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By Mario Mainelli
The market last week was anything but stable. The lasting effects of the sub-prime mortgage crisis, combined with the more recent debt and credit issues plaguing Europe and the US, have created a volatile market that has left many investors seeking safe haven investments. Treasury rates have reached all time lows as investors have flocked to treasuries amidst market turmoil, but there are still some relatively safe equity alternatives out there that have growth potential.
I recently came across A.O. Smith Corporation (AOS), one of the largest water heater manufacturers in North America. The company has made recent headlines for divesting their electrical products business to Regal Beloit Corporation, as well as for their $418 million purchase of Lochinvar. Intrigued by the headlines, I decided to do a little research on the company to see if this could be a prospective investment opportunity and was impressed with what I found.
A.O. Smith is the largest manufacturer of water heaters in the US, controlling just over 40% of the market share. They have a free cash flow per share of $1.56, which is the fifth best in the building products industry according to Zack’s Investment Research. Free cash flow is a measure of both financial strength and flexibility and could be crucial to surviving in a volatile market.
In addition to their large market share in North America, A.O. Smith has had some impressive success internationally. A.O.’s main focus internationally has been the Chinese market, where they predict that China’s middle class will expand exponentially to account for 75% of the middle class market by 2015. A.O. Smith has a 3 year plan to open 300 stores per year in China, which would be nearly a 50% increase in its Chinese presence. A.O. plans to accommodate these new stores with an increased production in China to 3 million units by 2013, nearly a 50% increase, made possible by the addition of a second manufacturing site.
This is a significant opportunity for A.O. to exponentially increase their sales. In 2010, A.O. increased their sales in the Chinese market by 30% over the previous year.
From page 16 of A.O.’s 2010 annual statement:

Our Water Products water heater operations in China grew significantly in 2010. We expect this growth to continue at a rate of nearly two times the growth in China GDP as geographic expansion, market share gains and new product introductions contribute to our growth.

This is a pretty bold statement, considering China is one of the fastest, if not the fastest, growing economies of the last decade. Are they being overly aggressive in their estimates? It is possible, but most annual reports tend to err on the side of the conservative. Making such a bold statement and falling significantly short would cause investors and shareholders to lose confidence in the company. I believe they are very confident with their knowledge of the Chinese water heater market and will be able to translate their store openings into a large growth in sales and profit. Their second quarter earnings in China increased 20% from the previous year’s second quarter, so the strategy seems to be paying off quickly.
There has also been some expansion by A.O. into India, another promising market in terms of growth. A.O. predicts $20 million in sales for its operations in India throughout 2011 and plans to pursue the market share in a similar way as they did with China.
Turning to their recent acquisition of Lochinvar Corporation, A.O. Smith has aligned themselves with a highly efficient water heater producer with a reputation for quality. A.O. believes they can leverage the strong Lochinvar brand name with their proficient manufacturing and sales outlets to gain synergies of $10 to $15 million within the first few years. Earnings per share could increase $.40 to $.50 per share in 2012.
S&P 500 has a five star stock investment rating on the company, while analysts on Reuters have recently begun upgrading from hold to outperform and buy. A.O. has also had a positive earnings surprise, meaning they beat analysts’ estimates, in each of the last five quarters.
The company has significant cash flows, but will it be enough to cover the vast expenses that will follow their expansions? As listed above, they are 5th among the building products in free cash flow per share and had a cash flow from operations of $124.8 million in 2010. The company has a solid cash flow base and shouldn’t have a problem increasing their debt if need be.
One could also question whether their foreign success will continue. A.O. has had great success in China, and is certainly pouring a lot more of their resources into the Chinese and Indian markets. Only time will tell if such a gamble will pay off. The company is, however, quite optimistic about their ability to continually expand their market share abroad.
Further, with a beta of .73, the company is a relatively safe equity choice in terms of market movement and shouldn’t be hit as hard by market turmoil as companies with higher betas. I think this is a good long term growth investment and the risk/reward trade-off makes this buy attractive.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: A.O. Smith's International Expansion Shows Great Potential