There's a new and highly contagious virus running amok in China known as COVID-19. Unless you are a hermit, you probably know that already. Just about any company with ties to that country is being scrutinized, and perhaps rightly so. But the world is a much larger place than just China, and investors should be looking at the bigger picture when examining investments.
This is why the 35% downturn in A. O. Smith's (AOS -1.37%) stock since early 2018 could end up being vastly overdone. Here's what you need to know about this dividend champion before you write it off as dead.
A very real problem
There's no denying the facts: A. O. Smith generates around a third of its top line from China, so the country is very important to the water heater maker's future. The trouble really started in 2018, when sales growth in the giant Asian nation began to slow. The company's rest-of-world segment, which is mostly made up of China, saw a sales rise of around 5% in 2018, with segment earnings basically flat. Weakening economic growth in China was the main reason.
As China's growth continued to stagnate in 2019, sales in the rest-of-world segment actually slid 20% for the year, leading to a painful 73% decline in segment earnings. A. O. Smith wasn't sitting idle through all of this. It was actively working to adjust its business in the country by shutting locations, laying off staff, and getting inventory levels in line with demand. The cost of these actions was one of the reasons behind the poor earnings showing. That said, management ended 2019 with the belief that it had at least cauterized the wound, projecting a modest low-single-digit uptick in Chinese sales in 2020.
However, during the fourth-quarter 2019 conference call, management threw out the COVID-19 (the virus formerly known as the coronavirus) wild card, stating, "Our 2020 EPS guidance excludes any potential impact to our businesses from the developing Coronavirus originating in China." Needless to say, investors are worried that A. O. Smith's business there will get worse, not better, as 2020 progresses.
This is a real issue with near-term implications. But if you step back, there are long-term factors that make now a pretty interesting time to examine A. O. Smith, including a vast new growth market it's looking to exploit.
But not the end of the world
A. O. Smith didn't manage to increase its dividend for 26 consecutive years by accident. It achieved that impressive record through hard work in good times and bad. A big part of this achievement can be traced to a conservative use of leverage.
Today, its financial-debt-to-equity ratio is roughly 0.05 times, a minuscule amount of leverage. It covers its interest expenses more than 40 times over. Put simply, it has a rock-solid balance sheet. And while weakness in China has led to an increase in the payout ratio, it is still a very reasonable 40% or so. That's a number that leaves ample room for further increases. There's no reason to think that problems in China will derail A. O. Smith or its dividend record over the long term.
Still, that assessment is only partly about China. The rest of the company's business is largely in developed markets, where slow growth is the norm. These markets are driven by a well-worn replacement cycle, so they should continue to perform roughly as they have in the past regardless of what occurs in Asia's largest economy. Then, there's the not-so-small matter of India.
A. O. Smith sells water heaters, which are an affordable luxury that basically everyone buys as soon as they can afford it. (Take an ice-cold shower and you'll quickly understand why.) China became such an important market for A. O. Smith because its residents were rapidly moving up the socioeconomic ladder, including a massive population shift from rural to urban locations. The numbers are impressive, with A. O. Smith reporting average annualized sales growth of 19% in China between 2009 and 2018.
But China isn't the only giant Asian nation that is looking to improve its economic position... India is basically just as large and in an earlier stage of economic development.
That's why A. O. Smith is moving more aggressively in India today, and it's using roughly the same playbook that worked so well in China. To be certain, A. O. Smith still sees a long-term opportunity in China, especially as it expands into water and air purification systems. But the company's expansion efforts in India could offer up the kind of growth that China saw over the last decade or so, noting that A. O. Smith expects its target market in the country to more than triple in size by 2030. If it can tap into that trend, which history suggests is a reasonable expectation, China's problems could quickly look less important as growth in India picks up the slack.
Don't write this one off
With a roughly 2.2% dividend yield, A. O. Smith isn't going to excite yield seekers. But dividend investors with a dividend growth focus will appreciate this industrial name, since the past decade has seen an impressive 21% annualized growth rate in the dividend payment. Yes, China is an important issue to watch, particularly in light of the COVID-19 virus, but this is likely to be a near-term issue that eventually passes. And waiting in the wings is the company's opportunity to expand in India.
If A. O. Smith gets even close to repeating its Chinese success in this Asian nation, the financially strong company still has a very bright future ahead of it.