Hot water is taken for granted in developed markets, and it is becoming an affordable luxury in developing markets. This simple statement tells you a massive amount about water heater maker A. O. Smith (AOS 0.47%) and its expansion efforts.
This S&P 500 component has been a huge dividend growth stock for years. If it can replicate past successes in some newer markets, it should remain one in the future.
A. O. Smith has a solid base to work from
If you have ever had to take a cold shower, you know just how much more enjoyable it is to have ready access to hot water. This is why people quickly replace broken hot water heaters. North America makes up around 75% of A. O. Smith's business, and the region is solidly in the developed market category. Replacement of old or broken water heaters accounts for roughly 80% of industry volume. There's new construction, of course, but the high replacement level provides a solid underpinning for the company's business.
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That is an important part of the story for this industrial stock. It means that A. O. Smith, even in a tough stretch, has a sizable amount of cash coming in the door. That cash can be used to pay and grow the dividend even as the company continues to invest in its long-term growth. To put some numbers on all of this, A. O. Smith's current dividend yield is around 1.7%. That's not huge, but the dividend has grown at a compound annual rate of 19% over the past decade, which is huge. Meanwhile, it has been increased annually for three decades. This is a very attractive dividend growth story.
Recent dividend hikes fell well short of that 19% long-term rate. But even the 7% increase made in the second half of 2022 is still a fairly attractive number compared to other dividend stocks.
It should also be noted that the dividend payout ratio is up around 70% today, which is a bit high historically speaking. The elevated payout ratio and the drop off in dividend growth bring up the hard times A. O. Smith wrestles with at the moment.
A. O. Smith also focuses on emerging markets
In North America, inflation and supply chains have been a headwind, but both problems should pass in time given the nature of the developed markets. The bigger question mark has been China, which makes up the lion's share of the company's international exposure (around 25% of the overall business). China had been growing robustly for years for A. O. Smith as the country was on a building spree for decades.
China's housing market is not in as good a place today, and that's been a major drag for A. O. Smith. Foreign sales bounced around a bit over the past five years and remain below where they were in 2018. However, margins improved greatly from the near-zero level witnessed in 2020 to about 10%. Most of the variability is because of China. Simply put, China is not as good as it was, but it is better than it was a couple of years ago. It is likely that water heater replacements will become increasingly important in this country as time goes on, and also likely that the historically rapid growth rate is a thing of the past.
The more exciting story internationally is India. China and India have similar population sizes, but China is further along on the economic development ladder. As India moves up the ladder (GDP growth is expected to average roughly 9% through 2026), it is highly likely that A. O. Smith's efforts to expand in the country will result in an outcome similar to what it achieved in China. In other words, the company looks as if it is getting ready for a second round of emerging market-driven growth. That's because it is using a similar playbook in India that it successfully used in China.
On top of the water heater division, A. O. Smith is also building a purification business. Clean water and clean air are increasingly prominent issues in emerging markets, let alone developed ones. This could be a sleeper opportunity that also helps to keep that dividend growing robustly, perhaps supporting growth beyond the water heater opportunity in India.
A. O. Smith stock is not cheap
Unfortunately, Wall Street is well aware of A. O. Smith's long-term success and the stock is rarely (if ever) cheap. But given the history here, this isn't a value play. For investors looking to own a dividend growth stock, this boring water heater maker has an exciting emerging market story to tell as China matures and India starts to take its place in the portfolio. If you haven't already taken some time to get to know A. O. Smith, now could be the right time to do so since India's importance in the portfolio is only just starting to be felt.
