Investors don't pay much attention to water-heater manufacturer A.O. Smith (AOS +3.75%), but they should. This under-the-radar company is one of those hidden gems that consistently beats the market without much fanfare. It has been able to accomplish this through a combination of a dominant market position in the North American market and the resulting consistent cash flow that allows it to pursue incredible growth opportunities overseas.
For this plan to work, management needs to be able to prove it can maintain its North American position while turning growing international sales into bottom-line results. One great way to get a feel for how this is progressing is to check in with management's conference call. So let's dig into the most recent one to see what management had to say. Here is a selection of quotes that should help you get a better understanding of this stock.
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A strong international market
China and India are the two growth drivers for A.O. Smith. Last quarter, the company reported a 27% year-over-year sales increase in China as the middle class there grows, and the company increased its market share. According to CEO Ajita G. Rajendra, the growth thesis in China remains very much intact as A.O. Smith expands into residential and commercial air- and water-purification systems. What's more important is that growing sales are translating into operating profits.
With several growth drivers underpinning our China business, we are confident to project an annual growth rate of at least 15% in local currency in 2017. These drivers include, overall water heater market growth driven by household formation and an emerging replacement market, geographic expansion, market share gain, continued strong growth of water treatment products and air purification product growth. These benefits from China growth, smaller loss is expected in India and our air purification products approaching breakeven, we project Rest of World segment operating margin will be at least 14% in 2017.
This past quarter, margins in all regions except North America were 12.5%, compared to North American margins of 21.5%. There is room here to improve, but it's encouraging to see that margins will improve even though the company is still operating at a loss in India.
Expansion in China coming soon
It's pretty clear from A.O. Smith's revenue results that there is a lot of room to run in China. To meet that demand, though, the company will need more production facilities. According to CFO John Kita, the company will spend the lion's share of its capital spending on expanding production in China:
Over the 2-year period, from 2016 to 2017, we expect to generate operating cash of approximately $825 million, which compares with $612 million during 2014 to 2015. 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.
Our 2017 capital spending plans of approximately $100 million include about $45 million related to this plant. Total cost for the facility, which is expected to begin production in the second quarter of 2018, will be approximately $65 million. After this expansion, we expect capital spending in 2018 and beyond to be at levels of approximately equal to our depreciation plus amortization.
One thing of note here: Investors shouldn't anchor to that "and beyond" part of Kita's statement on future capital spending. If growth in China and India continues to increase at projected rates over the next several years, chances are good that A.O. Smith will have to build more facilities.
Going shopping?
A.O. Smith has a dominant market share in the U.S., and it now owns 25% of the market in China. But that doesn't mean that the company can't improve upon that market share through acquisitions. When asked about any potential deals, Rajendra's answer seemed rather ominous:
There is a lot of activity. There are opportunities out there. We are looking at opportunities. The prices are still high, and as we've always said, that we need to be able to see the value proposition. We need to able to see returning costs across the capital to our shareholders in a reasonable period of time and we are running a very disciplined process.
And for obvious reasons, we are not going to be able to comment on something until it's a done deal. So we're not going to speculate on something that's in process. We can't.
Whenever members of management say they can't discuss or speculate about a possible deal, it typically means the company is involved in one. If it weren't involved or interested, management would flat out say so.
Overseas cash
One thing that is challenging for companies with sizable operations abroad is getting cash back into the United States in a tax-efficient manner. A.O. Smith may not have cash hoards abroad like some tech giants, but it has enough to make it challenging to make capital allocation decisions. When asked whether the company has plans to repatriate its funds held abroad, here's what Kita had to say:
I haven't heard much about a holiday so that won't happen; it doesn't appear. But the cash overseas, depending on how it all falls out, we may not bring it back immediately because we're looking, from an acquisition standpoint, globally. So obviously, if I did an acquisition in the U.S., I may bring it back. If I did an acquisition internationally, I'd rather have the money where it is now, in Europe and China, depending on where you do it.
For now, this is a non-issue. Holding cash abroad versus in the U.S. doesn't matter until that cash needs to get allocated to new investments.
Blurred lines
A.O. Smith has, historically, had little exposure to retail customers as it has sold its products to wholesalers and contractors. That is starting to change, however, as more and more commerce moves online. Management has decided to take on this challenge by opening up to the retail market. According to Rajendra, A.O. Smith needs to have a greater presence in front of the end customer if it wants to maintain its position in the North American market:
From our perspective, as we see the traditional channel boundaries blurring, the decisions being made more and more by the consumer because of online searches, and that's the first place people go looking products. We feel that having the A. O. Smith brand, both at wholesale and retail, it's just going to make it a stronger brand and help our growth across the board, in both wholesale and in retail. And the brand being at Lowe's gives it the opportunity to have 13 million viewings by consumers every week, and all of that will strengthen the brand which will make it a stronger brand at wholesale and at retail. So long-term, we think this is a great growth opportunity for the company.
Brand hasn't been of much concern for A.O. Smith before, because it was selling to contractors and developers who were familiar with the product. If homeowners are going to become more actively involved in product choice, the company needs to establish its brand -- and the only way to do that is by getting consumers' eyeballs on its products. Investors should pay a lot of attention to retail-channel sales in the upcoming quarters as they will be a gauge of how well the company is building its brand.
