Why Investors Should Love A.O. Smith’s Water Technology Business

Who doesn't love a hot shower in the morning? For many in the U.S. and around the world, their hot shower comes courtesy of a water heater from A.O. Smith (AOS 1.08%). For more than 100 years, A.O. Smith has been a leader in water technology, from its traditional water heater business to its recent entry into water treatment. As a result, the company has an impressive track record of earnings growth and dividend payments, qualifying the company for inclusion among the elite Dividend Aristocrat club.

In this clip, Motley Fool Analyst John Rotonti and Industry Focus: Energy podcast host Nick Sciple discuss why A.O. Smith's business is so appealing.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on May 16, 2019.

Nick Sciple: 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?

John 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, meaning 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 nondiscretionary 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 nondiscretionary 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 nondiscretionary 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 nondiscretionary 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 30th, 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 nondiscretionary. 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 nine 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 [ROIC] 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.