A. O. Smith Corporation

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

A. O. Smith is a global manufacturer of residential and commercial water heating equipment and water treatment solutions, facing both cyclical and competitive industry challenges, though benefiting from its global presence.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

A. O. Smith’s business primarily revolves around water heating, which includes residential and commercial water heaters. They generate 75% of the revenue from North America and the rest of the revenue from China, India and Europe.

Business Overview:

A. O. Smith Corporation operates in two main segments:

  1. North America: The North American segment accounts for the majority of A. O. Smith’s revenue and specializes in water heaters, boilers, water treatment products, and expansion tanks for both residential and commercial markets.
  2. Rest of World: Primarily driven by China, this segment consists of residential and commercial water heaters for emerging and developed markets.
    • This segment also includes sales in India, Europe and other countries.

Geographically, the company’s revenue is split, with the majority (approx. 75%) coming from North America, which sells water heaters, boilers, etc. The remaining 25% of revenues come from other regions, like China, India, and Europe.

Competitive Landscape:

The water heater market is relatively fragmented, with varying degrees of competition in different regions. A. O. Smith faces competition from other large players and smaller, regional companies. However, they have maintained high share in certain market segments, for example, A. O. Smith is the market leader in the US residential water heater market.

  • In the past few years, they have also been competing for a larger share in the Chinese markets, and have made investments there to expand production and sales.

Margins:

  • A. O. Smith’s gross margins are solid (around 37-40%) but remain stable, with slight increases or decreases based on the geographical segment.
  • Operating income and profit margins are stable and well maintained (around 10-13%). However, these fluctuate based on input costs and regional conditions.
  • The reported income taxes are unusually lower, but they do account for tax-credits that reduce the tax payment.
  • Overall, they have decent margins and have been able to maintain them during a wide variety of industry conditions.

A. O. Smith has had a history of solid returns on equity (ROE), with an average of 22% in the last decade, which indicates efficient use of capital. The company has managed to have positive income in every single segment it is operational in. This displays strong operational management.

What Makes the Company Different

A. O. Smith differentiates itself through its premium brands such as Aquasana, Takagi and Lochinvar, and a focus on higher efficiency and advanced technology in their products. The company emphasizes providing water solutions across many countries and has a growing emphasis on digital products.

  • The Company has a strong position in North America, and with the help of a diverse product portfolio and a long history in the water heating business, its competitive position remains strong.

Financials Analysis

Based on the recent quarterly report ( Form 10-Q for the three months ended September 30, 2023), A. O. Smith had net sales of $932.6 million, which represents a modest increase from prior year. The company’s performance in China continues to be strong but slightly below the expectations and with lower than last year volumes. Overall, margins remain mostly unchanged.

  • The company also noted that it is being affected by inflationary pressures and is looking at ways to pass it on to its consumers.
  • The long-term outlook for the company remains strong, as they continue to develop their business and strengthen their international footprint.
  • A notable amount of stock buyback (2 million shares were bought in Q3 2023) was present in the recent quarterly report, showing commitment to returning cash to its shareholders.

Moat Assessment:

A. O. Smith has a Narrow Moat at 3/5. While it is not a truly dominant player in its industry segments, it has certain attributes that are important in developing a durable competitive position. Here’s a detailed explanation of why it is a narrow moat and not a wide moat:

Intangible Assets: While A. O. Smith does have strong brand recognition, it is not as prevalent as Coca-Cola or other “brand” companies. It uses its recognizable brands and positions them in markets where they have a strong presence (for example, Takagi in North America, and A. O. Smith in China), however, there is no evidence to show that the brand creates a premium in prices over other competitors with similar products. There is also no protection on these brands as competition has been increasingly aggressive. Therefore, a moat based on “brands” will not qualify as a very wide moat. - The company also has a decent level of patents for their products, mostly on their latest, high-efficiency models. Patent applications can prove a degree of protection in the long term. However, these patents are hard to enforce, and there are often workarounds made by competitors for those patents. Therefore, a “patent moat” would not be a wide one for the company, but at least it provides a small level of durability.

Switching Costs: Switching costs aren’t the strength of A. O. Smith’s competitive position, although they do play a role. Most people don’t change water heater or boilers often, so when people choose a brand, they tend to stick to that brand. But these switching costs are less for retailers than for other businesses.

  • The company, however, benefits from tight integration with their clients’ supply chain. They provide customized products, delivery, and maintenance. This creates a slight customer lock-in. In the OEM businesses, these switching costs can be more powerful for A. O. Smith than for retailers because there is an implicit level of service tied to the transaction.
**Network Effects:** The company does not benefit from any significant network effects, and, as a result, its customers are free to choose alternatives whenever they want.

**Cost Advantages:** The main strength for A. O. Smith's business can be attributed to a low cost structure in manufacturing. It is the leading manufacturer in the US and China, and this scale advantage gives it an edge over smaller competitors and regional players. They have invested heavily in automation and plant efficiency, and these operations help cut costs and improve profitability.
 - However, this cost advantage is not unassailable. It is still replicable by a competitor who makes similar investments. Although, the high level of investments makes this less likely.    - They also derive a slight cost advantage from the geographic locations of their plants. By making products in China and Mexico and selling them in the local markets, they can save a bit of costs related to shipping, tariffs, and other local regulations.

Therefore, given this evidence, they are not a truly wide moat company, but have a decent narrow moat because of their intangible assets and low cost of production.

Risks and Resilience:

While A. O. Smith presents a stable picture, legitimate risks and concerns remain, particularly in the short term.

  • Cyclical Nature: The water heating industry is tied to economic growth and housing activity. In slowdown periods, demand for water heaters and boilers tends to drop, which negatively impacts the company’s topline.
    • The company is particularly vulnerable to demand from the new construction industry, and as such, a housing slowdown can hurt their finances.
  • Commodity Prices: The company is exposed to raw material costs. Steel, copper, and aluminum make up significant portions of A.O Smith’s manufacturing input, and increases in commodity prices can negatively affect margins. To mitigate this, the company has to pass on these costs to the end customer, a move that can be detrimental in the short run.
  • Competition: The company faces increased competition from Asian manufacturers, especially in the Chinese market. Local regulations and government interventions are also a source of concern that may negatively impact business. Also, if a competitor can replicate the manufacturing processes, they may be able to challenge A. O. Smith.
  • Foreign Exchange: The company has significant operations in foreign countries, such as China and India. Currency fluctuations will have a direct impact on revenue and earnings, since the company converts revenues to the US Dollar. To mitigate this, the company actively uses hedging strategies, but these strategies have not always worked. For example, they recently took a foreign exchange loss of $42 million in Q3 2023.
  • Acquisitions: The company has had a recent history of acquisitions, mainly for its water treatment businesses. These acquisitions can cause problems in integration, and if not executed correctly, it can result in write-downs and lower returns.

Despite the above, the company has a diverse and relatively well-managed business. If they are able to execute their operational expansion plans in new markets successfully, and manage the volatility of the commodity market, then A. O. Smith may be able to retain its position as a reliable player in the water heating sector. The strength of their balance sheet can also help them during downturns.

Understandability Assessment:

A. O. Smith has an Understandability rating of 2 / 5. While its core business—water heating—is easy to understand, complexities arise in the international operations, customer segmentation, multiple business lines, and the accounting for operations in foreign currencies. Also, the technical details behind some of the product lines and the industrial processes are harder to comprehend. The business model is a bit hard to wrap your head around fully.

Balance Sheet Health Assessment:

A. O. Smith has a Balance Sheet Health Rating of 4 / 5. The company is very well-managed in terms of its finances. Here are the details:

  • They maintain a low debt to equity ratio (around 0.3 in 2023), indicating that it does not rely too heavily on debt for funding.
  • Their debt is rated A3 by Moody’s, and their long term debt is approximately one-third of their assets, which signifies financial soundness.
  • Their cash reserves are substantial (over $1.5 billion), which is a sign of a robust safety net.
  • The current ratio and quick ratio are also high and above 1, indicating short term solvency.
  • Their quick ratio is very similar to their current ratio (which implies minimal inventory), and so the company’s assets can be quickly converted to cash.

Recent Concerns

The main concern faced by the company in the recent quarter is the softening demand in China due to the ongoing economic slowdown. While the company is seeing growth in volumes, they are facing margin pressures due to high input costs. The company also has seen some supply-chain disruptions.

  • The management has stated that they are looking at ways to tackle these issues by cost-cutting and by improving efficiencies in operations.
  • They have also shown confidence in their growth plans, and have shown positive guidance for their future quarters.
  • The company also mentioned that they had a one-time effect of their Chinese COVID situation, and are expecting growth in subsequent quarters.