A. O. Smith: A Durable Business with Strong Recurring Demand

A. O. Smith is a leading manufacturer of water heating and water treatment solutions, with a business model driven by recurring demand, innovation, and global expansion. As the dominant player in North America’s water heater market and a growing force in international markets, the company benefits from essential product demand and a strong distribution network. With a focus on energy efficiency, emerging markets, and strategic acquisitions, A. O. Smith is positioning itself for long-term growth. The question remains: Should this industrial leader have a place in your portfolio?

This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

For full disclosure, I should mention that I do not own any shares in A. O. Smith at the time of writing this analysis. If you would like to copy or view my portfolio, you can find instructions on how to do so here. If you want to purchase shares or fractional shares of A. O. Smith, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $50.

The Business

A. O. Smith Corporation is a leading global manufacturer of water heating and water treatment solutions, serving residential, commercial, and industrial markets. With a legacy spanning more than 150 years, the company has established itself as a trusted brand recognized for innovation, quality, and reliability. It holds the largest market share in North America for both residential and commercial water heaters and boilers, supported by an 80%–85% replacement-driven business model. This recurring demand provides A. O. Smith with stable and predictable revenue streams, making it highly resilient across economic cycles. The company’s strong customer partnerships, built over decades, reinforce its market leadership with major wholesalers, plumbing distributors, and retailers such as Lowe’s. A. O. Smith has built a competitive moat through a combination of market leadership, essential product demand, an extensive distribution network, and brand strength. Its well-recognized brands, including A. O. Smith, State, and Lochinvar, are trusted by contractors, homeowners, and businesses. In China, where the company has operated for 30 years, it holds a leadership position in premium water heaters and reverse osmosis water filtration. The essential nature of its products ensures steady demand, as customers cannot delay or forgo replacing water heaters and boilers. With a typical replacement cycle of 10 to 15 years, A. O. Smith benefits from a recurring revenue stream that is largely insulated from economic fluctuations. Its extensive distribution network further strengthens its competitive position. In North America, the company maintains strong wholesale partnerships with 900 independent plumbing distributors and is the exclusive supplier of A. O. Smith-branded water heaters to Lowe’s. In China, its products are available in 9,400 retail locations, including 1,600 exclusive stores. These well-established relationships with key retail and wholesale partners create a significant barrier to entry, making it difficult for new competitors to replicate A. O. Smith’s scale and reach.

Management

Kevin J. Wheeler serves as the Chairman and CEO of A. O. Smith Corporation. He was appointed CEO in September 2018 and later assumed the additional role of Chairman of the Board on May 1, 2020. Under his leadership, A. O. Smith has reinforced its position as a global leader in water heating and water treatment solutions, with a strong emphasis on long-term strategic growth, operational efficiency, and shareholder value. Kevin J. Wheeler has been with A. O. Smith for over 30 years, having joined the company in 1994 as a regional sales manager. Over the years, he has held a variety of leadership roles, gaining deep expertise in both domestic and international markets. His contributions have been instrumental in expanding A. O. Smith’s business in China, strengthening its retail presence in North America, and advancing the company’s global water treatment initiatives. Before becoming CEO, he served as President and Chief Operating Officer, overseeing the company’s water heater, boiler, and water treatment businesses worldwide. Beyond A. O. Smith, Kevin J. Wheeler plays an active role in the broader business and manufacturing community. He serves as a director of Graco Inc. and is a member of the Manufacturers Alliance Board of Trustees. He has also held leadership positions in the Air-Conditioning, Heating, and Refrigeration Institute. He holds a bachelor's degree from the University of Nevada, Reno, and completed the Advanced Management Program at Harvard University. Kevin J. Wheeler has emphasized a long-term strategic approach to A. O. Smith’s growth, prioritizing sustainable profitability over short-term gains. This philosophy is evident in the company’s recent decisions to restructure parts of its North American water treatment business, a move designed to improve competitive positioning and enhance profitability despite short-term revenue declines. With his extensive experience, deep industry knowledge, and commitment to strategic investments, I believe that Kevin J. Wheeler is the right person to lead A. O. Smith moving forward.

The Numbers

The first number we will look into is the return on invested capital, also known as ROIC. We want to see a 10-year history, with all numbers exceeding 10% in each year.  A. O. Smith exceeds expectations, having consistently delivered a ROIC above 15% every year over the past decade, with seven of those years surpassing 20% - a remarkable achievement. These consistently high returns indicate a strong competitive advantage and effective capital allocation. It is particularly encouraging that A. O. Smith has achieved its highest ROIC in the past two years. While ROIC decreased slightly in 2024 due to lower water heater sales volumes and macroeconomic challenges, particularly in China, these headwinds appear to be temporary. Given the company's long history of strong returns and resilience, this is not a major concern. The ability to sustain high returns on capital over an extended period suggests that A. O. Smith is a long-term compounder. Its disciplined approach to capital allocation and strong market positioning enable it to generate attractive returns, reinforcing its potential for continued value creation over time.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. A. O. Smith has had some years where equity has declined but has managed to grow its equity in seven out of the past ten years. It is encouraging that equity reached its highest level ever in 2024, as this reflects the company's ability to generate sustainable earnings, reinvest in its business, and return capital to shareholders while maintaining financial strength. The fact that equity has continued to grow despite occasional short-term challenges demonstrates A. O. Smith’s resilience.

Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins offer a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is not surprising that A. O. Smith has consistently delivered positive free cash flow in every year over the past decade. In 2024, both free cash flow and levered free cash flow declined slightly, primarily due to lower water heater sales volumes and record-high capital expenditures. Management has emphasized that these elevated capital expenditures are part of a strategic effort to ensure A. O. Smith has the right product portfolio and production capacity to maintain its leadership across all the markets it serves, ultimately maximizing value for shareholders. While capital expenditures are expected to remain above 2023 levels, management projects a decline in 2025 and anticipates free cash flow in the range of $500 million to $550 million. As A. O. Smith continues to grow its free cash flow, investors should benefit, given the company’s commitment to both dividends and share repurchases. It has raised its dividend for more than 30 consecutive years while also reducing shares outstanding by more than 17% over the past decade. Management further expects to reduce shares outstanding by an additional 2% in 2025, believing the stock remains undervalued. The free cash flow yield is currently at its highest level since 2020, suggesting that A. O. Smith shares are trading at a more attractive valuation than they have in recent years. However, we will revisit valuation later in the analysis.

Debt

Another important aspect to investigate is the level of debt, specifically whether a business has a manageable debt load that can be paid off within a period of three years. We assess this by dividing total long-term debt by earnings. After calculating A. O. Smith’s debt levels, I found that the company has no debt. Given this, debt is not a concern when considering an investment in A. O. Smith. In fact, the company has not carried more than three years’ worth of earnings in debt since 2017, and there is nothing to suggest that debt will become an issue in the future.

Exclusive Discounts on Seeking Alpha – Elevate Your Investing Today!

For those serious about investing, here's your chance to upgrade your strategy with exclusive offers you won't find anywhere else. These special discounts are available only through the links below—don’t miss out!

1. Seeking Alpha Premium: Access comprehensive financial data, earnings transcripts, in-depth analysis, market news, and more. Perfect for investors who want an edge in making informed decisions.

   Special Price: $269/year (originally $299) + 7-day free trial.

   Sign up for Premium here.

   
   

2. Alpha Picks: Get stock recommendations from a portfolio that gained +177% compared to the S&P 500's +56% from July 2022 through the end of 2024.

   Special Price: $449/year (originally $499).

   Sign up for Alpha Picks here.

   
   

3. Alpha Picks + Premium Bundle: The ultimate investment package with a $159 discount!

   Special Price: $639/year (originally $798).

   Get the Bundle here.

   
   

I use Seeking Alpha daily for its reliable insights and actionable strategies. These deals are available exclusively through my links, so take advantage of them now to level up your investment journey!

Act quickly - these prices won't last forever!

Risks

Macroeconomic conditions pose a significant risk to A. O. Smith, as its business is influenced by factors such as consumer confidence, construction activity, inflation, and broader economic cycles. While the company benefits from a high level of recurring demand due to its replacement-driven business model, portions of its revenue are tied to more cyclical markets, such as new housing construction and commercial capital expenditures. During periods of economic downturn or recession, consumers and businesses may delay discretionary purchases, including upgrades to energy-efficient water heaters, boilers, and high-quality water treatment products. If economic uncertainty slows new housing construction, demand for A. O. Smith’s products could decline. In 2024, for example, softness in the housing market and cautious consumer sentiment contributed to lower sales volumes in North America. In commercial markets, businesses may postpone renovations or expansion projects that require new heating and water treatment installations, further impacting demand. Macroeconomic risks extend beyond North America, as A. O. Smith has a meaningful presence in China, where economic conditions remain uncertain. A prolonged slowdown in China’s property market or a decline in consumer confidence could weigh on demand for premium water heaters and water treatment products. Another risk is the cautious approach taken by wholesalers and distributors in response to economic uncertainty. If businesses remain conservative in managing their inventories, A. O. Smith’s sales could be temporarily impacted even if underlying consumer demand remains stable. Entering 2025, management has noted that customers are taking a cautious stance, closely monitoring inventory levels and sell-through rates before committing to larger orders.

Competition is a key risk for A. O. Smith, as the company operates in highly competitive and evolving markets. It competes based on factors such as product design, reliability, quality, advanced technologies, and price. While A. O. Smith holds a leading market position, it faces competition from both established players and emerging challengers, particularly in water heaters and water treatment. Some competitors have greater financial, marketing, manufacturing, and research and development resources, allowing them to scale more aggressively or invest more heavily in innovation. Others primarily compete on price, undercutting A. O. Smith in certain product categories, especially in commoditized segments where differentiation is lower. The competitive landscape is particularly intense in water treatment, where A. O. Smith competes with established players such as Pentair and Culligan. The industry is fragmented, with numerous regional and international companies offering a wide range of filtration and purification solutions. If competitors expand their manufacturing capabilities or geographic reach, A. O. Smith may face increased pressure in key growth markets like China and India. Pricing pressure is another challenge, as heightened competition can force price reductions, particularly in segments with limited differentiation. A. O. Smith’s ability to sustain its premium pricing strategy depends on continuous innovation and brand strength. If competitors introduce lower-cost alternatives with similar perceived quality or performance, A. O. Smith may need to adjust pricing or increase promotional efforts, which could weigh on margins.

Material and component price volatility poses a significant risk to A. O. Smith, primarily due to its reliance on steel and other key inputs for manufacturing water heaters, boilers, and water treatment products. Steel, a major component of water heater tanks, is subject to price fluctuations that can directly impact production costs. While A. O. Smith has contractual agreements with some customers that allow for cost pass-throughs, these mechanisms do not fully mitigate the risk. When input costs rise rapidly, as seen during the 2021–2022 supply chain disruptions, the company may experience margin compression if it cannot adjust pricing quickly enough to offset higher costs. Another challenge is the time lag between rising material costs and A. O. Smith’s ability to pass these costs on to customers. Historically, the company has faced delays in adjusting its pricing, meaning temporary spikes in raw material prices could negatively impact profitability before higher costs are reflected in customer contracts. Additionally, aggressive competition within the industry may limit A. O. Smith’s ability to fully pass on cost increases, further pressuring margins. Supplier concentration adds another layer of risk. A. O. Smith relies on a limited number of suppliers for certain critical materials and components. If a key supplier experiences disruptions due to production issues, financial instability, or geopolitical factors, A. O. Smith could face manufacturing delays, increased costs from switching suppliers, or difficulty securing materials at favorable prices. These disruptions could lead to production slowdowns, inventory shortages, or higher operating costs, all of which could negatively impact the company’s financial performance.

Reasons to invest

Favorable long-term trends provide strong tailwinds for A. O. Smith, making it an attractive investment. The company is well-positioned to capitalize on several global megatrends, including energy efficiency, decarbonization, clean water demand, and demographic-driven housing growth. Regulatory shifts and environmental awareness are accelerating the transition toward energy-efficient water heating and boiler systems. Governments and businesses are increasingly prioritizing sustainability, with net-zero targets driving investment in clean energy and high-efficiency technologies. A. O. Smith is benefiting from this shift as commercial buildings seek to reduce their carbon footprint by replacing older, inefficient systems with modern, energy-efficient boilers. The growing demand for clean, accessible water is another major driver of long-term growth. Poor global water quality, coupled with rising consumer awareness of water purification systems, continues to support strong demand for A. O. Smith’s water treatment products. Demographic and housing market trends in the U.S. further reinforce A. O. Smith’s long-term prospects. The country faces a significant housing shortage, with estimates indicating a shortfall of 4,9 million homes over the past two decades. Industry experts suggest that approximately 1,5 million new homes need to be built annually to meet demand. Additionally, the Millennial generation - 72 million strong - is now entering prime home-buying age, which should further fuel residential construction. Since water heaters are an essential household product, homeowners will continue replacing units as they reach the end of their life cycle, providing A. O. Smith with a steady and recurring revenue stream. These structural trends position A. O. Smith for sustained growth. Its leadership in energy-efficient boilers, water heaters, and water treatment solutions aligns with long-term regulatory and consumer-driven shifts, ensuring the company remains well-positioned to benefit from evolving market dynamics.

Emerging markets present a compelling growth opportunity for A. O. Smith, particularly in China and India, where rising incomes, urbanization, and increasing demand for clean water and energy-efficient appliances provide strong long-term tailwinds. The company’s well-established brand presence, extensive distribution network, and ability to tailor products to local market needs position it well to capitalize on these trends. China remains a key market for A. O. Smith, despite recent economic challenges. With over 30 years of operations in the country, the company has built strong brand recognition, a broad distribution network, and a leadership position in water heating and water treatment. While the Chinese economy is currently facing weak consumer confidence and a sluggish property market, A. O. Smith is taking proactive steps to streamline costs and optimize its business structure. The company’s restructuring efforts aim to position it for profitable growth once economic conditions improve. Additionally, A. O. Smith is expanding its product portfolio in China, moving into adjacent categories to strengthen its competitive positioning. Despite near-term headwinds, the country’s long-term fundamentals remain attractive, with ongoing urbanization, a growing middle class, and increasing consumer focus on high-quality water and heating solutions. India is emerging as an important growth driver for A. O. Smith, with its operations in the country outperforming the broader market. The combination of a large and expanding middle class, rising awareness of water safety, and demand for modern home appliances creates a favorable market environment. India’s GDP is projected to grow at 6% or more in the coming years, supported by rapid urbanization and infrastructure development. A. O. Smith is actively expanding its product offerings in India, introducing innovative solutions that combine technology, aesthetics, and advanced features. With a broad and growing distribution network, the company is well-positioned to capture additional market share. Management expects mid-teen revenue growth in its legacy India business as it continues to expand its presence.

Acquisitions are a key pillar of A. O. Smith’s long-term growth strategy, enabling the company to expand its market presence, enhance its product portfolio, and strengthen its competitive positioning. The company has a strong track record of successful acquisitions, particularly in water treatment, which have diversified its revenue streams and allowed it to capitalize on the growing global demand for clean water solutions. One of A. O. Smith’s most recent acquisitions, Pureit, underscores this strategy. Acquired from Unilever, Pureit significantly enhances A. O. Smith’s presence in India and South Asia, one of the fastest-growing markets for water purification solutions. The acquisition effectively doubles the size of A. O. Smith’s water treatment business in India and elevates it to the number three position in the market. This move strengthens the company’s foothold in a high-growth region where rising incomes, urbanization, and increased awareness of water safety are driving demand. Beyond Pureit, A. O. Smith has demonstrated a disciplined and strategic approach to acquisitions, focusing on businesses that align with its expertise in water technology. In North America, the company has built a comprehensive suite of water softeners, filtration systems, and purification solutions through a series of acquisitions, including Aquasana (2016), Hague, Water-Right, Master Water, Atlantic Filter, Water Tec, and Impact Water Products (2024). These acquisitions have reinforced A. O. Smith’s "heat and treat" strategy, enabling it to offer both water heating and water treatment solutions through its existing distribution channels. A. O. Smith’s acquisition history reflects a focus on financial discipline and long-term value creation. The company is selective in its M&A approach, ensuring that each acquisition is accretive to earnings and delivers a ROIC above the cost of capital within three years. Notably, Pureit was acquired at a reasonable valuation and is expected to be neutral to earnings initially, suggesting that management remains price-conscious and avoids overpaying for growth. This disciplined approach is evident in past acquisitions such as Lochinvar (2011), which was a major success, as well as its series of smaller, strategic water treatment deals that have expanded profitability and geographic reach. Looking ahead, M&A remains a core component of A. O. Smith’s growth strategy. The company’s strong balance sheet and financial flexibility position it well to pursue additional acquisitions that expand its total addressable market, enhance technological capabilities, and strengthen its presence in key regions. With a proven ability to integrate and scale acquired businesses, A. O. Smith is well-positioned to continue leveraging acquisitions as a driver of long-term growth.

Unlock Your Trading Potential with VIP Indicators

Transform your trading with VIP Trading Indicators - powerful, AI-driven tools designed to make you a more confident and profitable trader. Whether you're a beginner or an experienced investor, these indicators help you identify when to buy, sell, or take profit with up to 93% accuracy.

Here’s what makes VIP Indicators stand out:

• Easy Setup in Just 1 Minute: Start trading profitably right away, even if you have zero experience.

• Works on Any Market: Use VIP Indicators on stocks, forex, crypto, and more.

• 24/7 Support & Free Trading Course: Get live help and step-by-step guidance to maximize your results.

  
  

For just $9, you’ll gain instant access to all the tools, plus a 30-day risk-free guarantee. If it’s not the right fit, simply request a refund—no questions asked.

Take control of your trading journey today and see what VIP Indicators can do for you. Click here to start now!

Valuation

Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators for free.

The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 3,63, which is from the year 2024. I have selected a projected future EPS growth rate of 9%. Finbox expects EPS to grow by 5,9% over the next five years, but A. O. Smith has grown its EPS at a 9,7% CAGR over the past decade.. Additionally, I have selected a projected future P/E ratio of 18, which is double the growth rate. This decision is based on A. O. Smith's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $38,24. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy A. O. Smith at a price of $19,12 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 582, and capital expenditures were 108. I attempted to analyze their annual report to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 76 in our calculations. The tax provision was 167. We have 145 outstanding shares. Hence, the calculation will be as follows: (582 – 76 + 167) / 145 x 10 = $46,41 in Ten Cap price.

The final calculation is referred to as the Payback Time price. It is a calculation based on the free cash flow per share. With A. O. Smith's free cash flow per share at $3,27 and a growth rate of 9%, if you want to recoup your investment in 8 years, the Payback Time price is $39,31.

Conclusion

I find A. O. Smith to be an intriguing company, and I have great confidence in its management. The company has a strong competitive moat built on market leadership, essential product demand, an extensive distribution network, and brand strength. It has consistently achieved a high ROIC, exceeding 15% every year for the past decade and surpassing 20% in seven of those years. While free cash flow declined slightly in 2024, this was partly due to higher capital expenditures that should benefit investors in the long run. Macroeconomic conditions pose a risk to A. O. Smith, as weak consumer confidence, slower construction activity, and cautious inventory management can impact demand for its products. While replacement sales provide stability, new housing and commercial spending cycles remain vulnerable to economic downturns, particularly in North America and China. The company also faces strong competition in both water heaters and water treatment, with price-driven competitors potentially pressuring market share and margins, especially in fragmented and fast-growing markets like China and India. Additionally, material and component price volatility remains a risk, as A. O. Smith relies on steel and other key inputs, which can impact production costs and profitability. While some cost pass-through mechanisms exist, pricing delays and supplier concentration could lead to margin pressure or higher costs. Despite these risks, favorable long-term trends support A. O. Smith’s growth. The company is well-positioned to benefit from rising demand for energy-efficient water heating, decarbonization efforts, and clean water solutions. Demographic and housing market trends, including a U.S. housing shortage and a growing middle class in emerging markets, provide a steady source of recurring demand for its products. Emerging markets, particularly China and India, offer significant growth opportunities due to rising incomes, urbanization, and increasing demand for clean water and energy-efficient appliances. Acquisitions remain a key growth driver, allowing A. O. Smith to expand its market presence, enhance its product portfolio, and strengthen its competitive positioning. The company's disciplined M&A strategy has successfully diversified revenue streams while maintaining financial discipline, positioning it for long-term growth and market expansion. I believe A. O. Smith is a great company, and I particularly like its replacement-driven business model. I believe buying shares at $59, representing a 25% discount to intrinsic value based on the Payback Time price, would be a good long-term investment.

My personal goal with investing is financial freedom. It also means that to obtain that, I do different things to build my wealth. If you have some extra hours to spare each month, you can turn a few hours a week into a substantial amount of money in a few years. If you are interested to know how to do it, you can read this post.

I hope you enjoyed my analysis! While I can’t post about every company I analyze, you can stay updated on my trades by following me on Twitter. I share real-time updates whenever I buy or sell, so if you’re making your own investment decisions, be sure to follow along!

Some of the greatest investors in the world believe in karma, and in order to receive, you will have to give. If you appreciated my analysis and want to get some good karma, I would kindly ask you to donate a bit to ADEPAC. It is a charity I know first hand and I know they do a great job and have very little money. If you have a few Euros to spare, please donate here by clicking on the PayPal icon. Even one or two Euros will make a difference. Thank you.