A. O. Smith Has Some Attractive Growth Angles, But The Valuation Isn't A Clear Bargain

 

A.O. Smith (AOS) could be one of my case-in-points as to why I think both quality and price/value matter. I’ve never seen any serious arguments that A.O. Smith isn’t a high-quality, well-run company with decent growth prospects, but I wasn’t excited about the valuation back in early 2018 and the shares have meaningfully lagged the broader industrial space since then (by over 20%), not to mention water plays like Watts (WTS) and HVAC names.

I do still like A.O. Smith’s leverage to growth opportunities in markets like China and India, and I likewise think there is a path for A.O. Smith to become more of an ESG story with its U.S. operations through both more efficient water heaters (and boilers) and a growing water treatment business. The main issue remains valuation, as even a premium valuation based upon the company’s superior returns (margins, ROIC, ROTA, et al) doesn’t suggest significant undervaluation today.

 

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A. O. Smith Has Some Attractive Growth Angles, But The Valuation Isn't A Clear Bargain

Leadership In China Driving A Bright Future At A.O. Smith

A.O. Smith (AOS) doesn't try to do everything, but focusing on doing what it does with a high degree of operating excellence has produced great results for shareholders - the market returns over the past five and 10 years have been well ahead of the norms for other appliance companies like Whirlpool (WHR) or Electrolux (OTCPK:ELUXY), while revenue growth, margin leverage, and returns on capital stack up very favorably as well.

That's great and all, but that's in the past right?

I expect that A.O. Smith's North American business will remain a mid-single-digit grower with very healthy margins, while exceptional growth from the company's efforts in China (and, further down the road, India) should keep overall revenue growth in the high single digits for quite some time to come. A.O. Smith's excellence is well-represented in the share price, though, and it's tough to see how this is a bargain unless you have very bold expectations for future revenue growth and margin leverage.

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Leadership In China Driving A Bright Future At A.O. Smith

A.O. Smith Gets Out While The Getting Is Good

It looks like ABB (NYSE: ABB) has managed to shake up the electrical motors business. In the press release announcing a deal whereby A.O. Smith (NYSE: AOS) will sell its motors business to Regal-Beloit (NYSE: RBC), AOS tacitly acknowledged that industry consolidation, and this recent deal between ABB and Baldor Electric (NYSE: BEZ), has made it too difficult to continue on with their own efforts. Facing up to reality and making the best of the situation, AOS is getting a pretty decent going-away prize for this business.

The two companies announced that Regal-Beloit would buy AOS's motors business for $875 million in a combination of cash ($700 million) and stock ($175 million). That is a healthy multiple (1.4x trailing sales) for a business that was the #4 player behind Emerson (NYSE: EMR), Regal-Beloit, and Beldor and relied heavily upon replacement sales (75%) for its business. By comparison, Beldor sold out for about 1.9x sales - Beldor was far larger, more diversified, more leveraged to growth opportunities, and filled a key gap in ABB's motors business.

A.O. Smith management was a little cagey about their plans for the proceeds - talking about using the capital to expand the water products business into new markets and perhaps acquire other products/technologies in that sector. That's almost certainly not enough money to acquire Franklin Electric's (Nasdaq: FELE) water pumps business, but maybe the company would think of taking a run at a large target like Badger Meter (NYSE: BMI) if management felt especially ambitious. What is much more likely, though, is that AOS would target one or more of the numerous small private companies that are involved in heaters, boilers, or tanks - particularly those that have a good business in emerging markets like China or Brazil.

I give AOS management a lot of credit for having the humility and rationality to realize that ABB was putting them in a box that would make their business increasingly nonviable and unlikely to earn attractive returns on capital. That does not mean that it's an awful deal for Regal-Beloit. Quite the opposite actually. Regal-Beloit has the scale that AOS lacked (especially with this deal) and does not seem to be overpaying for what should be a leveragable business. I would expect RBC to able to integrate this deal fairly easily and make it accretive in relatively short order.

Win-win deals are not that common, and certainly seldom come from a major rival getting more active in the space. Nevertheless, ABB's efforts to grow its North American motor business may just end up helping these two companies out if A.O. Smith can put the capital to good use and Regal-Beloit can avoid the footfalls of the new giant.