A. O. Smith : Investment Thesis
A. O. Smith (AOS) is a sell at its present share price. The company showed up in my screening of DGI+ Club database of dividend-paying stocks as likely to provide above-average returns at present share price. Closer analysis and review do not confirm that preliminary assessment. A. O. Smith’s past and likely future performance do not justify its high P/E multiple, presently in excess of 20.
The Dividend Growth Income+ Club Approach
The logo of the DGI+ Club explained:
Total Return, Dividends, Share Price
The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price – the only way.
The engines and the lubrication, along with human talent, driving the business. Shareholders have no legal rights to or ownership of the assets. Shareholders in a limited liability company have no legal obligations in respect of the liabilities.
Shareholders have an equitable entitlement to their equity in the company. Equity is increased by capital raised from shareholders, and by earnings of the company. While shareholders have an equitable entitlement to their equity in the company, they have little to no say in how the equity is distributed. In some companies, management actions in respect of the shareholders’ equity do not always benefit shareholders, and can be highly detrimental to shareholders. At the DGI+ Club, in addition to reviewing profitability, balance sheet strength, liquidity and other metrics, we take the extra step of checking the “Equity Bucket” for “leaks”; i.e., effective distributions out of equity that do not benefit shareholders.
Below I address for A. O. Smith,
- Historical And Potential Future Shareholder Returns
- Checking the A. O. Smith “Equity Bucket”
A. O. Smith: Assessing Historical And Potential Future Shareholder Returns
In this article and in most of my articles, I seek to show how targeting a desired return on an investment in shares can be facilitated by actually estimating what future returns will be based primarily on analysts’ EPS estimates and other publicly-available data. After all, gaining a return is the primary aim of most investing.
First, I provide details of actual rates of return for A. O. Smith shareholders investing in the company over the last five years.
Table 1 – A. O. Smith : Historical Shareholder Returns
For many stocks where I create a table similar to Table 1 above, I find a wide range of returns indicating a degree of volatility and risk. Table 1 above shows the results for A. O. Smith range from negative (8.4)% to positive 10.7% for eight different investors, each investing $3,000 over the last five years and holding to the present. The returns for four of the investors were positive, ranging from 2.1% to 10.7%. The remaining four investors’ returns ranged from negative (2.4)% to (8.2)%. These rates of return are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to second quarter 2020. There has been little impact on the share price due to the COVID-19 effect. In fact, the current share price of $45.11 is up on the closing share price of $44.09 on February 21, 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares.
Projecting Future Shareholder Returns
If rate of return is the basis on which we judge the performance of our investments, then surely we should be seeking to estimate future likely rates of return when we are making investments. But how do we do that? I use proprietary models to generate net income, balance sheet/funds flows, and projected rates of return going out three to five years. Much of this is automated, but still involves a great deal of research and business and data analysis to back up the projections. Let us first look at the traditional approach to assessing value of a stock for investment purposes.
Assessment Based On Quant Ratings For Share Investment Decisions
Share buy price, dividends, share sale price, and duration the shares are held are the only factors affecting the return on an investment in shares. That makes potential share sale price the single most important and uncontrollable unknown when making a share-buy decision. My expertise is in fundamental analysis, but I do recognize, any methodology, Quant or Elliott Waves or other techniques providing assistance in assessing possible future share price direction can be of benefit to share investors. I find SA Quant ratings useful for both screening for stocks of interest and as a form of due diligence.
Quant ratings for A. O. Smith show the company strong on all ratings except “Value” and “Growth.”
- The “A-” for “Profitability” reflects above sector performance for Gross Profit, EBIT, EBITDA and Net Income Margins, and Return on Total Capital, Assets and Equity, and Cash From Operations (TTM).
- If I click on “Growth,” I’m taken to a list of 19 fundamental measures each individually graded. For fifteen of these 19 measures A. O. Smith earns “Cs” and “Ds,” for growth in the areas of EBIT, EBITDA, EPS, ROE, CAPEX and Cash Flows compared to sector medians. The only ratings reflecting strong growth are for dividends, perhaps not surprising for a dividend aristocrat.
- For “Value,” A. O. Smith rates poorly across the board. This is not surprising for a company with P/E ratios above the sector median.
- For “Momentum,” A. O. Smith performs highly on all except 3-month price performance.
- For “Revisions,” A. O. Smith earns a “B-” for nil upward EPS revisions and 11 downward revisions over the last 90 days. The sector median also has nil upward revisions and likely more downward revisions due to the COVID-19 impact.
Assessment Based On Analysts’ EPS Estimates
Figure 2 – Summary Of Analysts’ Adjusted Non-GAAP EPS Estimates
Some observations on contents of Fig. 2 –
- The analysts’ quarterly EPS estimates for consensus, high and low, do not add to the yearly EPS estimates for consensus, high and low. This is generally the case because the analyst with the high estimate for the year is not necessarily the analyst with the highest estimate each and every quarter, ditto low and consensus figures. To overcome this, I adjust the quarterly EPS figures in the proportion of yearly totals to quarterly totals.
- Note, there are only two analysts contributing EPS estimates for 2023, and no estimates beyond that year. I consider the fewer analysts the less reliable the forecasts in most likelihood.
I incorporate the above analysts’ EPS estimates from SA Premium into my rate of return projections utilizing my proprietary 1View∞Scenarios Dashboards further below. As for Quant ratings, EPS and EPS growth estimates do not quantify the rate of return that can be expected for the stock in question.
Figure 3 – Non-GAAP P/E Ratios, Historical And Future Estimates
Figure 3 is primarily designed to determine an appropriate range of non-GAAP P/E ratios for determining estimated future share price levels for A. O. Smith. This is necessary for quantifying estimated future rates of return. Figure 3 also informs us of past non-GAAP EPS growth rates compared to forward estimates of EPS growth based on analysts’ consensus estimates. The forward EPS consensus estimates indicate expectations of a growth rate of negative (19.3)% for 2020 over 2019. Analysts’ consensus estimate of EPS for 2021 is estimated to be up by 26.1% on 2020 and 1.8% up on 2019. Analysts’ estimates for 2022 and 2023 show a return to solid EPS growth, but much lower growth rates than for 2017 and 2018. As mentioned above, there are only two analysts providing estimates for 2023. It should be understood, in quantifying the estimated rates of return below, I’m relying on the soundness of analysts’ consensus estimates of EPS. The other important factor is determining appropriate future P/E ratios, which is fraught with difficulty. P/E ratios are impacted by issues both at the macro and micro level. I don’t believe I will have any arguments against the notion current P/E ratios are influenced by expectations of future EPS growth rates. I’m able to quantify potential rates of return under various scenarios utilizing my proprietary 1View∞Scenarios Dashboards.
Assessment Based On Quantification Of Potential Rates Of Return
My forward-looking analyses bring another dimension – the quantification of potential returns utilizing various pieces of financial information already available.
Table 2.1 – 1View∞Scenarios Dashboard Projected Rates Of Return
Table 2.1 shows buying at the current share price would provide indicative rates of return of negative ~7% to 12% for an investor holding through the end of 2022. These rates of return assume EPS results in accordance with analysts’ consensus, high and low estimates (adjusted as indicated) and a constant adjusted non-GAAP P/E ratio of 22.33 (current P/E ratio). The P/E ratio of 22.33 is below the historical median of 24.65 and above the historical low of 16.36 through the end of Q1-2020 (per Fig. 3 above). This is concerning because there is no visibility of future growth in future EPS that would support such a high P/E multiple. The historical median of 24.65 was set in a period of double the current estimates of EPS growth. To provide more clarity on potential for future returns, I am able to carry out some “what if?” projections using my 1View∞Scenarios Dashboard, as per Table 2.2 below. In Table 2.3 below, I model for a reduction of the P/E ratio to the historical low of 16.36. This multiple is still above the sector median as shown in Figure 4 below.
Table 2.2 – 1View∞Scenarios Dashboard Projected Rates Of Return – Allowing For A Lower P/E Multiple
Table 2.2 projections have similar assumptions as for Table 2.1, except for the P/E ratio reducing to 16.36, equal to the historical low per Figure 3 above. Projected rate of return for holding through 2022 is around break-even for the high case, and negative for both the consensus and low case. Not at all encouraging, and the assumed P/E multiple is still above the 15.0 considered by many to be appropriate for an investment in equities. As per my article “Corporations Facing A World Of COVID-19 Challenges,” I do believe there will be opportunities in the months ahead to buy quality stocks such as A. O. Smith at lower and more acceptable prices. Table 2.3 below shows the effect on projected returns of buying shares in A. O. Smith at a lower share price.
Table 2.3 – 1View∞Scenarios Dashboard Projected Rates Of Return – Allowing For A Lower Share Buy price
Table 2.3 shows even buying at 20% below current share price, and holding through the end of 2022, the projected average yearly return for the consensus case is ~7%, high 9% and low 4%. Those projected returns are barely adequate for the equity risks involved. The $36.09 assumed share buy price is above the low of $33.80 recorded on March 23, 2020.
Checking the A. O. Smith “Equity Bucket”
Table 3.1 A. O. Smith Balance Sheet – Summary Format
Table 3.1 shows an increase in Shareholders’ Equity of $105 million over the 3.25 years, January 1, 2017, through the end of March 31, 2020. This $105 million, together with $222 million sourced from net cash reserves, was applied to increasing operating assets by $327 million to $1.4 billion.
Table 3.2 A. O. Smith Balance Sheet – Equity Section
I often find with companies, while they produce earnings that increase shareholders’ equity, significant amounts of distributions out of equity do not benefit shareholders. Hence the term “leaky equity bucket.” I do not see this happening with A. O. Smith.
Explanatory comments on Table 3.2 for the period January 1, 2017, to March 31, 2020
- Reported net income (non-GAAP) over the period covered reveals flat to declining growth.
- The only significant difference between non-GAAP and GAAP earnings is for a $82 million adjustment related to the 2017 tax changes.
- The net income figure is arrived at after a charge of $44 million for 1.5 million shares issued to employees (share cost expensed at average ~$29 per share issued). The issue of these shares was more than offset by 13.8 million shares repurchased for $686 million at an average share price ~$$50. The difference between the amount of $44 million charged against net income, and the estimated cost of shares repurchased to offset the shares issued to staff amounts to ~$31 million. This difference of $31 million has come out of shareholders’ equity without being recognized as a charge against net income – not material in the context of total net income over the 3.25-year period.
- By the time these various items, including share repurchases, are taken into account, we find the reported non-GAAP EPS of $7.33 has reduced to a $3.11 per share addition to equity for the 3.25-year period.
- Out of this $3.11 per share addition to equity, $2.44 (78%) was distributed to shareholders by way of dividend.
- Due to numbers of shares repurchased being more than shares issued to employees, share count reduced from 174.61 to 165.20 million over the 3.25-year period.
A. O. Smith : Summary and Conclusions
The A. O. Smith business –
The A. O. Smith business appears well managed and operated for the benefit of shareholders along with other stakeholders. It has a strong balance sheet with surplus cash and no net debt. Net income has been relatively flat over the period under review. Around $379 million for 2017 and $372 million net income for 2019. I have two major concerns with the business. The first is the company derived ~35% of its revenues from its China operations in 2019. With trade tensions, and an increasing assertiveness, operations in that country may become more difficult in the future. This is not a case of being able to shift manufacturing elsewhere – the company manufactures and sells locally in China. The second concern is ongoing disruption to operations in the US from the COVID-19 pandemic.
The A. O. Smith share price –
It is a truism, no matter how good a business, it is possible to pay too much for the shares of that business. This is what I see with A. O. Smith. In Tables 2.1 to 2.3, I have modelled rate of return projections under various scenarios. My conclusion is, unless present high P/E multiple of greater than 20 is maintained, returns will be inadequate for the risk involved to capital. It may well be that this popular stock will attract high multiples far into the future. But the exposure to risk of multiple contraction will be ever present. For a greater understanding of the risks I see over the months ahead for widespread multiple contraction, please see my article, “Corporations Facing A World Of COVID-19 Challenges” (linked above).
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.