Updated on April 15th, 2021 by Bob Ciura
Every year, we individually review all the Dividend Aristocrats. This is because we view them as particularly appealing stocks for long-term dividend growth investors.
The Dividend Aristocrats are a select group of stocks in the S&P 500, with 25+ years of consecutive dividend increases. You can see a full downloadable spreadsheet of all 65 Dividend Aristocrats, along with several important financial metrics such as price-to-earnings ratios, by clicking on the link below:
The next Dividend Aristocrat in our 2021 series is A.O. Smith (AOS). In October 2020, A.O. Smith increased its dividend for the 26th consecutive year. According to the company, in the past five years it has increased its dividend at a compound annual growth rate above 22%.
With a current dividend yield of 1.5%, A.O. Smith might not appeal to investors looking for high levels of income right now, such as retirees. Those looking for high-growth dividend growth, on the other hand, might find the company more attractive due to its long history of regular dividend increases.
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:
Source: Investor Presentation
- North America (73% of sales)
- Rest of World (27% of sales)
As you can see, the company has a sizable international presence.
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. From 2010 through 2020, sales and adjusted earnings-per-share increased 7% and 18% per year, respectively.
Combined with margin expansion and share repurchases, A.O. Smith’s impressive sales growth has fueled impressive earnings growth as well. Last year was a setback for A.O. Smith due to the coronavirus pandemic, which had a negative impact on the global economy. But once again, the company has proved its resilience by quickly returning to growth.
A.O. Smith reported its fourth-quarter earnings results on January 28. The company generated revenues of $830 million during the quarter, which represented an increase of 11% compared to the prior year’s quarter. Revenue increased 7% in North America, while revenue growth was even higher in the rest of the world primarily in China, as this is the company’s biggest foreign market. Earnings-per-share of $0.74 for the fourth quarter increased 31% year-over-year.
For the year, sales and adjusted earnings-per-share both fell 3% from 2020. The company performed relatively well for the year, all things considered.
A.O.Smith has also issued guidance for 2021. The company is forecasting earnings–per–share in a range of $2.40 to $2.50, which would reflect a meaningful earnings acceleration versus 2020.
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.
Outside the U.S., the company’s main growth prospects are in China and India, two key emerging markets with large populations and high economic growth.
Source: Investor Presentation
For 2021, A.O. Smith expects sales in China to grow 14% to 15% in local currency. The company also expects sales to increase at more than 20% in the Rest of World segment, which includes India.
Emerging markets such as China and India represent major long-term growth opportunities for A.O. Smith.
We expect A.O. Smith to grow earnings-per-share at a rate of 6% per year through 2026. We believe the company should be able to achieve at least this level of growth due to organic revenue growth and share repurchases.
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 over 30% domestic residential share, and over 40% of the commercial market share.
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 ~$67 and the midpoint of 2021 EPS guidance ($2.45), A.O. Smith shares currently trade for a price-to-earnings ratio of 27.6. We believe a price-to-earnings multiple target of 18 seems appropriate.
As a result, A.O. Smith seems overvalued right now. If the P/E multiple were to decline to the fair value estimate of 18, it would reduce annual returns by 8.2% over the next five years.
Shareholder returns will also be boosted by earnings growth and dividends, which together add up to 7.5% annual returns. All told, total returns are expected to be negative 1.3% per year. This is due to the significant elevation of the P/E multiple against our fair value estimate.
A.O. Smith is an industry-leading company. It has the top brand in its category, with compelling future growth potential. It has such a dominant market share of its industry that the company can continue to overcome short-term difficulties. Over the long-term, we believe the potential growth opportunities in emerging markets is highly attractive.
While the dividend yield is on the low side, the company’s dividend growth is impressive.
However, the stock valuation has increased dramatically over the past year. As a result, we view the stock as overvalued, and a correction could result in negative shareholder returns over the next five years.