A. O. Smith: China Reopening Could Reignite Growth (NYSE:AOS)

A. O. Smith Company (NYSE:AOS) is a strong firm whose inventory has potential upside if it might reinvigorate its enterprise in China.

Firm Profile

AOS manufactures and sells water heaters, boilers, water remedy, and different merchandise for the residential and industrial markets. In North America, it sells via each the wholesale and retail channels.

Within the wholesale channel, it sells water heaters underneath the A. O. Smith and State manufacturers. It additionally sells water heaters in 4 of the six high house middle retailers, and solely sells its A. O. Smith branded merchandise at Lowe’s Firms, Inc. (LOW). It additionally sells A. O. Smith branded water remedy merchandise via LOW and Amazon.com, Inc. (AMZN), and its Aquasana branded merchandise primarily via e-commerce websites. With its Lochinvar model, it sells each boilers and water heaters. About 60% of the model’s gross sales are boilers, and 40% water heaters.

The corporate additionally sells water heaters and water remedy merchandise internationally, with the majority of gross sales coming from China. Within the Chinese language water heater promote it sells electrical wall-hung, fuel tankless, combi-boiler, warmth pump and photo voltaic water heaters. Its merchandise are bought in roughly 12,000 places within the nation. It additionally sells its merchandise in India, Europe, the Center East, and different international locations in Asia.

Alternatives and Dangers

China stays each a chance and danger for A. O. Smith Company. Not like in North America, the water heater market is taken into account a little bit of a luxurious market in China. AOS was capable of capitalize on this development to change into a well known, widespread model in China with its personal specialty shops.

Nonetheless, gross sales peaked within the nation in 2018 at $1.07 billion, with the corporate seeing a -19% decline in gross sales, excluding foreign money, in 2019, which was earlier than Covid hit. Covid and subsequent restrictions didn’t assist the matter, sending Chinese language gross sales to $701.0 million in 2020. Gross sales improved to $922.4 million in 2021, earlier than falling again to $839.1 million in 2022, a -5% decline in native foreign money in addition to a $36 million hit from foreign money translation.

AOS noticed its Chinese language gross sales as soon as once more fall in Q1, dropping -10% in native foreign money. Nonetheless, it does anticipate China to return to development later this 12 months.

On its Q1 earnings name, CEO Kevin Wheeler stated:

“Our China enterprise carried out as anticipated within the first quarter. We imagine it’ll take time for shopper confidence to strengthen and for the economic system to enhance in China. We reaffirm our steerage that our gross sales in China will develop 3% to five% in native foreign money in 2023. Our steerage assumes volumes in China improved all year long. Our forecast assumes the Chinese language foreign money will devalue roughly 2% in 2023 in comparison with 2022. We’re adjusting our outlook for our boiler enterprise. …

“In China, we noticed sequential month-to-month enchancment in our gross sales via April, and we anticipate that to proceed via the 12 months. We’re happy with our free money circulate via March, and we anticipate a robust rebound in free money circulate for the complete 12 months, as China emerges from COVID-19-related disruptions, and our devoted give attention to stock discount throughout our North America operations.”

The massive query for AOS is whether or not it might get again to peak China gross sales after which develop from there. Covid and subsequent restrictions have distorted the image over the previous few years. The massive drop in gross sales earlier than Covid is a bit worrisome, and there’s no indication what a extra normalized China could appear like. India is a chance, however remains to be small.

In North America, AOS’s enterprise is rather more of substitute enterprise. And whereas it has diversified its product strains, water heaters are nonetheless 82% of its North American income, and the majority of that’s residential. If a water heater breaks, individuals tend to repair it fairly shortly. The corporate additionally has some publicity to new house development, in addition to proactive replacements, the place individuals exchange older heaters earlier than they break. However general, this can be a good, regular enterprise that advantages from improved product improvements and worth will increase.

The water remedy market, in the meantime, is a pleasant rising market. As a fragmented market, that is one place AOS has achieved and continues to have a look at acquisitions to assist drive development. Inside the area the corporate has made numerous offers, together with for Aquasana in 2016, Hague in 2017, Water-Proper in 2019, Grasp Water in 2021, and Atlantic Filter in 2022.

When dangers, the impression of commodity prices, significantly metal, is one space to be cautious of for AOS. The corporate stated it just lately noticed a spike in metal costs that may see its metal prices rise 20% within the second half, hurting North American margins. The corporate additionally wasn’t proof against a number of the over-ordering and subsequent de-stocking that many firms in numerous industries needed to take care of final 12 months.

The economic system may damage preventive gross sales a bit, however isn’t prone to have a huge impact on general North American gross sales. Worldwide is a little more in danger, however the bulk of that market remains to be China, which is popping out of Covid restrictions and seeing spending enhance.

Valuation

A. O. Smith Company trades at 12.9x the 2023 consensus EBITDA of $776.1 million and 12.3x the 2024 consensus of $816.0 million.

It trades at a ahead P/E of over 19x the 2023 consensus of $3.47. Based mostly on 2024 analyst estimates of $3.70, it trades at over 18x

The corporate is projected to develop income 1% this 12 months and almost 4% subsequent 12 months.

The corporate trades in direction of the low finish of its peer group and towards the low finish of its historic averages.

Conclusion

A. O. Smith Company has a pleasant, strong, regular enterprise in North America, with the potential for elevated development if it might return to prior degree gross sales in China. The enterprise generates strong free money circulate that can be utilized to pay the dividend and purchase again inventory. Working money circulate has common round $500 million the previous 5 years, with CapEx round $70 million. It guided without cost money circulate (“FCF”) of between $575-$625 million, which might be a file and surpass the $566 million in FCF it generated in 2021, however that 12 months had a whole lot of stock reductions. Q1 of 2023 had a fairly large stock drawdown, and so I would anticipate FCF to return to extra that $500 million degree in 2024. Nonetheless, that is some huge cash it might put to work and return to shareholders.

I’d additionally anticipate some continued bolt-on acquisitions within the water remedy enterprise to proceed to assist construct out that enterprise. M&A needs to be a pleasant development driver in that a part of the enterprise.

At its present valuation, A. O. Smith Company inventory appears to be like reasonably undervalued versus friends and traditionally. The inventory has had a robust begin to the 12 months, up properly. As such, I believe A. O. Smith Company inventory is a strong “Maintain.” If China can flip round, there needs to be some good upside left within the title. Nonetheless, for brand spanking new cash patrons, I’d want to be a purchaser of A. O. Smith Company inventory on a worth dip.