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A.O. Smith: A Dividend Champion Likely To Deliver Alpha Over The Next Decade

Having raised its dividend for the past 25 years, A.O. Smith is a Dividend Champion.

Despite its risks, I believe A.O. Smith is well positioned for the future as a result of its management and strong balance sheet.

Adding to the case for an investment in A.O. Smith is the fact that the company is trading at a 13% discount to fair value.

Between the 1.9% dividend yield, conservative 7-8% earnings growth, and 1.4% valuation multiple expansion, A.O. Smith is likely to at least deliver 10.3-11.3% annual total returns over the next decade.

Recent concerns over the US-China trade war have led to a market-wide selloff since the market reached record highs at the end of July.

Since the US and China began their trade war in 2018, industrial stocks have been sold off at the slightest hint of an escalation in the trade war between the US and China.

One example of this can be found with A.O. Smith (NYSE:AOS). Since the company peaked in January 2018 at just shy of $67 a share, A.O. Smith’s stock has tumbled over 30%.

While the company faces a few headwinds, I believe they are primarily short-term in nature, and the precipitous drop in A.O. Smith’s stock offers long-term dividend growth investors an opportunity to pick up shares of a Dividend Champion at a discount.

I’ll be discussing A.O. Smith’s dividend safety and growth profile, the company’s fundamentals and risks, and the valuation aspect of an investment in the company.

I’ll then conclude by offering my estimated annual total returns over the next decade for an investment in A.O. Smith at the current price.

Reason #1: A Very Safe Dividend With Room To Grow

Aside from the fundamentals of a business, I typically like to start by examining a company’s dividend safety and growth profile as a starting point. As a dividend growth investor, it’s of utmost importance to me that a business is likely to hold up over the long-term and able to deliver a safe and growing dividend to its shareholders.

I’ll determine A.O. Smith’s dividend safety by examining both its EPS and FCF payout ratios, and then comparing my opinion to that of Simply Safe Dividends’ opinion.

In its previous fiscal year, A.O. Smith generated adjusted EPS of $2.61 against dividends per share of $0.76 during that time, for an EPS payout ratio of 29.1%.

Looking at the current fiscal year, A.O. Smith is guiding for adjusted EPS of $2.35-$2.41 against expected dividends per share of $0.90 (assuming a 9.1% increase in the dividend announced in October), for an EPS payout ratio of 37.8% using the midpoint.

Moving to FCF, A.O. Smith generated operating cash flow of $448.9 million against capex of $85.2 million, for total FCF of $363.7 million, according to page 29 of its most recent 10-K. Against the $130.1 million in dividends paid during that same time, this equates to a 35.8% FCF payout ratio.

Given that the dividend obligation is set to increase and FCF is likely to decrease a bit with EPS, it seems likely that A.O. Smith’s FCF payout ratio will also spike a bit in the short-term as the company deals with short-term headwinds.

Regardless of current challenges, A.O. Smith’s dividend is clearly very safe when we consider its payout ratios and later its strong balance sheet.

Given our opinion above that we arrived at by considering A.O. Smith’s payout ratios, it should come as no surprise that Simply Safe Dividends and I both agree that A.O. Smith’s dividend is very safe for the foreseeable future.

Now that we’ve established the dividend is rather safe, the next consideration for us is dividend growth going forward.

While the 20% 10 year DGR and 27% 5 year DGR certainly aren’t realistic expectations going forward, I do believe that dividend growth will largely track whatever earnings growth A.O. Smith can deliver over the long-term. Given that I’m expecting a high-single digit dividend increase later this year, I’m forecasting that 2019 will be a notable exception to my expectations. But by in large, dividend growth will track earnings growth.

With that said, Yahoo Finance and Nasdaq are forecasting EPS growth rates of 6.4% and 8.7% over the next 5 years, respectively. For that reason, I believe dividend growth of 7.5-8.5% over the long-term is a realistic expectation going forward.

Reason #2: A Resilient Business Model, Proven Management Team, and Strong Balance Sheet

A.O. Smith manufactures residential and commercial gas and electric water heaters, boilers, and water treatment products sold in over 60 countries around the globe.

The company manufactures and sells water heaters to residences, office buildings, car washes, hotels, restaurants, among many other types of businesses.

In addition, A.O. Smith produces and sells residential and commercial boilers for hospitals and hotels, among other large commercial buildings.

A.O. Smith also manufactures and sells water treatment products, including water softeners, water filtration, and filtration bottles, which are used in many residences, offices, hotels, and restaurants.

Finally, A.O. Smith manufactures and sells expansion tanks, swimming pool and spa heaters, and commercial solar water heating systems.

The company operates in two reporting segments, which are North America and Rest of World.

North America: According to page 19 of A.O. Smith’s most recent 10-K, the North America segment accounted for 63.5% or $2.045 billion of A.O. Smith’s $3.219 billion in sales in 2018 and 75.7% or $464.1 million of A.O. Smith’s $613.4 million in total segment earnings.

Rest of World: The Rest of World segment accounted for the remaining 37.5% or $1.174 billion of A.O. Smith’s $3.219 billion in sales in 2018 and the remaining 24.3% or $149.3 million of A.O. Smith’s $613.4 million in total segment earnings

As illustrated above, A.O. Smith has established itself as the clear leader in the U.S. residential water heater market, controlling about 40% of the market.

A.O. Smith’s U.S. residential water heater sales are split quite evenly between wholesalers and retailers, with wholesalers such as Ferguson and Winnelson accounting for 55% of 2018 sales and retailers such as The Home Depot and Lowe’s accounting for 45% of 2018 sales.

A.O. Smith has established great relationships with over 1,300 distributors in its 100+ year corporate history, which has allowed it to become the clear leader in the U.S. water heater market, controlling about 40% of the market in 2018.

In addition to establishing great relationships with distributors, A.O. Smith has been able to command such a large market share by continuously allocating resources to its R&D to improve its products.

According to page 5 of the company’s most recent 10-K, A.O. Smith allocated about 2.9% of its sales to R&D in 2018, spending $94.0 million on R&D to maintain its position as an innovative leader in the water heater, boiler, and water treatment products markets.

Now that we have a better understanding of what makes A.O. Smith a market leader, we’ll delve into the catalysts that make me bullish toward the company.

The first reason I’m bullish toward A.O. Smith is due to the fact that the company has benefited from strong replacement sales. Water heaters generally need to be replaced every 8 to 12 years, which spurs strong and fairly stable demand for A.O. Smith’s replacement water heater sales.

Given the overall quality, price, and performance of A.O. Smith’s water heaters, it is quite common for customers to keep their business with A.O. Smith.

One of the major growth catalysts for A.O. Smith in the years ahead is undoubtedly China. The company has managed to grow its sales 19% annually over the past decade. Although conditions in China have been rough the past few quarters, I don’t believe this will become the norm.

Given that the trade war between the US and China has dragged out for over a year now, it’s to be expected that sales are slumping in China this fiscal year.

The company’s massive retail counter presence in China means that as customers learn that A.O. Smith’s products are high-quality, more and more will choose the company’s products.

Whenever the trade war between the US and China is inevitably resolved, I expect a resumption of the status quo. A continued expansion in China’s middle class will lead to millions of new potential customers for A.O. Smith.

The other largely untapped market is India. Given that the A.O. Smith target demographic in India is set to continue to grow well into next decade, this means that A.O. Smith is well positioned to also take a piece of this growing market as well.

The company’s strategy for growth in India is fairly similar to the growth strategy in China, with the success of the expansion largely depending on growing distribution in India.

While there is distribution in all 25 of the “Class A cities” and distribution in 63 of 68 “Class B cities,” there is a lot of work remaining to expand into the “Class C cities.”

If A.O. Smith is successful in its plan of deriving roughly half of its sales in India and China within the next few years, the company would be well positioned to return to growth more closely resembling that of the past than the recent sales and earnings decline.

Adding to the case for an investment in A.O. Smith is the company’s strong balance sheet. In 2018, A.O. Smith boasted an interest coverage ratio of 66.4, with total interest expense of $8.4 million against $557.8 million in EBIT, according to figures on page 28 of the company’s most recent 10-K.

The final reason for my optimism toward A.O. Smith is the highly experienced management team.

Leading the company is President and CEO Kevin Wheeler. Although Mr. Wheeler is a newcomer to the President and CEO positions (having been appointed in September 2018), he brings a wealth of experience from his previous positions within the company. Mr. Wheeler joined the company in 1994 as a regional sales manager for the former Water Products Company, and also served as the managing director of A.O. Smith Water Products Company B.V., Senior VP of the US retail business for the Water Products Company, and as Senior VP, President, and General Manager of North America, India, and Europe water heating. Prior to joining the company, Mr. Wheeler began his career at Hoyt Water Heater Company in 1984.

Executive VP and CFO Charles Lauber is also a newcomer to his current positions, having been appointed to them this past May. However, Mr. Lauber served as Corporate Director of Tax and Audit, VP and Controller of the Electrical Products Division, and Senior VP of Strategy of Corporate Development prior to assuming his current role. Before joining the company in 1999, Mr. Lauber held a number of auditing and management positions at Ernst and Young from 1984 to 1999.

Given the experience at key management positions and the strong balance sheet, I believe A.O. Smith is primed to deliver upon its growth plans and will continue to deliver strong growth to shareholders despite the current bump in the road.

Risks To Consider:

While A.O. Smith is a Dividend Champion and has a rich corporate history of rewarding shareholders, we’ve been reminded in the past by many Dividend Champions that have fallen off the list that risks must be considered because a deterioration in fundamentals and the realization of key risks can often break an investment thesis.

With that said, there are a number of risks that I believe must be considered before one considers an investment in A.O. Smith and risks that must be monitored on occasion once an investment is initiated in the company.

According to page 6 of A.O. Smith’s most recent 10-K, 43% of the company’s net sales were attributable to products sold outside the US. Furthermore, China accounted for 34% of net sales in FY 2018.

While the US and China are aiming to revive trade talks, it’s certainly far from a guarantee that the sides will reach an agreement in the near future to resolve the trade dispute as this trade war has only escalated since it unofficially began, when the US imposed tariffs on $34 billion of Chinese goodsin July 2018.

The overall macroeconomic environment in China has taken a toll on A.O. Smith in the near term, with the company guiding for sales in China to decline 16-17% in local currency terms this fiscal year, and 19-20% after a 3% currency headwind given that China recently devalued its currency below a 7 to 1 ratio with the US Dollar for the first time in a decade, further escalating tensions with the US.

While foreign currency translations tend to even out over time, a devalued Yuan is another risk to consider which could materially weigh on financial results for the foreseeable future.

Further exacerbating the above risk is the fact that 10,000 of the company’s 16,300 employees (as of December 31, 2018) were located in China (page 6 of the company’s most recent 10-K). Any local economic or political instability in China could threaten A.O. Smith’s operations, thereby harming the company’s financial results and its reputation.

Another key risk to A.O. Smith is that 39% of its net sales in 2018 were to 5 customers (page 6 of the company’s most recent 10-K). The company expects that concentration risk will continue for the foreseeable future. Any inability on the part of A.O. Smith to retain its key customers or maintain healthy business relationships with these customers could pose a materially adverse development to A.O. Smith’s financial results in the future.

Yet another key risk to A.O. Smith is from a regulatory standpoint. Because the company’s products are subject to a variety of regulations, it’s important to note that any modifications to regulations in the markets it serves or the introduction of new regulations would increase the company’s compliance costs, which could weigh on financial results (page 7 of the company’s most recent 10-K).

Another risk to consider that is also related to the US-China trade war is that A.O. Smith is particularly vulnerable to the 25% tariffs imposed on imported steel (page 8 of the company’s most recent 10-K). While it isn’t likely to be a long-term drag on the company’s earnings power, it is a notable risk in the foreseeable future that could lead to margin compression.

The final risk to consider is that according to page 10 of A.O. Smith’s most recent 10-K, the founding family of A.O. Smith controls 62.9% of the total voting power of the company’s Class A common stock, through its voting trust, taken together as a single class, and 96.5% of the voting power of the outstanding shares of the company’s Class A common stock, as a separate class (as of December 31, 2018).

Simply put, the Smith Family retains ultimate control of this company and while they have been excellent owners of the company thus far, there is no guarantee that they will continue to act prudently in the best interest of the company.

While there are other risks for investors to consider, I believe the above risks are those that are the most important for investors or potential investors in A.O. Smith to consider. For a more complete listing of the risks facing an investment in A.O. Smith, I would refer interested readers to pages 6-10 of the company’s most recent 10-K.

Reason #3: A Dividend Champion Trading At A Moderate Discount

Since we’ve established that A.O. Smith is an excellent company worthy of consideration from dividend growth investors, we’ll now move into the valuation aspect of an investment in A.O. Smith.

The first valuation metric we’ll use to determine A.O. Smith’s fair value is the 13 year TTM median dividend yield.

A.O. Smith’s current yield of 1.9% is well above its 13 year TTM median yield of 1.14%.

Assuming a fair value yield of 1.6% and a fair value of $55.00 a share, A.O. Smith is trading at a 15.9% discount to fair value and offers 18.9% upside from its current share price of $46.27 (as of August 18, 2019).

The next valuation metric we’ll use to arrive at A.O. Smith’s fair value is the 13 year median TTM PE ratio.

According to Gurufocus, A.O. Smith’s TTM PE ratio of 18.61 is well below its 13 year median TTM PE ratio of 22.09.

Assuming a reversion to a TTM PE ratio of 22 and a fair value of $54.70 a share, A.O. Smith is trading at a 15.4% discount to fair value and offers 18.2% upside from the current price.

The final valuation method we’ll use is the dividend discount model or DDM.

The first input into the DDM is the expected dividend per share, which is simply the annualized dividend per share. A.O. Smith’s current annualized dividend per share is $0.88.

The next input into the DDM is the cost of capital equity, which is another term for an investor’s required rate of return. I require a 10% rate of return given that return is a bit above the long-term historical average of the broader market, which I believe is ample reward for the effort I put into research and monitoring investments on occasion.

The third and final input into the DDM is the dividend growth rate, which is unsurprisingly the most difficult input into the DDM because there are a number of considerations that must be taken into account to arrive at a reasonable dividend growth rate estimate.

When we consider that A.O. Smith’s dividend has at least a bit of room to grow from an expansion of the payout ratio perspective and that EPS growth is likely to be in the range of 7-8% over the long-term, I believe that an 8.25% long-term DGR is realistic.

The above inputs give us a fair value of $50.29 a share. This implies that shares of A.O. Smith are trading at an 8.0% discount to fair value and offer 8.7% upside from the current price.

When we average the three fair values together, we arrive at a fair value of $53.33 a share. This indicates that shares of A.O. Smith are trading at a 13.2% discount to fair value and offer 15.3% upside from the current price.

Summary: A.O. Smith Is An Undervalued Dividend Champion Likely To Outperform The Market

A.O. Smith has established itself as the leader in the U.S. water heater market, which has allowed the company to grow its dividend at a strong clip for the past 25 years.

Despite the risks to A.O. Smith, I believe the company’s management team and strong balance sheet will help the company navigate these risks and continue to deliver strong results for shareholders in the years ahead.

Adding to the case for an investment in the company is the fact that shares are trading at a 13% discount to fair value. It isn’t too often that a Dividend Champion trades at a discount to fair value, let alone a double-digit discount to fair value.

Between the 1.9% dividend yield, conservative 7-8% earnings growth, and 1.4% valuation multiple expansion, A.O. Smith is likely to at least deliver 10.3-11.3% annual total returns over the next decade. This will most likely outperform the broader market over the next decade, thereby delivering alpha for shareholders.―Seeking Alpha

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