The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. This post was written on SumZero by Chris Trencher, who was formerly a portfolio manager with an industrials focus at Benten Capital, a New York-based hedge fund pursuing equity event-driven and long/short strategies.
AO Smith (NYSE: AOS) has had until recently two business units -- Water Systems (about 70% of revenues) and Electric Motors (about 30% of revenues). The company recently sold the Electrical Products company to Regal Beloit (NYSE: RBC) for approximately $875 million, comprised of $700 million in cash and approximately 2.83 million shares of Regal Beloit common stock. This culminates a process whereby management had dramatically restructured the business to improve margins and balance sheet metrics since 2006, particularly in the motors business. The company had been harvesting its motors business while rapidly investing in new capacity and new markets for its water heaters business. The sale makes AO Smith an attractive pure play on the need for clean water for the growing middle class in emerging markets, specifically China and India.
Since acquiring GSW in 2006 and making a long-term commitment to the water heater business in 2006, AOS is and has been the largest producer of water heaters worldwide. The company produces residential gas and electric water heaters, as well as commercial water heating systems used in factories, buildings, etc. AOS derives an estimated $320 million of its $1.6 billion revenues from China, where it has an estimated 22% or better market share in a market growing at 25%+ annually and that is only 15% penetrated. (Approximately 20% in Beijing and Shanghai and below 10% in Tier II cities.) The number of wealthy or mass affluent households will at least double in the next five years and double again the following five years. The other 80% of its revenues are from the United States, 60% from the residential water heater market and 20% from the commercial market, which has seen a healthy replacement and upgrade cycle.
Currently, experts believe that at least 70% of China's water is unsafe. China is now the absolute and per capita leader in incidence and death due to stomach and liver cancer, which is mainly attributable to consuming polluted water. Most of the public is well aware of this, driving sustainable secular demand for water heaters. The market for water heaters is about 15% penetrated at most. AOS currently has about 22% of the Chinese market and has grown share organically from 15% over the last two years. Management has grown revenues in this business at 25% per year over the last five years and lifted margins from 10% to "high teens," and they continue to forecast 2-3x GDP growth in this market. Importantly, there has recently been a move to premium and high-quality names, and AOS is the biggest beneficiary of this. AOS recently doubled its capacity in China to handle growth and admits margins will continue to rise. Execution in this business has been consistently solid.
Last year, AOS purchased an 80% stake in Tianlong Holding (since renamed "Shanghai Water Treatment"), which makes water filtration systems for the home. Tianlong has been neutral to 2010 earnings per share (EPS), but will add at least a dime to 2011. More importantly, the quality of these systems and the acceptance in the local retail channel has been so positive that in 2010 Q3, AOS introduced premium (mostly higher price / higher flow) versions of the home units branded with the AOS name that are selling well. In China, the biggest competitor is Haier, although AOS is regarded as the most premium brand in China.
While new construction in China may slow down due to the recent rate hike, there exists numerous empty apartments in and around major urban areas in China. Due to the easy install/uninstall modular nature of water heaters, any slowdown in construction will not affect AOS, but rather slower construction and declining rents that drive up occupancy will actually help the company. I do not see AOS as being particularly vulnerable to a China "slowdown."
Finally, the company has purchased a stake in an Indian water heater company, and revenues from this joint venture will ramp up significantly during the strong spring season. There is little contribution from India in any of the consensus sell-side models.
The U.S. water heaters business, while not as exciting, is performing well enough. Domestically, over 85% of the volume in both residential and commercial is replacement demand. AOS has about 52% of the residential market and 45% of the commercial market. Any uptick in new construction will be a big plus but is not in the model. Per AHRI, shipments to the residential sector have run -5% year over year through April, and commercial shipments are +3%.
The company's biggest competitor domestically is Rheem. Margins in the U.S. businesses typically face a one-quarter lag in passing through steel costs, which did hurt margins in 2010 Q4 and 2011 Q1 by about 90 basis points. Management put through a 7%-9% price increase in the fourth quarter and so far the 12% increase in April that led to significant pre-buying in Q1 has stuck. The ability to pass through steel, and to a lesser extent, rising copper costs has been and will remain the biggest risk to the U.S. business.
There are some concerns about levels of normalized demand after the Q1 pre-buying ahead of the April 1 price increase, but I believe they are overblown. In the recently reported normally seasonally slow 2011Q1, the company handily beat expectations ($0.52 vs. $0.47 exp. adjusted EPS) driven by a whopping 52% year-over-year revenue gain in Chinese water heaters. The company did, however, acknowledge that half of this growth was driven by a pre-buy prior to the 12% price increase on April 1 necessary to recover steel costs. The company did not concede, as was expected on the call, that Q2 would decline sequentially, indicating that it is poised to better full-year forecast of a low 20% growth rate.
I believe the timing of the sale of the motors business was very good. AOS had improved the cost structure and realized much of the expected revenue benefits of the current cyclical recovery. The motors business performed its manufacturing in China and Mexico but sales were over 75% domestic.
Currently, I would rather be a seller than a buyer of a U.S. short-cycle industrial production leveraged business. Accordingly, the sale of this business at at least 17x management's previous implied guidance for 2011 earnings contribution is an excellent result and adds credibility to management's efforts to add value through significant corporate activity and use the cash hoard wisely. (Note: I have made some very conservative assumptions regarding what portion of corporate costs and R&D to allocate specifically to this business given that management has not yet clarified these details.)
The economics of the sales of the motors business are shown below.
Proceeds: $905
Pay Down debt: $145
Tax liability on sale: $165
Pension contribution: $120
Cash to balance sheet: $475 ($10.28 per share)
AOS still has two classes of stock, with the Smith family owning a controlling interest in the super-voting class A shares and an approximate 15% economic interest in the company. A collapse of the dual class structure would be another catalyst to create value.
The company guided 2011 earnings to $1.90 to $2.10 per share and maintained this guidance after Q1. I believe it is being conservative due to the Q1 pre-buy, the still-slow U.S. residential market, and so as not to create unrealistic expectations regarding timing of investing the cash hoard. The Street is at $2.10 and my estimate is $2.25 due to picking up market share in China, contributions from the Indian joint venture and the recent decline in commodity prices producing a favorable price adjustment lag.
So we have a stock trading at $41 with $10+ per share in cash or about 15x ex-cash forward estimates that I think they will beat. (13.5x on my number.) On an EBITDA basis, I forecast $175 million, so TEV/EBITDA is at 8.1x. The company plans to reinvest the cash and I believe it will do so accretively to ROIC and EVA. 2012 financials depend on the timing of any acquisition, but on organic growth alone, I forecast EPS of $2.52 and EBITDA of $193 million.
There are no pure comparable companies. The stock is very cheap compared to pure filtration and treatment companies not principally serving petroleum markets such as Donaldson, Clarcor, Robbins & Myers, which trade in the 18x-20x range. AOS also trades slightly below the level of other heavily copper-exposed filtration names, such as Watts Water Technologies, which is currently trading at 17x 2011 estimates. (Growth for Watts is also quite dependent on some measurable recovery in residential construction.)
We have also seen acquisitions of water treatment companies in the 11x-13x EBITDA range (CUNO, Millipore). The company would be an ideal acquisition target for any number of companies including Siemens, GE, 3M, or the forthcoming ITT Water Unit. This is a company with event upside but one that needs none to work. My target price with no corporate activity is $48.50 based on 17x my 2011 estimate of $2.25 plus the $10.28 net cash, or 14.5x my 2012 estimate of $2.52 and $12.00 net cash at 12/31/11.
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