There's nothing subtle about the products that underpin A. O. Smith's (NYSE: AOS) business. Take one ice-cold shower and you'll quickly appreciate how desirable the company's water heaters are. But there's an interesting story underneath all this that investors need to know. That's because the emerging markets of China and India are key to the company's growth.
You will buy another one
North America makes up around 75% of A. O. Smith's top line. This is a mature market that is very used to having hot water available at the turn of a faucet. Although demand from the construction market isn't immaterial, the real driving force for the company is replacement sales. Simply put, if your water heater breaks, you will almost instantly get on the phone to try to get it replaced.
Image source: Getty Images.
It makes sense. Taking a hot shower is just something you've grown accustomed to and are unlikely to be willing to do without, at least not for an extended period of time. That's not the situation in emerging markets like China and India. In these countries, where residents are still moving up the socioeconomic ladder, hot water is more of an affordable luxury. As soon as people can buy a water heater, well, they do. And then, like you, they don't want to give it up. A. O. Smith's "rest of world" segment, which largely consists of China and, to a smaller degree, India, makes up the remaining 25% of the company's top line.
So the big story for A. O. Smith is that it has a fairly predictable core business -- i.e., North America -- that underpins its faster-growing operations in emerging markets. It's not a bad balance for an industrial stock with a somewhat focused product portfolio. That said, China has been a bit of a weak spot over the past year or so. But that appears to be changing, with second-quarter earnings in the rest-of-world segment jumping 56% thanks to a demand recovery in that giant country. In fact, that recovery helped to power A. O. Smith's adjusted earnings to a new record.
The company is getting back on track
This is important because China was a real drag on the company's results in recent quarters. In 2022, the company's rest-of-world segment saw a 7% sales decline because of China. Even the 28% sales growth (in constant currency) in India couldn't offset that given the size of the company's exposure to China. Notably, in the second quarter, India remained strong with 15% year-over-year (constant currency measured) sales growth. So the important story for A. O. Smith is really the recovery of the Chinese market.
With China and India both heading in a good direction, A. O. Smith's growth engine is starting to hit on all cylinders again. Investors have picked up on this fact, pushing the shares up notably from recent lows. Yet the shares are still off 15% from their most recent high-water mark. What should investors make of the stock given that backdrop?
The company's price-to-sales, price-to-book, and price-to-cash flow ratios are all a little above their five-year averages. The price-to-earnings ratio is notably above its longer-term average, but one-time charges in the first quarter of the year make that ratio a bit harder to read. In all, A. O. Smith doesn't look cheap, but it doesn't necessarily look wildly overpriced, either.
AOS Dividend Yield data by YCharts
The dividend yield of 1.6%, meanwhile, is toward the higher end of the stock's 10-year yield range. That's not a huge figure, but the average annualized growth rate over the past decade was a very attractive 19%. More recent figures have been in the high single digits, which is still pretty solid given the headwinds from China of late. Yet paying full fare for a dividend growth stock that looks like it's starting to get its mojo back isn't the worst thing you could do.
Not an easy decision with A. O. Smith
If you're a value investor, you won't find A. O. Smith stock to be attractive at current prices. However, if you're on the lookout for dividend growth stocks or are fond of a growth and income investment approach, you might want to do a deep dive. When China was in the dumps, the stock was more attractively priced because of the uncertainty of a turnaround in that country. Now that China appears to be getting back on track, investors have responded by bidding A. O. Smith's shares higher again. Yet they don't seem drastically overvalued for those willing to pay full fare for a company with a great dividend track record and still desirable growth prospects in the world's largest emerging markets.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends A.O. Smith. The Motley Fool has a disclosure policy.
