Every year, we individually review all the Dividend Aristocrats. The Dividend Aristocrats are a select group of 53 stocks in the S&P 500, with 25+ years of consecutive dividend increases.

There have been three recent additions to the Dividend Aristocrats, including A.O. Smith Corp (AOS). On January 19th, A.O. Smith increased its dividend by 29%. This marked the 25th consecutive year of dividend growth for the company, meaning A.O. Smith is now officially a Dividend Aristocrat.

A.O. Smith is a high-growth dividend growth. In the past five years, it has increased its dividend by 25% each year, on average. With a current dividend yield of 1.1%, A.O. Smith might not appeal to investors looking for income right now, such as retirees.

But with a strong business, potential for growth, and a low dividend payout ratio, A.O. Smith could have much greater appeal to dividend growth investors.

Business Overview

A.O. Smith is a global leader applying energy-efficient products and solutions. It manufactures a variety of residential and commercial water heating equipment, as well as a water treatment and air purification products.

Source: Investor Presentation, page 9

The company is perhaps best-known for its water heaters. It operates in two operating segments, separated by geography:

• North America (63% of sales)
• Rest of World (37% of sales)

As you can see, the company has a sizable international presence, particularly in emerging markets like China.

On January 30th, A.O. Smith released fourth-quarter earnings, which were very strong. The company generated earnings-per-share of $0.60, on revenue of $768.6 million. Both figures handily beat analyst expectations, which called for earnings-per-share of $0.56, and revenue of $767.4 million. Quarterly revenue increased 10% from the same quarter a year ago.

For the full year, revenue increased 12%, while adjusted earnings-per-share increased 17%, to $2.19.

Growth Prospects

A.O. Smith’s growth prospects in the U.S. include continued economic growth and increasing housing prices. As a manufacturer of water heating, water treatment, and air purification products, the company is reliant on a financially healthy consumer and housing market.

Source: Investor Presentation, page 10

When home prices are rising and unemployment is low, consumers with disposable income are much more willing to invest in upgrades like new water heaters. This is how A.O. Smith realized record sales for 2017.

Outside the U.S., the company’s main growth catalyst is China, where it already has a large operation. China is arguably the most attractive economy in the world. Not only does it have a population of 1 billion, and a growing middle class, but the country is growing its economy at a high rate.

Source: Investor Presentation, page 17

Sales in China rose over 20% each year, in the past 10 years. A.O. Smith’s sales in China rose 18% in 2017.

A.O. Smith expects organic revenue growth of 8% on average, over the next several years. Meanwhile, ValueLine analysts expect 22% earnings growth in 2018.

Competitive Advantages & Recession Performance

A.O. Smith’s strong growth is due to its competitive advantages, primarily its top market share. A.O. Smith has the #1 market share in U.S. water heaters. It holds 40% domestic share, nearly 10 percentage points above its closest competitor.

In the commercial gas water heater market, A.O. Smith’s U.S. market share exceeds 50%, while the closest competitor has market share below 30%.

Possessing the top industry position gives A.O. Smith pricing power, and high margins. In turn, this provides the company the ability to generate lots of cash flow, which enables it to invest in new product innovation.

One potential risk for A.O. Smith is a recession. As a manufacturer, the company is closely tied to the health of the overall economy. It is not a highly recession-resistant business model. Earnings-per-share during the Great Recession are below:

• 2007 earnings-per-share of $0.48
• 2008 earnings-per-share of $0.49 (2% increase)
• 2009 earnings-per-share of $0.57 (16% increase)
• 2010 earnings-per-share of $0.43 (25% decline)
• 2011 earnings-per-share of $0.60 (39% increase)

As you can see, the company performed very well during 2008 and 2009, the worst years of the recession. Earnings took a significant hit in 2010, but quickly recovered in 2011. Overall, the company performed exceptionally well, since it was able to grow earnings over the course of the recession.

Valuation & Expected Returns

Based on 2017 earnings-per-share of $2.19, A.O. Smith shares currently trade for a price-to-earnings ratio of 29.9. According to ValueLine analysts, A.O. Smith has held an average price-to-earnings ratio of 18.7 in the past 10 years.

Source: Value Line

As you can see, A.O. Smith is currently trading well above its average valuation, going all the way back to 2002. The valuation multiple has expanded significantly in the past few years, particularly in 2017. The result is that the stock now trades at a % premium to its 10-year average valuation.

Our estimate of fair value for A.O. Smith , is a price-to-earnings ratio of 20 to 22. This is above its 10-year average, but is justified given the company’s accelerating earnings growth, and future growth prospects. However, this would equate to a fair value share price of $43.80 to $48.18, which implies the stock is currently overvalued by approximately 26% to 33%.

It would not be unreasonable to assume as much as 10% annual earnings growth for A.O. Smith moving forward. In the past 10 years, the company grew earnings by 14% compounded annually. As a result, a potential breakdown of future returns is as follows:

• 6% to 8% revenue growth
• 0.5% to 1% margin expansion
• 1% share repurchases
• 1% dividend yield

Including dividends, expected returns would reach 8.5% to 11% per year. A.O. Smith’s dividend does not contribute a significant return in the short-term, as it has a 1.1% dividend yield. However, the dividend has lots of room for growth in the years ahead.

However, investors should consider the impact of overvaluation. If A.O. Smith shares return to fair value, it would represent a significant reduction of expected returns. For example, if it took five years for the stock to trade near fair value, the resulting loss would reduce total returns by approximately 5% to 7% per year.

As a result, total returns would be just 3% to 4% per year, once the impact of a declining price-to-earnings ratio are taken into account.

Final Thoughts

A.O. Smith is an industry-leading company. It has the top brand in its category, with compelling future growth potential, in the U.S. and China. It is also in the early stages of growing its business in India.

However, the stock seems to be significantly overvalued. While it does not yet meet our definition of a confirmed sell, the stock is too overvalued to recommend as a buy. Investors should wait for a lower price—which would reduce its price-to-earnings ratio and raise its dividend yield—before buying A.O. Smith.