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A.O. Smith Sees Plenty of Room to Run

By Tyler Crowe – Updated Mar 18, 2018 at 2:46PM

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Despite record results in 2017 and spectacular growth over the past decade, the water heater company has its sights set on a lot more opportunities.

You may not have noticed, but sleepy, boring water heater company A.O. Smith (AOS 0.54%) has put together a decade of returns that would be the envy of some high-flying tech companies. Of course, for a slow-growth business like water heaters, boilers, and water filtration systems, the question is how long it will be able to keep it up. Based on management's plans for the upcoming years for new technology and geographic markets, though, it appears entirely possible.

Here are several quotes from the company's most recent conference call that should give investors an idea of where management stands and what investors need to watch for the rest of the year. 

Faucet dispensing hot water with steam rising up

Image source: Getty Images.

A new sales outlet

Much of the investment thesis for A.O. Smith has hinged on its ability to grow its water heater business geographically, specifically in China and India. That isn't the only thing that the company has been working on, however. It has also been getting into tangential products such as water treatment and purification as well as air filtration systems for homes. According to CEO Ajita Rajendra, this is becoming a big business. 

Our global water treatment sales exceeded $300 million in 2017. We are very proud of the global water treatment platform we have built over the last seven years. Beginning in 2011 with about $35 million of water treatment sales in China, we grew significantly to almost $240 million last year. As we experienced rapid organic water treatment growth in China, we added several bolt-on acquisitions in the US and Europe, launched water treatment products in India and Vietnam and added a significant number of water treatment engineers and technologists to our global engineering center.

As a result of our investments, we project our global water treatment sales to be approximately $400 million in 2018.

It should be noted that like its geographic expansions, its water treatment products aren't pulling in the same kinds of margins as its bread-and-butter water heater and boilers in North America. There are areas such as the U.S. where we should start to see these investments pay off.

Giving back to shareholders

In terms of sales and net income growth, you would probably call A.O. Smith a good but not amazing company. Its sales have climbed 50% over the past five years and net income has almost doubled thanks to expanding margins. Those are good results on their own, but what makes the investment thesis more lucrative is management's propensity for buying back stock and growing its dividend payment. Here's Rajendra giving a quick recap of what A.O. Smith did with its excess free cash flow in 2017.

We repurchased over 2.5 [million] shares for approximately $139 million. We announced a 29% increase to our dividend earlier this month. The five year compound annual growth rate of our dividend is over 25%. 

Of course, there's no guarantee that the dividend will grow at that rate over the long term or for share repurchases to continue at all. To get an idea of how management sees its priorities for cash use, here's CFO John Kita.

Our capital allocation strategy will remain focused on three pillars. One, to support our growth with capital spending; two, to pursue acquisitions, which expand our core water heating and water treating platforms globally as well as expand our product lines, primarily in China; and three, to return cash to shareholders. We will continue to review opportunities within the three pillars and discuss with our board.

AOS Total Return Price Chart

AOS total return price data by YCharts.

Cash concerns?

For those shareholder-friendly initiatives to work, the company has to generate an adequate amount of cash, but cash from operations -- $326 million -- this past year was significantly lower than in 2016. This should certainly raise a few caution flags for investors. According to Kita, it may not be as bad as the headline number suggests. 

Higher adjusted earnings were more than offset by higher outlays for working capital, primarily due to the higher than anticipated positive cash flows in the fourth quarter of 2016 as well as higher inventories in China to reduce the impact from our -- to our new plant this quarter. 

Furthermore, he expects a significant rebound in 2018.

We expect our cash flow from operations in 2018 to be between $475 million and $500 million, which is much higher than the $326 million generated in 2017.

When a company starts bringing in less cash than before, no matter the business, investors should be a little wary. But since A.O. Smith has delivered on its promises rather well over the past decade or so, it deserves the benefit of the doubt here. If 2018 cash doesn't significantly improve from last year, however, then we may need to reexamine things. 

Housing market remaining strong

Even though 85% of water heater sales in North America are for replacements or upgrades of existing systems, the sales of water heaters to new construction and housing development are great indicators of the general health of the housing market. Homebuilders have been going strong lately, and there aren't many signs of a slowdown right now. Rajendra echoed this sentiment with the company's outlook for North America sales in 2018.

Both residential and commercial water heater volumes experienced strong growth in 2017. We project US residential water heater industry volumes will increase 250,000 to 300,000 units in 2018 due to continued new construction and expansion of replacement demand. 

From an investment perspective, a booming housing market is good for A.O. Smith, but by no means is it a must-have element for success. The most significant benefit of a strong housing market is that it allows the company to more easily pass on higher prices to customers to offset higher steel costs, which have been a drag on margins for the past few quarters. 

From here on out, the only concern for investors is the company's cash-generation abilities. With a new manufacturing facility under construction, higher working capital requirements in the form of inventories of materials and finished product are inevitable. The question will be whether management can get back to robust cash flow once that working capital build is complete. If things go according to Kita's plan, A.O. Smith still looks like an attractive investment. 

Tyler Crowe owns shares of A. O. Smith. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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