A.O. Smith's Efficient Water Heater Profit Percolates

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H ow can a 141-year-old water heater maker likeA.O. Smith ( AOS ), with 30% of sales from a struggling China, qualify for IBD's New America? The New America feature identifies entrepreneurial companies changing the way we live or do business. These innovators often lead the next stock-market advances.

By those measures, A.O. Smith easily qualifies.

In the mid-1990s, A.O. Smith generated about $1.6 billion in sales annually and hadn't entered China yet, BB&T Capital Markets analyst Kevin Maczka told IBD. "More than half of its business was related to automobile components, and water products were only 15% to 20% of sales," he said.

It gradually sold off parts of its auto business.

Big Shift

In August 2011, the company underwent a dramatic transformation to become a leading global water-technology company.

That month, it sold its electric motors business toRegal Beloit ( RBC ) for about $875 million and bought high-tech boiler maker Lochinvar for $418 million.

Lochinvar mainly makes what are called condensing boilers, high-efficiency machines that trap waste heat from gases used for heating water and re-use it to preheat cold water entering the boiler.

Today, A.O. Smith is the No. 1 seller of water heaters in China. It's also No. 1 in the U.S., where it has more than a 40% market share.

It sells under its own name as well as American Water Heaters, GSW, Lochinvar and other brands.

A.O. Smith is "doing a terrific job if compared to recent results of most industrial companies," Maczka said. "They have strong growth drivers to outperform the market."

BB&T initiated coverage of A.O. Smith on Sept. 22 with a buy rating and an 80 price target.

A.O. Smith's annual revenue grew from $1.49 billion in 2010 to $2.36 billion last year, and it's on track to record roughly $2.5 billion this year.

The company has reported double-digit revenue growth for the last three quarters in a row.

Over that period, it saw earnings per share grow 23%, 20% and 20% again last quarter vs. the same quarters a year earlier. Analyst consensus is for EPS to climb 34% in the current quarter.

KeyBanc Capital Markets analyst Jeff Hammond credits management, led by Ajita Rajendra, who took the reins as chief executive in January 2013 and was named chairman in April 2014.

"Ajita ... has done a fantastic job," Hammond said. "They've been able to continue to drive top-line margin growth, and they've been disciplined capital allocators."

Hammond put an overweight rating and an 80 price target on A.O. Smith.

The company's stock, which is on the IBD 50 list of top-rated issues, rose to an all-time high at 77.43 on July 23 before consolidating amid the market correction.

On its second-quarter earnings call on July 23, the company raised its 2015 EPS guidance by 30 cents, to $3.04 to $3.09. The midpoint of the updated guidance represents a 26% increase over its 2014 EPS.

A.O. Smith sells and distributes in more than 60 countries, and from its own stores in some of them.

Rajendra told analysts on an earnings call that "We continue to expect strong, profitable growth in China," where A.O. Smith is seen as an aspirational brand.

The company competes in China against Hong Kong-based Haier, German manufacturing giantSiemens ( SIEGY ) and others. A.O. Smith is sold via more than 7,000 outlets in China, about a quarter of them A.O. Smith specialty stores. Hammond said that A.O. Smith plans to open 400 more stores there in the next few years.

In the U.S., it competes with privately held Rheem and Bradford White.

Rajendra said that he expects continued global "market share gain, expanded distribution, improved product mix and significant water-treatment product growth."

In the U.S., sales are rising as consumers replace aging water heaters with more efficient models, including tankless water heaters that continuously provide hot water, generally at a lower cost than traditional tank water heaters.

The federal government is spurring the move to energy-efficient water heaters. In April, the government enacted revised standards under the National Appliance Energy Conservation Act (NAECA).

A.O. Smith offers products such as its Voltex hybrid electric-heat pump water heaters, designed "to dramatically decrease the cost of operation, which translates into significant savings for the homeowner," the company said.

Noted Hammond: "With those higher-efficiency water heaters come higher prices. So, on average, based on higher input costs, bigger units and more technology, they have increased prices," leading to higher profits, he said.

Room To Grow

In 2009, the company entered the water purification industry with a new venture, A.O. Smith (Shanghai) Water Treatment Products. That company supplies reverse osmosis water treatment and filtration products in China and exports them throughout the world.

Hammond says that A.O. Smith has a long growth runway in the U.S., China and other markets.

In the U.S., for example, "homebuilders built a lot of homes in the five years leading up to 2007. Water heaters typically last 12 to 14 years, so many of them are starting to hit that point where they need to be replaced," he said.

To keep up with growing demand, on Aug. 25, A.O. Smith broke ground on a 20,000-square-foot addition to its Florence, Ky., plant, which will increase the size of that facility by 40%.

"If you look at the data," plant manager Glenn Pfendt said, "our output has been increasing 15.3% per year since 2000, or a 638% overall increase."

And that growth is expected to continue for at least the next three to five years, he said.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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