A.O. Smith (NYSE:AOS) might be in your house at this very moment. Your water heater probably came from A.O. Smith. But even if it didn't, there's a fair chance that the motor in your water system, swimming-pool pump, treadmill, or air conditioner came from the company.
The company makes water heaters and motors for residential and commercial uses. Since the housing market is going gangbusters, this must be a record time for the company, right? Well, not exactly.
A.O. Smith has found itself sandwiched between wholesale inventory gluts and higher input costs related to steel and energy. Looking at second-quarter results, total sales were flat, operating income was down, and net income was also down (with or without the inclusion of a restructuring charge).
In the water systems business, sales were down 3% and operating earnings were flat. Although the company boasted of a 30% increase in water-heater business in China, an inventory glut in the wholesale inventory channel kept business as a whole pretty mediocre. Looking at electrical products, sales were up 3%, but operating income (excluding a restructuring charge) dropped 23%.
On one hand, there are reasons for optimism. It looks like the business has bottomed out, and it appears restructuring efforts should begin to pay off in terms of lower costs next year. The acquisition of Canadian water-heater company GSW should also pay off down the road because it's a sole supplier of water heaters to Lowe's (NYSE:LOW).
On the other hand, there are a few issues that make me a bit uncomfortable. First, management refused to go into any details about the acquisition of GSW, even stonewalling on the disclosure of a purchase price. Given that GSW isn't tiny (more than $400 million in sales last year), that's a big piece of information to be missing.
I'm also concerned about this apparent glut of inventory across the industry. If these are boom times for new home construction, it would seem logical that there would be solid demand for products like water heaters or HVAC systems. Unfortunately, there really aren't many publicly traded companies to compare against A.O. Smith in order to assess industry conditions. Companies like Baldor Electric (NYSE:BEZ) and Regal-Beloit (NYSE:RBC) are only partially comparable, and larger companies like Emerson Electric (NYSE:EMR) and General Electric (NYSE:GE) don't divulge that sort of detailed information.
Issues aside, if you like turnaround stories and companies that are generally underfollowed, this is one worth watching. If business has in fact bottomed out, there could be some appealing margin leverage and growth in a year or two. But beware: Buying ahead of the turn is risky, and proper due diligence is an absolute must.
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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).
