Headquartered in Milwaukee, where it was founded over 140 years ago, A.O. Smith Corporation (NYSE:AOS) is a leading manufacturer of residential and commercial water heaters, boilers, and water treatment products. The company derives about 60% of its sales from water heaters in North America. This is an attractive market, with only three major players that have demonstrated a history of rational pricing policies. A.O. Smith is the largest participant with more than a 40% share in residential heaters and a 55% share in commercial heaters. Few homeowners or businesses consider hot water to be a discretionary item; generally a heater is replaced as soon as it breaks, and price is often a secondary consideration. As a result, the bulk of the company’s heater sales are comprised of steady replacement revenue (85% to 90% of residential sales). Additional growth comes from new housing starts, commercial construction, and customers’ desire for new products with increased energy efficiency.
An additional 10% of A.O. Smith’s sales come from its North American boiler business, Lochinvar, which is expected to grow 8% per year, driven by the increased adoption of more energy efficient products. The remaining 30% of A.O. Smith’s sales come from China, where the company has established a dominant presence over the past 20 years. Sales in China are anticipated to grow 15% per year, anchored by its 26% market share in the Chinese water heater market. In China, water heaters are a considered a consumer appliance and A.O. Smith has built a premium brand, along with impressive distribution and manufacturing capabilities. The company is also entering nascent, faster growing product categories such as water treatment and air purification to expand its growth there.
The company expects to achieve 8% top-line growth over the next several years. We believe that earnings growth should be faster, as a result of margin expansion from price increases, operating leverage, and the accretive use of its substantial free cash flow.
From Barron Asset Fund fourth quarter 2016 commentary.
