This Global Water Technology Company May Revamp Investors’ Portfolio

Posted on Aug 24, 2015

The global electric water heaters market is expected to reach $ 29.32 billion by 2022. As per Grand View Research, Inc., increasing residential and commercial projects worldwide, growing demand for tankless water heaters, and rising disposable income will drive the market demand. A. O. Smith Corp. (NYSE:AOS) is one of the most prominent players in this industry.

A. O. Smith Corporation is one of the world’s leading manufacturers of residential and commercial water heaters and boilers offering a comprehensive product line. The company operates its business through two segments, which include North America (roughly 70% of revenue) and Rest of World (roughly 30% of revenue). It has operations in the U.S., Canada, Mexico, China, India, the UK and the Netherlands. The North America segment manufactures and markets specialty commercial water heating equipment, condensing and non-condensing boilers, and water systems tanks. The Rest of World segment manufactures and markets water treatment products such as electric, gas, gas tankless, heat pump and solar units, as well as combi boilers, primarily in Asia.

Performance check: Impressive figures posted

On July 23, A. O. Smith reported financial results for the second quarter ended June 30. The company reported record second quarter net earnings of $ 71.1 million or $ 0.79 per share, compared to a year-ago figure of $ 0.63 per share. A. O. Smith’s reported sales increased 9.76% to $ 653.5 million from $ 595.4 million a year ago. Higher prices in North America, higher boiler sales in the U. S. and continued demand for the company’s water heating and water treatment products in China are the main reasons behind this increased sales.

At the end of the quarter, A. O. Smith reported cash equivalents of $ 248.1 million compared with $ 319.4 million at the end of 2014. Its long-term debt increased to $ 266.2 million as of June 30, from $ 210.1 million as of Dec. 31, 2014. During the first half of 2015, the company repurchased approximately 730,000 shares of common stock at a total cost of $ 47 million. At the end of the second quarter, the company has a remaining balance of about 1.8 million shares in its existing shares authorization program.

Segments’ performance

Second-quarter sales for the North America segment (includes U.S. and Canada) increased 8% year over year to $ 442.7 million compared to second quarter 2014 sales of $ 410.1 million. Rise in prices of residential and commercial water heaters from April 2015, and rise in sales of boilers in the U.S. are the main drivers for this increase. Segment’s operating earnings increased 36% to $ 86.0 million compared to $ 63.2 million earned in the year ago quarter. Operating margin has also increased 19.4% compared to 15.4% reported in 2Q 2014.

Sales in the Rest of the World segment (includes China, India and Europe) increased 14% in the second quarter of 2015 to $ 221.3 million compared to second quarter 2014 sales of $ 193.6 million. Continued strong customer demand for the company’s premium water heating and water treatment products drove China sales 15% higher. Operating earnings for this segment were $ 30.9 million compared with $ 29.3 million earned in the 2014 second quarter due to higher profits in China. Second quarter 2015 operating margin of 14.0% was lower than the 15.1% operating margin in 2014. Higher selling and advertising costs, and larger expenditures in India to support the launch of water treatment products are the main reasons for this decrease in operating margin.

Initiatives taken due to implementation of NAECA III

On April 16, National Appliance Energy Conservation Act’s new government regulations, referred to as NAECA III, became effective. As per the rule, the minimum energy efficiency standards for residential water heaters are mandatory to be increased in the U.S. Hence, A.O. Smith has segmented its robust residential product offering into three tiers to help its customers differentiate its products into good, better, and best categories by introducing the A. O. Smith Promax, Conservationist, and Conservationist Preferred product families. All of these are included in A. O. Smith’s premium features.

Projections for 2015

A. O. Smith expects an improvement in full year residential and commercial water heater demand in the U.S. compared with last year, as well as continued lower material costs. It believes that sales of Lochinvar branded products are on track to grow 10%, again this year and sales in China to grow twice the rate of China’s GDP growth in 2015. Based on the above factors, the company raised its 2015 earnings per share in the range of $ 3.04 to $ 3.09, from $ 2.72 to $ 2.82 guided earlier. Further, A. O. Smith expects the following:

  1. Operating cash flow is expected to be $ 300 million.
  2. Capital expenditures will be in the range of $ 100 million to $ 110 million.
  3. Depreciation and amortization is expected to be $ 65 million.
  4. ERP implementation expense will be in the range of $ 19 million to $ 20 million.
  5. Corporate and other expenses are expected to be $ 45 million.

China and India at a glance

As per Mckinsey Annual Chinese Consumer Survey, the majority of the Chinese consumers prefers foreign brands of household electrical appliances. Over the last 10 years, sales in China have grown 28% (CAGR). A. O. Smith has over 7000 outlets in China out of which 35% are located in Tier 1 cities, and 65% are in Tier 2/3 cities. In China, the company has extensive distribution and service network, innovative new products and world class manufacturing, and the local management team and organizational development. Further, A. O. Smith has enough growth opportunities for its air purifier market in China.

A. O. Smith entered the Indian water heater market in July, 2008 and has already expanded to 10 key cities in India, with a significant presence in Bengaluru, Delhi, Chennai, Goa and others. The company’s Indian headquarter is located in Bengaluru. In the first two years, sales in India have exceeded its expectations. In India A. O. Smith has attractive growth demographics and local management. The company is leveraging global capabilities with products designed for the Indian market. To achieve more sales target, A. O. Smith India recently appointed Parag Kulkarni as managing director. Kulkarni will have full profit and loss responsibility for the operation, which manufactures residential water heaters and recently launched a line of residential water treatment products for the Indian market.

On a concluding note

Overall, A. O. Smith is a rock solid company with a solid financial position with reasonable debt levels, notable return on equity, revenue growth, and increasing profit margins. Further, the company has value creation opportunities, and marginal accretion with growth rates higher than U.S. GDP. Therefore, I expect that this global water technology company will deliver exceptional returns in the near future, and I would recommend this company as a buy.

(Source: Company’s Website)

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