by CatLane
Introduction
When individuals consider dividend aristocrats, they most of the time consider previous, mature corporations with first rate yields and low development charges. That may be a cheap assumption, as mature corporations, most of the time, include larger dividend yields and slower development. Nevertheless, there are some exceptions. The Milwaukee, Wisconsin, primarily based A. O. Smith Company (NYSE:AOS) has raised its dividend for 30 consecutive years. Nevertheless, as an alternative of slowing down, the corporate maintains a double-digit long-term dividend development price, speedy free money movement development, a wholesome stability sheet, and a enterprise mannequin that can greater than doubtless present outperforming capital positive aspects the second the housing market rebounds.
On this article, we’ll talk about all of that as I am going to make an funding case for two.0%-yielding AOS shares.
So, bear with me!
What’s AOS?
A. O. Smith is likely one of the oldest corporations I’ve ever mentioned on In search of Alpha. The corporate’s historical past goes again to 1874 when it was based by Charles Jeremiah Smith as C.J. Smith and Sons. Again then, the corporate was a child carriage and bicycle components producer.
Within the Nineteen Sixties, it opened a industrial water heater and boiler plant in Stratford, Ontario. By 1969, the corporate had produced its 10-millionth residential water heater. This enterprise is now the core of the corporate.
On a facet notice, I simply skipped nearly 100 years of the corporate’s historical past. When you’re within the particulars, the corporate’s Wikipedia web page is really fascinating because it reveals how some corporations rework and adapt to new applied sciences and innovation.
Quick ahead, we’re now coping with an organization that employs near 14,000 individuals with worldwide operations. The corporate has one working phase, which is water heaters, boilers, tanks, and water remedy. AOS sells these in its two areas: North America (71% of 2021 gross sales) and the remainder of the world.
A. O. Smith Company
The remainder of the world phase primarily covers China, Europe, and India. These segments primarily manufacture and market of their respective areas of the world.
In China, the corporate has been working for greater than 25 years. The Chinese language water heater market is predominantly comprised of electrical wall-hung, fuel tankless, combi-boiler, warmth pump, and photo voltaic water heaters. The corporate believes it is likely one of the main suppliers of water heaters and reverse osmosis water remedy merchandise to the residential market in China in greenback phrases.
In the USA, the corporate gives a variety of water heaters, boilers, and water remedy merchandise. In 2016, AOS purchased Aquasana, which added water remedy publicity to the OAS portfolio. Since then, the corporate has purchased a number of different corporations to develop its operations on this key trade centered on water high quality.
A Quick-Rising Dividend Aristocrat
A dividend aristocrat is an organization that has hiked its dividend for at the least 25 consecutive years. A. O. Smith is in that class with greater than 30 uninterrupted dividend hikes.
There are a number of the reason why dividend aristocrats are so particular and useful for long-term wealth technology.
In line with S&P World (SPGI):
“Dividends play an necessary position in producing fairness whole return. Since 1926, dividends have contributed roughly 32% of whole return for the S&P 500, whereas capital appreciations have contributed 68%. Due to this fact, sustainable dividend earnings and capital appreciation potential are necessary elements for whole return expectations.
Throughout the entire time horizons measured, the S&P 500 Dividend Aristocrats exhibited larger returns with decrease volatility in contrast with the S&P 500, leading to larger Sharpe ratios.”
This evaluation is smart, as I’ve typically made the case that the power to pay a dividend is a stamp of approval. Surviving in a aggressive enterprise atmosphere is hard. Letting traders profit by common money funds within the type of dividends is not straightforward.
Nuveen
Dividend development corporations exhibit a particular capacity to thrive. The market rewards that with long-term outperformance and subdued volatility as traders choose to promote lower-quality shares throughout bear markets.
With that stated, AOS is an outperformer. Going again to 1986, the inventory has returned 13.4%. This beats the S&P 500 by roughly 300 foundation factors per 12 months. Whereas AOS outperforms the market fairly constantly, it isn’t a low-volatility inventory. That’s solely primarily based on its cyclical enterprise mannequin, which depends upon housing demand and associated monetary indicators. Therefore, the inventory is underperforming the market on a 3/5-year foundation as the info under reveals. This underperformance began in early 2022 when the market peaked. Since then, the inventory has misplaced roughly a 3rd of its market cap. However extra on that later.
Portfolio Visualizer
With that in thoughts, AOS shares presently pay a dividend of $0.30 per share per quarter. That is $1.20 per 12 months, which interprets to a dividend yield of two.0%.
Whereas 2.0% is not a excessive yield,it is larger than the “common” dividend aristocrat and dividend development inventory yields.
ProShares S&P 500 Dividend Aristocrats ETF (NOBL): 1.9% yield
Vanguard Dividend Appreciation Index Fund (VIG): 1.8% yield
Furthermore, the corporate’s In search of Alpha dividend scorecard reveals a whole lot of inexperienced. The corporate scores very excessive on dividend consistency (it is a dividend aristocrat) and dividend development and considerably excessive on security and yield.
In search of Alpha
The “A” dividend development rating may be defined by a 10-year common annual compounding dividend development price of 20.3%. The commercial sector median is 7.9%. On a five-year foundation, these numbers drop to fifteen.3% and seven.5%, respectively.
Information by YCharts
With that stated, the corporate’s dividend development is not simply excessive, it is also very sustainable.
Because the overview under reveals, the corporate’s capital priorities are:
Natural development by investments in its enterprise segments and capabilities.
Acquisitions so as to add new capabilities.
Dividends are anticipated to develop steadily after the corporate has taken care of natural and bought development.
Extra money can be utilized on share repurchases.
A. O. Smith Company (Creator Annotation)
Whereas it’s not possible to include future acquisitions into monetary expectations, we will show capital expenditures (natural development) and the corporate’s debt place. What you are taking a look at under is the corporate’s free money movement, CapEx, and internet debt. Free money movement is money an organization can spend on dividends, buybacks, and debt discount after it has taken care of funding wants (CapEx necessities). As the corporate’s CapEx necessities have remained very secure all through the previous few cycles, the corporate can flip larger working development into excessive free money movement.
Between 2012 and 2024E, the annual compounding income development price is 5.8%. Normalized internet earnings is rising by 11.0% CAGR. Free money movement is rising by 17.7% CAGR. Which means that the corporate is more and more environment friendly with regards to turning larger development into even larger money technology. That’s nice information for all events concerned.
It additionally helps the corporate’s goal to keep up sturdy, double-digit dividend development.
Furthermore, the corporate has adverse internet debt, which implies AOS has more money than gross debt on its stability sheet. As analysts usually are not incorporating buybacks into their fashions, internet debt is predicted to fall into deeper adverse territory within the years forward.
That stated, if we assume that the corporate can do $509 million in FCF in 2023, it will indicate a 5.4% FCF yield utilizing its $9.5 billion market cap. This not solely covers its 2.0% dividend yield but in addition leaves a whole lot of room for buybacks. In line with the corporate:
The energy of our stability sheet permits us to keep up our sturdy monitor file of delivering returns to shareholders. This has been executed by each our dividend that we’ve elevated for 30 consecutive years in addition to share repurchases which have totaled $650 million for the reason that starting of 2021.
Over the previous ten years, the corporate has repurchased 17% of its shares excellent. This helped to show 230% internet earnings development into 288% earnings per share development.
Information by YCharts
With that stated, let’s dive into the valuation.
Valuation
AOS shares are up 7% this 12 months, however down 26.5% over the previous 12 months.
FINVIZ
Weak spot began in early 2022 when traders began to cost in a a lot weaker housing market. The chart under compares the AOS inventory value to constructing permits.
TradingView (AOS, Constructing Permits)
Because the free money movement chart on this article confirmed, the ultimate outcomes for 2022 are anticipated to point out a weaker 12 months. In its North America phase in 3Q22 (the newest quarter), the corporate generated 1% decrease gross sales as volumes precipitated a $100 million headwind. Adjusted working earnings had been down as inflation precipitated extra headwinds, pressuring margins.
A. O. Smith Company
In the remainder of the world, gross sales had been down 13% because of decrease Chinese language volumes, which greater than offset 16% development in India. Working earnings fell from $27 million to $22 million as a result of aforementioned weak point in Chinese language orders.
The Chinese language reopening is nice information for the corporate as it’d enhance volumes within the quarters forward.
On a full-year foundation, the corporate expects at the least 5% income development.
We mission income development for 2022 of 5% to 7%, which is decrease than our outlook in July because of softer-than-expected demand in residential water heating. Our gross sales assumptions embody, after roughly 8% development in every of the final two years, which is nicely above the historic common development price, we estimate U.S. residential water heater trade unit volumes will probably be down roughly 12% to 13% on final 12 months as clients rightsize their inventories and trade demand normalizes.
This 12 months, the corporate is predicted to generate $740 million in EBITDA, which suggests 2.7% EBITDA development after 1.5% anticipated development in 2022. The corporate is buying and selling at 12.3x 2023E EBITDA primarily based onits $9.1 billion enterprise worth (market cap plus internet money).
This valuation could be very truthful and nicely under the longer-term median near 13x NTM EBITDA.
Given the financial circumstances, I consider that AOS is a good purchase near $50. At that time, I’d purchase in intervals, which means including steadily over time. If the housing market continues to weaken, traders will doubtless be capable of common down. If the inventory market all of the sudden takes off, traders have a foot within the door.
Takeaway
A. O. Smith is an amazing long-term compounder. The corporate is working in a mature enterprise, however able to excessive development due to its portfolio of superior heaters, boilers, and water remedy merchandise. Due to this, the corporate can defend its standing as a dividend aristocrat with double-digit annual dividend hikes. These are backed by excessive and fast-rising free money movement, a wholesome stability sheet, and administration’s willingness to let shareholders profit.
The one downside is that AOS suffered from provide chain points and Chinese language lockdowns. Now, the corporate can also be being pressured by weakening housing demand, which is able to doubtless be a subject of debate within the subsequent earnings name.
Whereas I consider that AOS will stay rangebound as a result of macroeconomic challenges, I’ve little doubt that the inventory will outperform the market on a long-term foundation and get away as quickly as demand bottoms. I count on that to occur within the second half of this 12 months.
(Dis)agree? Let me know within the feedback!
