If you've ever had your water heater break, you understand how reliable the demand for A.O. Smith's (NYSE:AOS) products is. In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool analyst John Rotonti take a close look at the No. 1 player in the water heater space. On the first half of the show, they explore what makes the business work, how fast it's growing, and some exciting prospects both overseas and domestic. It's not all green lights, though -- stay tuned to the second half for a deep dive into some risks and red flags, including the short report that just dropped on the heater behemoth.

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This video was recorded on May 16, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, May 16, and we're discussing A.O. Smith. I'm your host, Nick Sciple, and today I'm joined by Motley Fool analyst John Rotonti via Skype. How are you doing, John? 

John Rotonti: I'm great, Nick! Thanks for having me!

Sciple: It's great having you on once again! A few weeks ago, maybe a couple of months ago, I had you on and we talked about Graco, another great, growing industrial company that's been around for a long time. This week, we're talking about A.O. Smith. Graco, we're talking about paints and sprayers. We're also in the liquids/fluids space here with A.O. Smith, talking about water heaters. A high-level, 10,000-foot view for our listeners who may not be familiar with this company, can you give a brief overview of what A.O. Smith does and how it's grown over time?

Rotonti: Sure! A.O. Smith was founded in 1874, so it's like 145 years old. It's based out of Milwaukee, Wisconsin. It's a global water technology business. Their strategy is to be green, meaning energy efficient, and environmentally friendly, and to be smart, meeting IoT ready, internet of things ready. They are the world's largest maker of water heaters and boilers. They also have a global water treatment business, and then a small air purification business in China. 

Sciple: Right. That traditional part of the business has been in the water heaters. They recently moved into the area of water treatment. They've seen some growth opportunities there. Two-thirds of the businesses in North America, and a third of that is overseas. I want to talk first about the North American part of the business. When you look at the market share they have, and the concentration of this market for water heaters, it really has a lot of characteristics that we like to see. If you look at the residential water heater market in the U.S., A.O. Smith has 40% of that market. The top three players have over 90%. So you really see a concentration of that market. We were talking about before the show how this creates opportunities for businesses to raise prices over time and really steadily grow. Can you talk a little bit about how A.O. Smith has played in that market over time and the opportunities it has there as a business? 

Rotonti: Sure, great question! As you said, A.O. Smith operates in an oligopoly in North America. It has the largest market share in commercial water heaters, about 50% market share. And in residential water heaters, they have 40% market share, roughly speaking. Rheem and Bradford White are the other two players that have significant market share. 

Water heaters are an interesting business. They last 14 or 15 years and they are a non-discretionary item, meaning that when a water heater breaks, people replace it almost immediately. On the residential side, that takes the shape of emergency replacement. Basically, if you own a home, when your water heater breaks, you get it replaced as soon as you possibly can. You want a good water heater, and you're getting it replaced regardless of economic conditions because water heaters are so important to household hygiene and comfort. On the commercial side of things, where they have 50% market share, this really takes the form of proactive replacement. If you're a hospital, a restaurant, a school, an apartment building, anything like that, you're trying to replace these water heaters proactively, before something breaks. If it breaks while you have customers or patients in the building, that's a big problem. Like I said, these things last 14 or 15 years, so customers are willing to pay for a good, high-quality, reliable product that's going to last them 14 or 15 years. 

So, quickly, to the pricing power, traditionally, in North American industry, it's an oligopoly, as we discussed. Pricing among the top three players has been very rational. They don't implement annual price increases if you go back over a long period of history. Rather, they implement price increases to offset things like higher steel prices, which is their largest input. However, A.O. Smith has implemented price increases in 2015, 2016, 2017, and 2018. The 2015 price increase was 20%. U.S. regulators implemented some new policies and regulations around energy efficiency, and that required a lot of R&D and investment and cost of goods sold investment on the part of A.O. Smith. So they tried to capture that investment by a 20% price increase in 2015. And then in 2016 and 2017, price increases were about 4% to 5%. And then once again in 2018, they increased prices 10% to offset higher steel prices. So, this is a business that has real pricing power when it has to, like I said, because this is a product that last 14 or 15 years, and consumers and businesses are willing to pay for that. 

Sciple: I tell you, if you've ever been to a hotel and the hot water wasn't on, you have an idea of what the demand is like for these products. You don't realize how bad you need it or how bad you want it until you don't have it. And when you have a market like that, where the demand is really, really strong, it's not going to go anywhere, and the market is concentrated in a way that really allows the people who operate in it to extract business value over time, it's really an attractive market. They've been able to do that in the U.S. But as well, they've expanded their business into China. That now represents a meaningful part of their business overseas. They've been doing business in China for 20 years. Sales there crossed $1 billion in 2017. As you look at that side of the business, and how they've been able to grow their presence in China when it comes to water heaters as well as water treatment they've been moving into recently, how significant is that for the business? How have they grown that over time? 

Rotonti: Good question! A.O. Smith's exposure to China was one of the things that originally attracted me to the business. Like you said, they've been building their scale and their distribution in China for 20 years. They are one of the top market share leaders in China as well. I believe they have about 25% market share of water heaters in China. The thing that I like about the Chinese market is that depending on what source you use, there are roughly 300 million to 400 million middle class people in China today. There are estimates that that number will grow to 700 million over the next couple of years. We're looking at a double in the middle class in China over the next couple of years. 

Another thing I recently read a report by Diamond Hill Capital Management, a highly respected research firm. They weren't writing about A.O. Smith, but they were writing about China. And they said that the Chinese government plans to move 225 million people, I believe, from rural areas to urban areas through 2026. The Chinese government plans to relocate 225 million people to urban areas by 2026. And I thought, "Well, these 225 million transplants are going to be getting apartments or condos and buildings that demand water heaters and boilers." So, that was my early investment thesis in China. 

And then, just the fact that not all Western brands translate well into China. A lot of large, leading U.S.-based companies have had difficulty growing in China. A.O. Smith stood out to me in my early research as one of the companies that has really been able to grow in China profitably. That was something else that attracted me to it. 

Sciple: Yeah. In one of their investor presentations, they have a chart of their market share in China relative to their competitors, and they are just moving straight up and to the right while everyone else has stagnated. They've really been able to enter that country in a meaningful way and grow to a significant part of their business over time. They're also moving into India as well. They had 30% year over year growth last year, expecting that part of the business swing to profitability in 2020. 

As you looked at that opportunity, are you seeing a similar playbook to what we saw line up in China, as it comes to people entering the middle class, and demand for these types of, I guess you could consider them luxury items for some. Here in the U.S., we might take them for granted, but access to hot water is a huge increase in quality of life for a lot of people all over the world. Is that story playing out in India as well?

Rotonti: It looks like it is. They haven't been in India as long as they've been in China. But I think they're approaching it in a similar way. They're trying to build the right distribution, the right scale. And like you said, they think that their businesses in India will reach profitability in 2020. That could give a boost to margins. India has similar growth dynamics to China. It's a fast-growing economy. I think there's some interesting stuff there as well.

At some point in this podcast, we'll probably talk about water treatment and water purification, which I think is an underappreciated part of the A.O. Smith story based on my research thus far, and here's why. As we said, a hot water heater in the U.S., or let's say in a Western country, is a non-discretionary purchase. You really need one for hygiene and comfort purposes. I don't think that water purification and water treatment is thought of as a non-discretionary purchase, as water heaters are or boilers are. So, I don't think the market appreciates their new ventures into the water treatment side of the business. But, in China and India, where pollution, water pollution or air pollution, is a much bigger concern, water treatment is considered non-discretionary already by those that can afford it. Already, there, it's a must. If you can afford it, you really need to pay for that clean water. 

In the U.S., there's been a change of sentiment with regard to health and safety with regard to water. It started with the crisis in Flint, Michigan. Since then, there's been several reports on poor quality of water in the U.S. I'm just going to read you a couple of titles from news media that I pulled up this morning. A Business Insider article from April 30, 2019, is titled "California's Contaminated Drinking Water Could Lead to Nearly 15,500 Cancer Cases." A Bloomberg article from Nov. 6, 2018, is titled "The Cancer-Linked Chemicals in America's Tap Water." On Nov. 27, 2018, CNN produced a video titled "Dirty Water: Danger From the Tap." This goes on and on. There's an article in the Chicago Tribune. I do think that within the next five, 10 years in the U.S., water purification, water treatment, will be considered non-discretionary. Think of it maybe like an alarm system on your house. It just gives you that peace of mind, it gives your family that peace of mind. Also, there's recurring revenue associated with water treatment because of the replacement filters. There are some good dynamics on the water treatment side as well. 

Sciple: And as you mentioned, they've only been in that business for about 10 years. They moved in there in 2009 with an acquisition. 37% compound annual growth rate over that period of time. Until Flint, I don't think a lot of people in this country were as cognizant about the importance of water quality and what goes into maintaining that type of infrastructure. You see people becoming aware of that, and the growth the business has had. It definitely is an interesting opportunity moving forward. 

You put all that together. This is a company that's up 9 times over the last 10 years, a 90% gain over the last five years. It's a dividend aristocrat. I mean, there's a lot to like about this business from a financial point of view. Anything else you want to mention about A.O. Smith? We'll talk about some risks on the back half of the show. 

Rotonti: Like you said, the company's up 9 times in 10 years. This all goes back to 2010. Maybe I should have mentioned this earlier in the podcast. In 2010, A.O. Smith went through a business model transformation, a large transformation. It sold off its lower-margin electrical motor business and it acquired Lochinvar, which is the leading boiler brand in the U.S. Lochinvar is higher margin and faster growing. So there was a big margin mix shift. They sold off a lower margin business that was slow growing, and they acquired a much higher margin, faster growing business. That happened in 2010. 

A couple of other things happened. I mentioned, in 2015, they increased prices 20%. Then they followed that with price increases in 2016, 2017, and 2018. We have a business model transformation toward faster growing, higher margin products. We have significant price increases over a five year period. And then finally, A.O. Smith generated very good revenue growth since 2010. When you drive revenue growth over a manufacturing asset base, you can achieve operating leverage and an increase in operating margins. 

So, those three things -- the business model transformation, the price increases, and the operating leverage -- led to a 1,000-basis-point increase in gross margins, operating margins, and returns on invested capital between 2010 and 2018. That's a 10% increase in gross margins, operating margins, and ROIC over the past eight years. This is a business where it appeared that the fundamentals and the financials were really on an upswing. 

Sciple: Obviously, that was a great capital allocation decision, to reposition where the business is in.

All right, John. Off the bat, as we dive into some of the risks surrounding A.O. Smith, I think we have to mention the short report that came out this morning. We've only had a few minutes to look at it before we got on here to record the podcast. But from what you saw on there, and talking before the show, you said so some red flags from that short report lined up with some things you'd seen about the business. Can you give us an overview of what we're seeing from that report and it what you'd seen in your own independent looking at the company? 

Rotonti: Like you said, this is an exciting time to be talking about A.O. Smith because a short report came out this morning. I had about two minutes to quickly review it. Basically, the report talks about a relationship with a distributor that A.O. Smith has in China. It mentioned some channel stuffing. And it mentions that a lot of A.O. Smith's cash is trapped overseas in China, and that it won't easily be able to access that cash, among other things. 

Honestly, I was completely familiar with A.O. Smith's go to market strategy in China by using distributors. I was completely unfamiliar with this particular distributor relationship. It sounds like the authors of the short report did a lot of on-the-ground channel checks and scuttlebutts in China, which I have not done yet. 

That being said, I own A.O. Smith. I've owned it for a while. But I have been monitoring some of my own red flags in my own research lately. Some of those are its revenue growth, its organic revenue growth, has been slowing. One thing I like about the A.O. Smith management team is, they provide long-term guidance for revenue growth. Very few companies provide long-term guidance. They either provide quarterly or yearly guidance. A.O. Smith takes a long-term view, which I like. And they recently lowered their long-term organic revenue guidance from 8% to 7%. That's their long-term guidance. But then, you see that revenue in the first quarter of 2019 fell 5% because its revenue in China fell 18%, and China accounts for 34% of companywide revenue, so it weighed down the total. So, an overall slowing in revenue growth is a red flag that I pay close attention to.

The second one. Over the last five years or so, free cash flow has been growing slower than GAAP earnings. The free cash flow conversion ratio, or free cash flow divided by net income, is one measure of earnings quality. I have done some earnings quality look on the business. It appears to me that the reason free cash flow at A.O. Smith has been growing slower than net income is because of working capital investments in China to grow its business in China, and because of what looks like deferred tax assets, which are taxes that you pay today, but you will not owe down the road. And since it's a cash outflow today, that's impacting free cash flow. It seems OK to me that free cash flow is not growing as fast as net income; or it seems explainable to me. But it's not something I like to see. I like to see free cash flow growing in line or even faster than net income. So, that's the second thing. Falling revenue growth is No. 1, free cash flow not growing as fast as net income is No. 2. 

And then thirdly, and perhaps most concerning, is their days sales outstanding has been rising. When DSOs rise, it can sometimes -- not all the time -- be an indicator that demand for the products is slowing and that the company has to provide more favorable terms to sell the product. I'm not saying that's what's going on here. I am saying that these three red flags have caught my attention. 

Sciple: So, when we look at A.O. Smith today and how we need to evaluate this company, obviously, sales are slowing in China. Is this a Chinese economic story? Is that what's driving the success or failure of A.O. Smith today? Or are there other things at work driving the way the business's revenue and free cash flow growth trends are moving? 

Rotonti: It's going to take me weeks or months to really get to the bottom of what's behind this short report that came out today. Like I said, I'm not on the ground in China, so I'm going to have to rely on a lot of third-party analysis to really find out what's going on. 

However, to answer your question, I do think it's largely a China problem. A couple of things are going on in China. One is, the Chinese economy as a whole is slowing. I think its growth is still about twice the U.S. I think it's growing around 6%, their GDP. But, that's the slowest rate in a very long time. Two, the housing market in China is slowing significantly. As you know, water heaters, water purification products, are sold to residential houses. Three, FX, or currency translation, is a big headwind for A.O. Smith since 34% of its revenue comes from China, and the dollar has been strengthening. We've got a weakening overall Chinese economy, we have a weakening housing market in China, we have very strong FX headwinds because of the strengthening U.S. dollar and A.O. Smith's very large exposure to China. 

And last but not least is, we have negotiations with China over a new trade agreement. And recently, the rhetoric has been getting more intense. And the U.S. recently announced that it's going to do a second round of higher tariffs on China. This is not good for A.O. Smith, at least in the short term. It could decrease demand for A.O. Smith's products. In the very least, Chinese consumers may want to buy local domestic Chinese products out of a sense of national pride during the time these trade talks are going on. 

There's also a company-specific issue in China, an A.O. Smith-specific issue. They had some elevated inventory levels. Basically what I think happened there was, the Chinese economy slowed, the housing market in China slowed, and A.O. Smith has always had a premium price point product in China. I think the Chinese consumer started to trade down to a lower price point product, and A.O. Smith did not have a lower price point product. So they had been quickly trying to ramp up research and development and to launch a mid-price point product to try to meet consumer demand in China. They had been playing catch up there a little bit, I would say. So, there's some broader economic concerns in China and some company-specific, A.O. Smith-specific concerns in China as well. 

Sciple: Sure. John, as we look at these concerns, obviously, in the near term, it appears China's economy has been slowing. You see that, as you mentioned, trickling down into parts of A.O. Smith's business. But the long-term trend that we laid out in the first half of the show of more and more people across the world entering the middle class, and having demand for this, wanting to have a hot shower every morning, at what point would this narrative that we're seeing in China and the slowing economy overwhelm your conviction in this long-term thesis enough to sell the stock? How should we think about these two sides of the risks of the business as well as these clear long-term drivers and long-term demand for the fundamental product that the business sells? How are you weighing that in your head as an analyst right now looking at A.O. Smith?

Rotonti: If the problems in China are only around a slowing Chinese economy, that's not a big concern for me. It's not an overwhelming concern for me. If the problems in China run deeper, into some of the issues discussed in the short report -- which, like I said, I only had a couple of minutes to review before I got on this podcast -- that would be a deeper concern. If they have been stuffing the channels or something like that, or if they can't access that cash, or whatever it may be, those would be larger concerns for me. 

The biggest risks for me are these earning quality metrics that I discussed. Earnings quality is often a sign that there's deteriorating fundamentals, and that demand for the company's products are maybe not as strong as past financial results may suggest. Like I said, I've identified in my own research slowing organic revenue growth, free cash flow conversion that is not at 100%, rising DSOs, which can often be a sign of falling demand. I need to dig deeper into these earnings quality metrics. That would be a big risk for me. 

Another risk for me is, A.O. Smith is a 145-year-old business, and they have a century-long tradition of consistently investing in research and development and capital expenditures to drive long-term growth. If you look back over five or 10 years, they spent pretty much consistently 3% of their revenue every year on R&D and 3% of their revenue every year on capex. But A.O. Smith missed the tankless water heater innovation. Tankless water heaters are different to tank water heaters in that they don't have a tank, so they require much less water and are much more environmentally friendly. And because they don't have a tank, they're smaller, they can hang on the wall. They run on gas or electricity, just like a tank water heater does. But the other benefit is that you can have an endless supply of hot water. The hot water doesn't run out when the water in the tank runs out. Although tankless water heaters are a little more expensive on the front end, when you factor in energy savings and less maintenance and upkeep over time, the price is favorable, in my opinion, and they're more energy efficient. A.O. Smith, the leading water heater company in the world, was late to the tankless market. That concerns me a little. Maybe their innovation engine is slowing a bit. Or maybe not. They are catching up. They have formed a partnership with a Japanese manufacturer. They have, I think, exclusive rights to sell that Japanese product in North America, or at least in the U.S. and Canada. And I think they have 10% to 12% market share in tankless now. So they're gaining. The tankless market is interesting. It's currently only about 8% of the total addressable market in North America, but it's growing faster than the tank market. 

I'm worried they missed that product. They're there now, but they were late to the game. I'm worried about some of these earnings quality metrics that I do need to dive deeper into. 

And then lastly, a broader economic slowdown in the U.S. would hurt them. We see what an economic slowdown in China is doing to their sales. Sales fell 18% in China in the first quarter. A broader economic slowdown in the U.S. would obviously hurt them in the short-term. I think their sales fell 38% in 2008, or 2009, during the depths of the global financial crisis. To be fair, that was the worst financial crisis in almost 100 years. And to be fair, A.O. Smith grew its net income, its free cash flow, and increased its dividend in that year. But sales did fall 38% in the depths of the crisis. 

Sciple: Yeah. So, takeaway, wait and see how things shake out. Would look into this short report, maybe have you back on as we get more details of what's going on with A.O. Smith's business. Again, I think the long-term drivers of demand for the product they sell are going to be there. But it's a question of, again, are they going to be able to grow their market share in tankless? Is the economy going to cooperate? We'll just have to see how things go. John, I'll have you back on again soon as we know more!

Rotonti: Nick, I appreciate it! I look forward to coming on again to discuss A.O. Smith or another industrial company!

Sciple: Yeah, you mentioned maybe Trex. I know that's a company a lot of our listeners are probably familiar with. If that's something y'all want us to talk about on the show, listeners, tweet us, @MFIndustryFocus, and we'll see if we can have John back on and talk about it soon. Thanks, John!

Rotonti: Thank you, Nick!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For John Rotonti, I'm Nick Sciple. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.