in AO Smith, but that I wasn’t sure about it and that I might sell it. Well I did sell it.
I will now try to give you an idea why I took a starter position in this stock and then sold it. I first heard of the company when Matt brought an article about the stock to the board. Here are some excerpts from the article (as modified in my notes):
This company doesn’t sell flashy technology like an electric car, or promise the next big consumer product. While it boasts an illustrious industrial history that ignited the early days of the auto industry A. O. Smith’s business today is driven by a staple of modern living: hot water.
The water-technology specialist achieved record sales and earnings in 2016, but several significant growth opportunities in Asia promise future growth for years to come. Investors who may have been overlooking it should give it a closer look.
In 2011, A. O. Smith sold its electric motor business, the last remaining piece of its auto industrial past, to focus exclusively on becoming a leading global water-technology company. They are up 511% since then.
Today, A. O. Smith sells water heaters, boilers, and water-treatment technologies to both residential and commercial customers. It generates the bulk of its sales in North America, which provides a steady base for operations and powerful cash flow. The largest growth opportunities are China and India, where they have a long-term strategy to build leading market positions.
Their North American revenue was up 2% last year, but their International revenue (a third of the total), was up 11%. Earnings were up 17%
The driving forces behind the company’s growth differ by region. In established markets such as North America, residential and commercial customers are increasingly gravitating toward high-efficiency products for replacements and new construction. For example, sales of high efficiency commercial gas water heaters have more than doubled since 2010, while high-efficiency condensing boilers will soon account for more than half of annual sales for all commercial boilers. A. O. Smith specializes in both.
It’s important to note that, while North America provides a cash cow for them, growth remains limited because over 85% of residential water heaters sold on here each year are replacements rather than new construction.
In less established markets such as China and India, growth is driven by the rapid expansion of middle-class populations.
AO Smith was one of the first US companies to enter the residential water heater market in India in 2008, although the business is still in its infancy. Last year, sales in India amounted to just $18.2 million.
It has had a presence in China for considerably longer – and it shows. In 2002, it commanded just 5% of the residential water heater market in the country, but it is now the leading brand with over 25% market share. The company also sells water-treatment products and air purification products (a relatively new offering) in the region.
Last year, China accounted for one-third of all revenue, or $888 million. That’s up from just $50 million in 2003. Better yet, management hopes it can deploy a similar strategy with minor tweaks in India. If it proves successful, then the business could see above-average growth for many years into the future.
A. O. Smith doesn’t own a flashy business, but it’s a leader in nearly every market segment in which it operates. That includes top market positions in residential water heater sales in North America (40%) and China (25%), residential water treatment sales in China (26%), and commercial water heater sales in North America (53%).
It has a stable foundation of high-margin business in North America and ample growth opportunities in China and India. It isn’t afraid to make strategic acquisitions to grow more quickly. It pays a respectable dividend yield of 1.1%. And most importantly, it focuses on long-term opportunities and trends to drive its business forward.
(Saul Here) – Okay, that gives you an idea what the company is about. Here’s what their first quarterly earnings looked like
A. O. Smith reports 19% earnings growth on 16% increase in sales
EPS of 50 cents beats by 3 cents. Revenue of $740 million beats by $42 million
Water technology company A. O. Smith announced record quarterly net earnings of $88 million or 50 cents per share on record sales of $740 million. Last year net was $73.5 million or 41 cents. This is the fifth consecutive year it has achieved record first quarter sales and earnings.
Sales were up 16%, and up 18% in constant currency. Sales in China were up 20%, and up 27% excluding the impact from the stronger U.S. dollar.
The strength of both the U.S. water heater industry and our consumer product demand in China is encouraging. With double digit sales growth in both operating segments in the quarter, we are starting the year on solid footing.
North America segment
First quarter sales for the North America segment increased to $487 million from $423.9 million. The increase in sales was primarily due to higher volumes of residential and commercial water heaters in the U.S. and Canada as well as a price rise in August 2016 related to steel cost increases and inflationary pressure on other costs. The Aquasana water treatment business, acquired in August, added $10.3 million to the North America segment sales (roughly 2% of the total).
Segment operating earnings of $104.2 million up 13% from $91.9 million a year ago. The favorable impact from higher volumes of water heaters and higher prices was partially offset by higher steel and other input costs. Operating margin of 21.4% was down slightly from 21.7%. (The operating margin of the newly acquired Aquasana business is lower than the segment average and explained the overall margin decline).
Rest of World segment
Sales of this segment, which is primarily comprised of China, Europe and India, was up 19% to $259 million from $217 million. Continued strong customer demand for the company’s premium products, and a pre-buy in advance of a price increase related to steel and other cost inflation, drove China sales 27% higher in local currency and over 20% higher in U.S. dollars. (They feel people buying to beat the price rise in the first quarter pulled some from sales in the second and third quarters).
In China, water treatment sales grew over 50% and air purification sales were up over 80% in local currency. We broke ground in 2016 on a construction of a new water treatment and air purification manufacturing facility in Nanjing to support the strong growth of these products in China.
Operating earnings for this segment were $32.5 million up from $26.9 million. The impact to profits from higher China sales was partially offset by higher SG&A expenses in China. Higher selling and advertising costs to support growth in China were the primary drivers of higher segment SG&A expenses. Currency translation reduced China earnings by approximately $2 million compared with the prior year. Segment operating margin of 12.5% was flat with 12.4% in 2016.
Share Repurchase and Other Items
During the quarter, we repurchased 606,850 shares at a total cost of $30.1 million. Approximately 4.3 million shares remained on the existing discretionary repurchase authority at the end of the quarter.
Total debt as of March 31, 2017, was $369 million, resulting in leverage of 19.1 percent as measured by the ratio of total debt to total capital. Cash and investments, located outside the U.S., totaled $722 million at the end of the quarter.
Our effective income tax rate in the quarter was 27.2% percent. It was lower than the 29.1% in the prior year quarter primarily due to a larger benefit associated with stock-based compensation and a change in geographic earnings mix. The lower tax rate compared with a year ago benefited results by 1 cent per share. We expect our full-year income tax rate will be between 28.75 and 29%.
“Our outlook for 2017 is positive, and we are optimistic we will grow revenues between 9% and 10%. Thanks to our strong sales and earnings growth this quarter, we increased the midpoint of our full-year earnings per share guidance by 3 cents. We now anticipate our 2017 earnings to be about $2.06.”
(Saul here again)
So, why didn’t I stay with this excellent company: I decided I was just too worried with their major plant being built in China, and over a third of revenue, and almost all its growth coming from China. In a year or two it would have a majority of revenue coming from China. They talk about “China and India,” but revenue from India is irrelevant (2.0% of the total of the two, one-fiftieth of the revenue from China). Now water purification and air purification in China sounds great, but this is a key industry for China. They will be greenhousing and bringing up their own companies to compete with AO Smith, combined with future restrictions on foreign companies in key industries. The company is relatively slow growing. But it has a PE of about 27. And while it’s unlikely, if the US and China got into even a minor shooting dispute over the South China Sea, I could easily see China nationalizing this company, or at least freezing its assets longterm. So I decided to exit. I can only invest in a limited number of positions, and if I chose this one it would have to replace another that was faster growing, and had less political risk.