A.O. Smith Corporation

AOS: NYSE

A.O. Smith Corporation manufactures residential and commercial water heating equipment and air purification products.[1] The company was founded in 1874, and is headquartered in Milwaukee, WI.[2]

Investment thesis

A.O. Smith is the largest manufacturer of water heaters in North America, with a leading share in both residential (40% share) and commercial markets (55% share).[3] About 85% of North American sales are a replacement of existing products.[4] A.O. Smith has been in China for the last 20 years, and has over $1 billion in sales annually in China.[5] We believe that over the next 5-10 years, North American business will be slow, single digit growth, while China should grow at a faster clip. We are of the opinion that India is a small contributor in revenue,[6] but has the opportunity over the next 10 years to be a much larger part of the total business. We feel that the company will continue to deliver strong free cash flow, has net cash on the balance sheet, and has a strong history of conservative capital allocation.

Confirmation through research

A.O. Smith has leading share in water heaters in North America and China.[7] In China specifically, we believe consumers prefer foreign brands and are willing to pay higher prices for quality. There is growing potential for water purification and air purification in China.[8] We think that A.O. Smith has the potential to grow in India, once China becomes a more mature market for the company. A.O. Smith has generated ever growing free cash flow with compounded free cash flow at a 15% clip over the last 5 years,[9] and the company has over $1.6 billion in net cash.[10] Finally, we consider the company to be very strong from a capital allocation front. They have been increasing their dividends over last 25 years.[11] We recognize the company to be a good acquirer, especially due to their purchase of Lochinvar, a leading boiler company. We feel they paid a very reasonable price for Lochinvar considering its growth and margins.

Variant Perception

We believe that the market is not assigning a fair value to the business considering the company’s dominant share in water heaters, growth trends in China and India, water and air purification opportunity, and the management’s disciplined capital allocation. We believe over time the multiple should re-rate, as the company continues to execute over the next few years.