When it comes to investing, I'm a huge fan of "boring." That is, I appreciate companies with crucial but more obscure products that are so much a part of our daily lives that most people wouldn't even think of them as investments.
Take Packaging Corp. of America (NYSE: PKG), which makes about the most boring things you could ever think of -- cardboard boxes and other types of packaging. Yet as I pointed out when I profiled the company in April, its stock has triple-digit upside during the next five years.
Still, the investment potential of this firm, A.O. Smith Corp. (NYSE: AOS), is very exciting.
Its stock has generated some outstanding returns already, rising nearly 350% during the past five years. And I think the price could easily double again in the next five years.
This potential wouldn't exist without A.O. Smith's leadership in the water heater industry, where it owns just over half the residential market, nearly half the commercial market, and a reputation for premium products. Sales have climbed a brisk 12% annually for the past several years, from $1.5 billion in 2010 to $2.2 billion currently. Earnings grew nearly 15% a year, from $1.21 to $1.92 a share, during the same period.
A much improved real estate market should help catapult shares higher, since a key feature of prosperity in the sector is new construction requiring the latest and most efficient water heaters like A.O. Smith's. One nice thing about the company, though, is it doesn't necessarily need a boom in new construction to do well. That's because replacement products in existing homes and businesses are by far its largest revenue source, accounting for 85% of sales volume.
In the short and intermediate-term, there could be especially strong demand from commercial customers thanks to the gradual economic recovery, which could spur greater spending on new water heaters as a part of upgrades, expansions, and totally new construction. For instance, A.O. Smith ought to get plenty of business from the hotel/lodging industry, an area that struggled a bit last year but is projected to resume solid growth in coming quarters.
|A.O. Smith is a leader in the water heater industry, where it owns just over half the residential market, nearly half the commercial market, and holds a strong reputation for premium products.|
In fact, the industry will likely need to increase capacity soon because lodging demand is exceeding supply. This year, for example, U.S. demand is up 2.4% with only a 0.1% increase in supply, analysts report. The domestic hotel/lodging industry clearly needs more rooms, and that should generate orders for A.O. Smith.
The firm isn't the powerhouse overseas that it is domestically, but it's getting there and international operations are built up to where they now contribute 30% of total revenue. A.O. Smith already controls nearly 25% of China's water heater market, and it's developing a presence in India, too.
Both countries should contribute greatly to the company's growth for years as their ballooning middle-classes are increasingly able to afford such "luxuries" as hot water in their homes. Sales in China jumped 25% in the latest quarter, for example, and, to meet growing demand, A.O. Smith recently opened its second water heater plant there. The plant is expected to boost capacity in the region by 50% once it's fully operational.
Another potentially big opportunity in China: polluted water.
It's estimated that up to 70% of the water in China in unsafe for human use. So, in 2009, A.O. Smith began offering water filtration and purification systems for use in residential and some commercial settings. This business is still relatively small, accounting for only about 2% of the company's total revenue. However, rapid growth seems likely under the circumstances.
To enter this market, A.O. Smith acquired an 80% stake in a tiny Chinese home water filtration products company, Tianlong Holding Co., for $77 million. This caused no undue financial stress for A.O. Smith, which had free cash flow of $211 million and current assets of $740 million in the year the transaction was completed. (Right now, the company has free cash flow of $154 million and current assets of $1.2 billion, and both are at or near decade highs.)
Although China's economy and real estate market are looking to downshift, perhaps dramatically, a slowdown shouldn't severely damage A.O. Smith's profits. While orders related to new construction might fall off, the firm would probably still see healthy demand for replacement water heaters, just as it does in North America. One key catalyst would be the increased rental activity that often occurs when residential real estate markets are in the doldrums, since rental properties regularly need replacement water heaters.
Risks to Consider: A focus on replacement business rather than new construction helps protect A.O. Smith from downturns in real estate, but ailing real estate markets can still hurt the firm's sales, profits and stock price.
Action to Take --> A.O. Smith is market leader with solid revenues and rapid earnings growth, as well as fantastic shareholder returns despite its "boring" products. The firm is well-positioned to meet consensus estimates for growth of 23% a year, which would increase earnings to $5.41 a share in five years from $1.92 currently. Based on a historical price-to-earnings (P/E) multiple of 22, this implies a stock price of $119 at that time for a 153% gain from the current price of about $47.
Notably, the stock held up very well during the housing crisis of 2008, falling 13.7% -- far less than the S&P 500's 37% loss. So I see the stock as a superior and much safer way to play domestic and international real estate markets.