A.O. Smith Corporation (NYSE:AOS) isn't a household name like Apple or Amazon, but its stock has risen more than 700% over the past decade. Backing that has been sizable earnings growth, which might be somewhat shocking when you consider that this industrial company makes water heaters. However, the stock has been falling since January and is now down nearly 20% from its early-year highs. Is A.O. Smith's growth spree over?
Why water heaters are awesome
The next time you take a shower, use cold water. Not just tepid, turn the cold all the way on. Just letting that frigid water touch your skin helps explain why A.O. Smith has seen such massive growth in recent years. The truth is that most consumers in North America (roughly 65% of Smith's revenue) probably wouldn't make it through an entire cold shower. Simply put, developed markets take hot water for granted because water heaters are ubiquitous in the Western world.
In fact, the company believes it is the largest water heater maker in the United States. Generally speaking, North America is a slow-growth market for Smith, with replacements and new construction driving sales. Over time, the company expects growth of only around 4% a year in this segment of the business.
The real growth driver has been China, where water heaters are still an affordable luxury. As a quick cold shower will make clear, anyone who can afford a water heater will try to buy one. China makes up the vast majority of Smith's business outside North America. Growth in China has been nothing short of awe-inspiring, with revenue expanding at 21% a year over the past decade. That massive growth has driven A.O. Smith's overall adjusted EBITDA growth of 21% a year since 2010 and earnings growth of 26% over the same span. Emerging markets are the growth engine here.
Is the opportunity over?
With the stock falling most of the year, investors might question whether A. O. Smith's rapid growth days are over. That doesn't appear to be true. For starters, the company posted record second-quarter sales, and earnings per share advanced a heady 25% year over year.
What's driving investor concern is that the company's Chinese business slowed along with China's economy. That's clearly not good, but on the second-quarter conference call management remained confident in its market position and long-term prospects. Part of that is driven by an expansion into air and water purification, two other things that Western societies generally take for granted. Although there's no telling what the future holds, even analysts on the call were still largely upbeat, suggesting that perhaps organic growth in China will drop from 15% to 12% or 13% as the country's economy matures. That's still very impressive growth.
China, while the largest piece of the company's foreign business, isn't the only developing country to watch. Fellow Asian giant India is an increasing focus for A.O. Smith. The company expects its target customer segments in India to more than double between 2020 and 2030. It is, basically, using the same plan that was so effective in China as reaches further into India. This is a huge opportunity and should help keep emerging market growth strong for years to come, allowing Smith to meet its target for 14% annual sales growth in its foreign business over the longer term.
A temporary pullback
When all is said and done, the story behind A.O. Smith's growth remains largely intact. The pullback in the stock price, meanwhile, mirrors temporary declines witnessed at least four times since the 2007-09 recession ended. At this point, it appears that long-term investors with a focus on growth are being offered a buying opportunity at A.O. Smith. Yes, keep an eye on China, but don't get too caught up in the short-term ups and downs -- demand for hot water isn't going away any time soon.