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Hot water heaters isn’t exactly the sort of headline-grabbing business that attracts investors, but that’s precisely why you should consider A.O. Smith (AOS 1.57%), a Fortune 500 company best known for its water heaters and water treatment systems.
Investing legend Peter Lynch loved businesses like this, and recommended buying stocks of boring companies. He once wrote, “The perfect stock would be attached to the perfect company, and the perfect company has to be engaged in a perfectly simple business, and the perfectly simple business ought to have a perfectly boring name.”
That describes A.O. Smith to a T, down to the unassuming name. Yet with the housing market looking like it’s in free fall — after all, water heaters are a product closely aligned with housing — let’s look more closely at why an investor would want to jump into a stock that is down 33% year to date.
Image source: Getty Images.
A.O. Smith has a long history dating back to the late 1800s (though not always in water systems). It’s been through numerous business and economic cycles and has always survived, if not thrived through these upheavals. While established companies can and do go under, A.O. Smith is nowhere near financially troubled let alone distressed. It is a global leader in the industry, and it looks to have many decades more of growth ahead of it.
The company is known for its high-quality residential and commercial water heater products. It serves 60 countries, though North America is its preeminent market, accounting for 75% of sales and profits. A.O. Smith also has an extensive presence in China and a growing one in India.
Rising costs, persistent supply chain issues, and slowing residential and commercial real estate markets are why A.O. Smith is struggling this year. Add in the pandemic lockdowns in China that have only just begun to ease, and it’s easy to see why sales have started falling. Where North American sales were down 1% in the latest quarter, the company’s rest of world segment was down 13%, with China in particular off by 10% in local currency.
Housing obviously plays an important role in A.O. Smith’s business as its products are typically installed in new constructions and renovations. Historically, the residential water heater market is a 1.5% to 2% volume growth market on average, but in 2021 that shot up to 8% growth. And now with new home activity rapidly cooling off, A.O. Smith forecasts residential water heater volumes will be down approximately 12% to 13% this year.
That is playing out in its full-year sales guidance, which A.O. Smith now expects will be up only 5% to 7% versus its prior expectation of 12% to 14% growth. It also expects adjusted earnings of $3.05 to $3.15 per share for 2022 compared with its previous guidance of $3.35 to $3.55 per share.
Yet there remain some very good reasons why A.O. Smith’s stock should remain high on an investor’s buy list.
Image source: Getty Images.
First, as important as housing is, the replacement market is a key component of A.O. Smith’s business. It estimates that replacement demand represents approximately 80% to 85% of U.S. water heater and boiler volumes and it says that portion of its business is “resilient.” When your water heater goes, it’s not an expense any homeowner will put off. It must be replaced.
Second, the emerging markets of China and India still hold vast potential. As noted earlier, China is reopening again, which should help its own housing market, while India’s demographics mark it as an especially promising opportunity.
There’s also the matter of A.O. Smith’s dividend, which it has paid for 38 years and increased for 28 years. Its dividend increases have also been generous. Although they’ve only gone up by single-digit percentage rates since the pandemic began, previous to that the dividend hikes were more often than not 20% or more.
A.O. Smith is the largest player in the water heater business, particularly here at home, but with a big runway of growth ahead of it in China and India. While the business is cyclical in nature, as we’re seeing now with housing, there is still a stable base supporting the rest of its operations.
Also, as a premier dividend growth stock, A.O. Smith is an attractive company that has seen its stock crushed, but that just provides for an attractive entry point for investors with a long enough horizon to see it start heating up again.
Rich Duprey has no position in any of the stocks mentioned. The Motley Fool recommends A. O. Smith. The Motley Fool has a disclosure policy.
*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.
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