A.O. Smith (NYSE:AOS) isn't a household name for investors, but maybe it should be after 26 consecutive years of dividend increases. The average annual dividend increase over the last decade was roughly 11%, too, so this is a solid dividend growth stock. The only problem is that the industrial company has been facing some headwinds in one of its most important global markets: China. And things are only getting worse. With the stock price now down roughly 35% from its 2018 highs, is this an opportunity to buy on weakness, or should investors stay on the sidelines until the outlook in China is more clear?
Supplying basic needs is good business
A.O. Smith is not exciting in any way. Its bread-and-butter product is water heaters, though it has been expanding its reach into similarly boring fare like water and air purification. The thing is, while people in developed markets take hot water for granted; safe, reliable water heaters is still an affordable luxury in developing markets like China. Try taking a cold shower and you'll understand why anyone who can afford a water heater buys one.
For many years Smith has been focused on two core markets: North America and China. Today, the slow-growing North American market (replacement is the core driver here) makes up around 64% of revenue. The rest comes largely from China. That had been a great business for a long time as the country spent vast amounts of money building new homes for citizens moving from rural areas to big cities.
To put a number on that, Smith's China business expanded at an annualized rate of 19% between 2009 and 2018. That's a huge number and helps explain why this country is so important to the company's financial results and future. The only thing is, China hasn't been so great lately for A.O. Smith.
The trouble with China
The issues started in 2018, when China's growth began to ebb a little. It wasn't exactly a bad year for A.O. Smith, with revenue in the "rest of world" segment, which consists mostly of China, up around 5%. The problem was that earnings in that division were flat. Things got worse in 2019, when China's economy started to show more serious signs of slowing. Last year, earnings in the "rest of world" group declined nearly 75%. In the fourth quarter of 2019, they dropped a staggering 96%!
That's terrible by any measure and helps explain why its stock has been falling. However, the company was hardly sitting idle hoping for things to get better. It has been trimming operations and rationalizing its business, focusing on balancing its operations in China with the underlying demand it was seeing. When Smith reported fourth-quarter 2019 earnings, it actually sounded relatively upbeat about its Chinese operations, expecting a 2.5% sales jump (in local currency).
While not exactly a screaming win, that would be a huge improvement over 2019's results, when sales in China fell 19% for the year. In the Q4 2019 conference call, CEO Kevin Wheeler commented:
In the near term, the Chinese economy remains weak. We have a strong premium brand, broad product offering in our key product categories, broad distribution and a reputation for quality and innovation. Over time, we are well positioned to maximize favorable demographics in both China and India to enhance shareholder value.
That said, the first quarter was expected to be weak because of the Lunar New Year holiday. After that, Smith assumed results would start to pick up. Only the coronavirus cropped up and the issue has been steadily growing in intensity, effectively shutting down entire regions of China. During A.O. Smith's conference call, it basically admitted that the COVID-19 outbreak was a wildcard: "Our 2020 EPS guidance excludes any potential impact to our businesses from the developing coronavirus originating in China."
Although it is clearly too soon to tell how bad it will be, the answer is that A.O. Smith's Chinese operations in 2020 will probably perform worse than originally expected. That's not good news, since the company had finally gotten a handle on its business in the region following two difficult years. The saving grace here, however, is that nearly two-thirds of sales at the company come from developed markets with a slow and steady growth rate driven by a well-worn replacement cycle. So China could clip earnings, but it won't completely derail them.
Furthermore, the company's balance sheet provides a firm foundation from which to weather this storm. To put some numbers on that, Smith's debt-to-equity ratio is an ultralow 0.05 or so. It covers its interest expenses by an incredibly strong 43 times. And its payout ratio is 40%. While that payout ratio is up over the recent past because earnings were down in 2019, it is hardly a concerning figure. The company can clearly deal with the headwinds it is facing.
Another tough year
At this point, investors should probably expect 2020 to be a rough year for A.O. Smith's rest of world segment, which is largely made up of its Chinese operations. This means that the company's forecast for 2020 could be a bit too rosy at this point and might get dialed back as the year progresses. That said, a lot of bad news has already been priced into the stock. And while the 2.2% dividend yield isn't terribly compelling on an absolute basis, it is higher than it has been in a decade. Dividend growth investors should probably take a closer look at this company today while other investors are running scared. Even if 2020 is another tough year, the company should have no trouble surviving it...and thriving again once the headwinds fade away.