You may think any business built around water heaters is destined to be pretty boring (and you may be right), but A.O. Smith (AOS -2.25%) doesn't care much for flair. You may not either after considering the stock has easily outpaced the returns of Amazon and Apple since focusing all of its bandwidth on core opportunities in 2011.
The company has achieved its impressive growth on the backs of the quickly growing ranks of China's middle class. That's because one of the first purchases made by a household with newly disposable income is a quality water heater. Turns out, people like the luxury of warm water. And unlike the North American market, which is supported almost entirely by replacing old water heaters, many households in China are purchasing their first systems. Ever.
While China is poised to become a $1 billion market for A.O. Smith in the next few years thanks to continued growth of the middle class, management thinks another country could represent a long-term opportunity as large as China -- and one of the biggest barriers to growth was just removed.
Is India the next $1 billion market?
The 30,000-foot view of A.O. Smith's growth strategy is pretty simple: Find countries adding middle class households at a furious pace and sell them quality products that are staples of modern living. That leads to a pretty obvious successor to China for the next blockbuster market, although management hasn't exactly been shy about its ambitious growth plans for India.
There are some encouraging parallels. Consider that in 2003 China accounted for just $50 million in revenue, which lept to $888 million in 2016. Compare that to India, which notched just $18 million in revenue last year, but is expected to grow in excess of 30% in 2017.
Growing from $18 million in annual revenue to over $1 billion will take a lot of time, but investors shouldn't write it off as wishful thinking. Ajita Rajendra, the company's CEO, is from India and more than familiar with the country's cultural norms and economic policies. The latter have been some of the biggest obstacles for both foreign investment and growth of the middle class, both of which have lagged behind China's success.
But the nation just took a big leap forward.
On July 1, India overhauled its tax system in an effort to modernize the economy and grow government revenue by increasing the reliability of tax collection, rather than rates -- a big step for a largely informal economy. The new Goods and Services Tax (GST) replaces a complex web of over 500 indirect taxes across the country's 29 states with just one national value-added tax collected at the point of consumption.
That means everything from food to fertilizer to smartphones is now accompanied by its own unique tax rate across the entire country of India, rather than varying from state to state. Under the old system, truck drivers were often stopped at each state border crossing to fill out paperwork and pay local taxes.
Despite epic technology glitches from the initial rollout of GST (that have fueled equally epic memes on social media), modernizing the tax system should be a big boon to growing India's domestic trade and middle class by boosting domestic consumption.
That alone would have major indirect implications for A.O. Smith. Successful tax reform could increase the amount of available middle-class households, and therefore customers, sooner. That could lead the company to invest more resources aimed at growing its brand presence in India sooner.
What may that look like? Well, A.O. Smith's first Chinese production facility is opening in the first half of 2018. While India is only expected to notch $24 million in revenue in 2017 -- hardly enough to justify a new manufacturing facility in the country -- the company is also well-positioned to take bigger risks.
Management has learned valuable lessons from implementing the growth strategy in China, is making a big push to diversify the portfolio with products that didn't exist a few years ago (which may be valuable in Indian households), and is supported by record levels of financial flexibility. That could give management all the confidence it needs to make a major investment well before revenue from India hits $888 million.
Whether $100 million or $500 million in annual revenue is needed to justify a similar investment in the new market can be debated, but that's also not the point. Tax reform means investors should have a newfound confidence in the growth potential of India and the company's ability to achieve it sooner.
What does it mean for investors?
China will become the company's next $1 billion market in the next few years, and will likely become the largest market early next decade. That makes China a difficult act for India to follow, especially for a country with distinctly different cultural and political norms. Yet, while turning India into another formidable growth opportunity won't be easy, the new nationwide tax reform was a necessary step for A.O. Smith to achieve its ambitious goals. Now it needs to capitalize by tweaking its growth strategy and executing -- and navigating the unique risks the country poses.
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