When it comes to investing, I'm a huge fan of "boring." That
is, I appreciate companies with crucial but more obscure products
that are so much a part of our daily lives that most people
wouldn't even think of them as investments.
Take Packaging Corp. of America (NYSE:
, which makes about the most boring things you could ever think
of -- cardboard boxes and other types of packaging. Yet as I
pointed out when I profiled the company in April, its stock has
triple-digit upside during the next five years.
#-ad_banner-#So does another "boring" stock I'd like to tell
you about. I'll leave it up to you to decide if the underlying
company's main products, high-efficiency residential and
commercial water heaters, are as boring as cardboard. But I think
it's safe to say they don't spark the imagination the way 3-D
printing, wearable computers, mobile banking, e-cigarettes and
other emerging products do.
Still, the investment potential of this firm,
A.O. Smith Corp. (NYSE:
, is very exciting.
Its stock has generated some outstanding returns already,
rising nearly 350% during the past five years. And I think the
price could easily double again in the next five years.
This potential wouldn't exist without A.O. Smith's leadership
in the water heater industry, where it owns just over half the
residential market, nearly half the commercial market, and a
reputation for premium products. Sales have climbed a brisk 12%
annually for the past several years, from $1.5 billion in 2010 to
$2.2 billion currently. Earnings grew nearly 15% a year, from
$1.21 to $1.92 a share, during the same period.
A much improved real estate market should help catapult shares
higher, since a key feature of prosperity in the sector is new
construction requiring the latest and most efficient water
heaters like A.O. Smith's. One nice thing about the company,
though, is it doesn't necessarily need a boom in new construction
to do well. That's because replacement products in existing homes
and businesses are by far its largest revenue source, accounting
for 85% of sales volume.
In the short and intermediate-term, there could be especially
strong demand from commercial customers thanks to the gradual
economic recovery, which could spur greater spending on new water
heaters as a part of upgrades, expansions, and totally new
construction. For instance, A.O. Smith ought to get plenty of
business from the hotel/lodging industry, an area that struggled
a bit last year but is projected to resume solid growth in coming
A.O. Smith is a leader in the water heater
industry, where it owns just over half the residential
market, nearly half the commercial market, and holds a
strong reputation for premium products.
In fact, the industry will likely need to increase capacity
soon because lodging demand is exceeding supply. This year, for
example, U.S. demand is up 2.4% with only a 0.1% increase in
supply, analysts report. The domestic hotel/lodging industry
clearly needs more rooms, and that should generate orders for
The firm isn't the powerhouse overseas that it is
domestically, but it's getting there and international operations
are built up to where they now contribute 30% of total revenue.
A.O. Smith already controls nearly 25% of China's water heater
market, and it's developing a presence in India, too.
Both countries should contribute greatly to the company's
growth for years as their ballooning middle-classes are
increasingly able to afford such "luxuries" as hot water in their
homes. Sales in China jumped 25% in the latest quarter, for
example, and, to meet growing demand, A.O. Smith recently opened
its second water heater plant there. The plant is expected to
boost capacity in the region by 50% once it's fully
Another potentially big opportunity in China: polluted
It's estimated that up to 70% of the water in China in unsafe
for human use. So, in 2009, A.O. Smith began offering water
filtration and purification systems for use in residential and
some commercial settings. This business is still relatively
small, accounting for only about 2% of the company's total
revenue. However, rapid growth seems likely under the
To enter this market, A.O. Smith acquired an 80% stake in a
tiny Chinese home water filtration products company, Tianlong
Holding Co., for $77 million. This caused no undue financial
stress for A.O. Smith, which had free cash flow of $211 million
and current assets of $740 million in the year the transaction
was completed. (Right now, the company has free cash flow of $154
million and current assets of $1.2 billion, and both are at or
near decade highs.)
Although China's economy and real estate market are looking to
downshift, perhaps dramatically, a slowdown shouldn't severely
damage A.O. Smith's profits. While orders related to new
construction might fall off, the firm would probably still see
healthy demand for replacement water heaters, just as it does in
North America. One key catalyst would be the increased rental
activity that often occurs when residential real estate markets
are in the doldrums, since rental properties regularly need
replacement water heaters.
Risks to Consider:
A focus on replacement business rather than new construction
helps protect A.O. Smith from downturns in real estate, but
ailing real estate markets can still hurt the firm's sales,
profits and stock price.
Action to Take -->
A.O. Smith is market leader with solid revenues and rapid
earnings growth, as well as fantastic shareholder returns despite
its "boring" products. The firm is well-positioned to meet
consensus estimates for growth of 23% a year, which would
increase earnings to $5.41 a share in five years from $1.92
currently. Based on a historical price-to-earnings (P/E) multiple
of 22, this implies a stock price of $119 at that time for a 153%
gain from the current price of about $47.
Notably, the stock held up very well during the housing crisis
of 2008, falling 13.7% -- far less than the S&P 500's 37%
loss. So I see the stock as a superior and much safer way to play
domestic and international real estate markets.