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A.O. Smith's Stock May Be Volatile Lately, but Earnings Aren't

By Tyler Crowe – Apr 30, 2018 at 11:06AM

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Wall Street seems uncertain about A.O. Smith and the fate of steel tariffs, but the company's earnings don't show any signs of real concern.

For such an uneventful business as selling water heaters and water treatment systems, shares of A.O. Smith (AOS 3.38%) have been on quite the bumpy ride in 2018. That's what happens when one of your largest input costs -- steel -- just so happens to be the target of U.S. government trade policy and tariffs. 

Looking at its most recent results, A.O. Smith doesn't appear that deterred by rising steel costs for now. Let's take a look at the company's most recent earnings results and what steel tariffs could mean for its results down the road.

A tankless water heater.

Image source: Getty Images.

By the numbers

Metric Q1 2018 Q4 2017 Q1 2018
Revenue $788 million $768 million $740 million
Operating income $125.4 million $140.8 million $120.4 million
Net income $98.8 million $22.7 million $87.7 million
Diluted EPS $0.57 $0.13 $0.50

Data source: A.O. Smith earnings release. EPS= earnings per share.

After taking some large one-time charges related to taxes in the U.S. in the prior quarter, it looks as though A.O. Smith got back on track with another quarter of growing its bottom line. This past quarter, the company got a lot of help from a lower tax rate to keep its streak of growing net income alive as A.O Smith experienced higher costs for steel and research and development (R&D) expenses for new product development. Management even noted that projected cost inflation from higher steel prices and increased freight costs in North America were a large factor that led it to increase the price of its products by 12%. 

From a business segment standpoint, the company's two regions appear to be maintaining the same track they have for some time. North America continues to grow in the low single-digit range from higher price increases and modest volume growth, while sales for the rest of the world -- notably China and India -- continue to grow at a double-digit pace. 

AOS Earnings by business segment for Q1 2017, Q4 2017, and Q1 2018. Shows small gains for both North America and Rest of World.

Data source: A.O. Smith earnings release. Chart by author.

For the quarter, A.O. Smith generated about $43 million in operating cash. That doesn't sound great on paper, but the first quarter is typically when the company has a large working capital build for things like inventory for the rest of the year. In fact, it is a big improvement on the $19 million cash burn it reported this time last year, so it's already on a better pace for 2018. 

The operating cash gain coupled with repatriating cash allowed management to pay down some debt as well as buy back about $33 million in stock. At the end of the quarter, it had $392 million in cash and securities in excess of its debt load. 

What management had to say

The big announcement this past quarter was that A.O. Smith had signed a deal to be the primary water treatment products supplier for Lowe's. According to management, the transition to A.O. Smith products will take place in August and will add $15 million to annual revenue for 2018 (start-up costs will make its earnings contribution minimal).

While he expressed his optimism for the deal in the company's press release, CEO Ajit Rajendra also increased 2018 guidance. Here's his press release statement.

After one quarter, our outlook for our global water heating and water treatment products is positive. We expect organic growth, supported by stable water heater replacement demand, will result in sales growth for the year between 10% and 10.75%. This leads us to increase our adjusted 2018 earnings guidance to a range of $2.55 to $2.61 per share. The midpoint of our adjusted 2018 earnings guidance represents a 19% increase over 2017 adjusted earnings per share.

AOS Chart

Data source: AOS data by YCharts.

Tripped up by tariffs?

Shares of A.O. Smith have been on quite the wild ride in 2018. The threat of higher steel costs resulting from recent government decisions on imported steel and aluminum tariffs could significantly increase the company's input costs for North America. The fear from Wall Street is that those higher costs will eat into earnings, but that may not necessarily be the case. More than 85% of water heater sales in North America are to replace existing systems. Most people don't want to go without hot water when a system breaks, so there isn't much demand response from higher prices. Therefore, the company should be able to pass on price increases to offset steel costs without it impacting margins or the bottom line. Also, these issues shouldn't have much of an impact on sales outside North America.

Overall, A.O. Smith appears to be maintaining a steady course. Double-digit revenue growth for 2018 coupled with improving margins outside North America and a steady diet of share repurchases should make another year of 20% earnings growth an attainable target. That should put any investor concerns about trade wars and tariffs at ease.

Tyler Crowe owns shares of A. O. Smith. The Motley Fool recommends Lowe's. The Motley Fool has a disclosure policy.

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