Seeking Alpha

A.O. Smith Shares Are Not A Buy Yet

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About: A. O. Smith Corporation (AOS)
by: AllStarTrader
AllStarTrader
Long/short equity, value, Growth, dividend investing
Summary

Investors love A.O. Smith for the exposure to the secular growth in the water industry.

The company is a dividend king, but the yield is still low and not quite attractive enough to justify paying a premium.

Recent earnings have been poor and should be viewed as a negative.

The company's shares would fit in a well diversified portfolio at the right price.

Source: Wikimedia

Shares of A.O. Smith (AOS) are still off from 52-week highs but also still trades at a lofty valuation. The shares seem to often get a premium due to being a dividend king and its involvement in the water industry. The company primarily manufacturers and distributes water heaters, boilers, and treatment systems for uses in homes and commercial applications. While this is an attractive industry due to the nature of replacement cycles, there still has to be justification for the valuation. The company has had a strong history of growth, but it seems that recently it has slowed and should be reflected in the stock price. As much as I would appreciate a dividend aristocrat like AOS in my portfolio, a fair price for shares is more important.

Performance

The company recently reported earnings that were less than appealing.

Source: Seeking Alpha

A miss on both the top line and earnings in line with expectations should leave investors wanting more. With revenue declining 3.4% year over year, I was surprised to see the shares had little reaction to the report.

While the company enjoyed growth of 6% in its largest market, North America, the rest of the world saw a significant decline.

Source: Earnings Slides

The rest of the world is primarily focused on China, which saw a decline in sales of 20%. The company attributes this to built-up inventory levels in local channels and weakness in demand. On a more positive note, India sales continued to see growth increasing 9%. However, considering China is going to be the largest contributor to earnings in the coming years, improving sales and margins in the region is of the upmost importance. The company now projects full year China sales will decline 23% in U.S. dollars.

The company also saw a decline in its cash flow from operations which is also a negative

Source: Earnings Slides

This was attributed to lower accounts payable and lower earnings in general. The company stands in a positive net cash position, but most of the cash is withheld outside of the U.S. and is subject to the repatriation tax. Should the company bring this cash back inside the U.S., it would be of course beneficial, but the company could also use it to acquire a company from elsewhere in the world.

The company has a strong history of earnings growth, but is not forecasting strong growth for the rest of the year.

Source: Earnings Slides

As a result of the ongoing weakness in the international segment, the company had to revise guidance downward. It now expects earnings to be in the range of $2.25 and $2.28 per share. This would be a 13% decline at the midpoint compared with last year.

The company is to be recognized as a worldly operator even though a majority of sales are domestic.

Source: Investor Presentation

The company will continue to focus on sales in the rest of the world to help grow earnings and revenue.

The company commands a significant market share in the U.S. due to its continued recognition for reliability.

Source: Investor Presentation

It should be noted that Rheem is not far behind and is making headway into industries such as the Pool equipment industry. As it does this, it will become more familiar and have further brand recognition with home owners. This push will enable Rheem to perhaps capture more market share.

The company has a strong presence in the commercial segment as well.

Source: Investor Presentation

I would expect if management can make continued acquisitions that this would enable it to offer a broad suite of products to the commercial customer. Having one supplier for all water demands in a commercial location would protect its market share and improve ability to win installations.

Furthermore, the company has an opportunity to improve demand for its products through strong water consumption trends.

Source: Investor Presentation

Growth in demand for water is non-stop and clean water is needed of course. As the company offers solutions for a wider category of water systems, the revenue should grow too. The company has diversified its product offerings under different brand names to ensure it protects its retailers, installers, and wholesale channels while having the ability to serve e-commerce and direct to consumer channels.

Source: Investor Presentation

The continued growth in its water treatment segment will be the way the company benefits going forward. This is also what has driven a premium in the shares.

Valuation

Looking at the 5-year historical valuation of shares, we can get an idea of where shares typically trade at versus now.

Source: Morningstar

Currently, it appears that shares are trading at a discount to their average valuation, with the P/E, P/CF, P/B, P/S, and forward P/E all being lower than their average for the last 5 years. However, it should be noted that the PEG ratio is higher and this signals the problem. The earnings growth is now expected to be slower than it has. Due to this, the shares deserve to trade at a discount than they normally have. This discount should probably be great than it is, however, as the growth expected is significantly less than what the current discount to the average is.

With 26 years of dividend history, looking at historical yields can also tell us whether or not the shares are currently under- or overvalued.

Source: Yieldchart

The average yield for A.O. Smith over the past 24 years has been 1.81%. Currently, shares offer a yield of 1.96% which is above average. This implies shares are undervalued as well. However, It is worth noting the yield is close to the median and should the yield rise to 2.25% that would imply a slightly better deal for the shares. Still, this yield is hardly impressive and I wouldn't go out of my way to add shares to my portfolio. I would begin to look at shares at this level; however, I prefer them around 16X earnings or closer to $36 a share. This is below the current market multiple and I would be comfortable given the long-term tailwinds the company has to benefit from.

Conclusion

A.O. Smith certainly has an attractive business with enviable market share. Being a dividend aristocrat and having a cash position that is net positive is also a huge plus. Given the company operates in a somewhat cyclical environment due to reliance on new homes built, this ensures it can withstand a downturn. The company has some headwinds in China, and as it continues to grow its market share in the region, it needs to ensure it can stabilize sales. Seeing revenue drops of almost 20% in a quarter gives little confidence to this. While the company certainly has plenty of avenues of growth and benefits from worldwide water demand growth, there is still a valuation that must be fair for shares. Currently, I wouldn't look to add shares until the discount to historical averages for both P/E and yield become wider. I will revisit this, however, should the fundamental picture change.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.