Updated on February 25th, 2019 by Nathan Parsh
Every year, we individually review all the Dividend Aristocrats. The Dividend Aristocrats are a select group of stocks in the S&P 500, with 25+ years of consecutive dividend increases.
On October 9th 2018, A.O. Smith (AOS) increased its dividend by 22%. This marked the 26th consecutive year of dividend growth for the company.
With a current dividend yield of 1.7%, A.O. Smith might not appeal to investors looking for income right now, such as retirees. Those looking for high-growth dividend growth, on the other hand, might find the company attractive. Over the past five years, it has increased its dividend by 27% each year, on average.
And with a strong business domanice, potential for growth, and a low dividend payout ratio, A.O. Smith could have much greater appeal to dividend growth investors.
A.O. Smith is a global leader applying energy-efficient products and solutions. It manufactures a variety of residential and commercial water heating equipment, as well as water treatment and air purification products.
The company is perhaps best-known for its water heaters. It operates in two operating segments, separated by geography:
- North America (64% of sales)
- Rest of World (36% of sales)
As you can see, the company has a sizable international presence, particularly in China where it generates 34% of total sales. The company is also in the early stages of operating in India, the second most populous country in the world. This business represents approximately 2% of total sales.
A.O. Smith has performed very well over the past decade, thanks largely to the steady global economic recovery coming out of the Great Recession of 2007-2009. The company’s sales have grown at a double-digit annual rate, on average, in the past 10 years.
Source: Investor Presentation
Combined with margin expansion and share repurchases, A.O. Smith’s impressive sales growth has fueled impressive earnings growth as well. In the same 10-year period, adjusted earnings-per-share increased 25% per year.
A.O. Smith has continued its growth in recent periods. On January 29th, A.O. Smith released fourth-quarter earnings, which were very strong. The company generated earnings-per-share of $0.74, which topped estimates and were an improvement of 23.3% from the previous year. Quarterly revenue grew 5.7% to $812.5 million, but missed estimates by $8.9 million.
For the full year, revenue increased 6.4% to $3.2 billion, while adjusted earnings-per-share increased 19%, to $2.61.
A.O. Smith’s growth catalysts in the U.S. include continued economic growth and increasing housing prices. As a manufacturer of water heating, water treatment, and air purification products, the company is reliant on a financially healthy consumer and housing market.
When home prices are rising and unemployment is low, consumers with disposable income are much more willing to invest in upgrades like new water heaters. This is how A.O. Smith realized record sales for 2018, which broke 2017’s record sales total.
Outside the U.S., the company’s main growth prospects are in China, where it already has a large operation. China is arguably the most attractive economy in the world. Not only does it have a population of 1 billion, and a growing middle class, but the country has been growing its economy at a high rate.
While sales in China for 2018 grew 4% (2% excluding currency), sales for this very important region declined 5% quarter-over-quarter. In local currency, sales in China declined 3% from the fourth quarter of 2017.
The company cited deprecation of Chinese currency and higher advertising cost related to online holiday shopping as the primary reasons for the decline in the quarter. Trade worries could also be impacting sales in the country
Still, China represents a major long-term opportunity for A.O. Smith. China now contributes over $1 billion in annual sales for the company, and is growing at a high rate.
Sales in China rose more 20% each year in the ten year-period through 2017.
Source: Investor Presentation
There are reasons to be optimistic about A.O. Smith’s China business. Besides China’s large population, the air quality in the country is quite poor. This has caused demand for A.O. Smith’s air purifiers to be quite strong.
We expect A.O. Smith to grow earnings-per-share at a rate of 9% per year through 2024, which is half of the company’s growth rate over the last decade. We believe the company should be able to achieve at least this level of growth due to organic revenue growth and share repurchases.
A.O. Smith bought back 3.8 million shares in 2018 and has 6.1 million shares remaining on its repurchase authorization. The remaining share repurchase authorization represents 3.6% of the current $9 billion market cap.
Competitive Advantages & Recession Performance
A.O. Smith’s strong growth is due to its competitive advantages, primarily its top market share. A.O. Smith has the #1 market share in U.S. water heaters. It holds 40% domestic share, nearly 10 percentage points above its closest competitor.
In the commercial gas water heater market, A.O. Smith’s U.S. market share exceeds 50%, while the closest competitor has market share below 30%. A.O. Smith is also the exclusive supplier of Lowe’s (LOW) water treatment products.
Possessing the top industry position gives A.O. Smith pricing power, and high margins. In turn, this provides the company the ability to generate lots of cash flow, which enables it to invest in new product innovation.
One potential risk for A.O. Smith is a recession. As a manufacturer, the company is closely tied to the health of the overall economy. It is not a highly recession-resistant business model.
Earnings-per-share during the Great Recession are below:
- 2007 earnings-per-share of $0.48
- 2008 earnings-per-share of $0.49 (2% increase)
- 2009 earnings-per-share of $0.57 (16% increase)
- 2010 earnings-per-share of $0.43 (25% decline)
- 2011 earnings-per-share of $0.60 (39% increase)
As you can see, the company performed very well during 2008 and 2009, the worst years of the recession. Earnings took a significant hit in 2010, but quickly recovered in 2011. Overall, the company performed exceptionally well, since it was still able to grow earnings over the course of the recession.
Valuation & Expected Returns
Based on the current share price of $53 and the company’s earnings per share guidance for 2019 of $2.72, A.O. Smith shares currently trade for a price-to-earnings ratio of 19.5. The stock has traded with a least a price-to-earnings ratio of at least 20 for much of the past decade. As such, we have a price-to-earnings multiple target of 20 for 2024.
While the stock has spent much of the last ten years above this valuation, shares of A.O. Smith are slightly undervalued at the moment against this figure. If the stock could expand to meet our target valuation by 2024, investors would see an additional 0.5% added to annual returns over the next five years.
Total annual returns will also include earnings growth and dividends. As a result, a potential breakdown of future returns is as follows:
- 9% earnings-per-share growth
- 0.5% multiple expansion
- 1.7% dividend yield
Added together, we expect shares of A.O. Smith to offer a total annual return of 11.2% through 2024.
Another item investors should keep in mind is that A.O. Smith has a fairly low dividend payout ratio. The company should payout $0.88 in dividends per share in 2019.
Using the company’s guidance for earnings-per-share, this would equate to a payout ratio of just 32.4%. This is slightly above the company’s 10-year average payout ratio of 25.5%.
This leaves A.O. Smith plenty of room to increase its dividend, even in the event of a prolonged recession.
A.O. Smith is an industry-leading company. It has the top brand in its category, with compelling future growth potential.
While currency and trade issues may impact performance in China in the short term, A.O. Smith has such a dominant market share of its industry that the company can likely weather near term difficulties.
The stock is also somewhat undervalued today. While the yield is on the low side, the company’s dividend growth is impressive.
With more than 11% expected annualized returns over the next five years, A.O. Smith is a good option for investors looking to add to the industrial portion of their portfolio.