Value Investing Looking for Feedback on a thesis - Short AOS AO Smith |
| Looking for Feedback on a thesis - Short AOS AO Smith Posted: 09 Dec 2018 10:25 PM PST The pitch is pretty undeveloped - most of the work has been trying to figure out if all of the legs of the thesis work in general so far. If I get encouraging feedback on this front, I'll work on formalizing the pitch and bringing exact measurements into the picture, especially around the valuation part. Thesis: Short AO Smith, degree of bearishness is contingent on Chinese view. Valuation on LTM EV/EBITDA is 12.5x is egregious compared with similar home product manufacturers in light of US difficulties and Chinese risks. The company has previously performed like a growth stock and has traded like one, but the company should trade at 7-9x EBITDA similar to comps like Generac. Key issues: Larger china exposure than the market is expecting. Market has extrapolated recent explosion in US commercial revenues as secular, but the increase was due to a regulatory change, and should revert to trend line revenues. US Residential revenues should also either stagnate or decline due to lapping replacement cycle from 2005-2007 era. Overview: AO Smith makes water heaters, boilers and water treatment filters. Water heaters make up 90% of revenue. 64% of revenue comes from the US, 34% from China, and 2% from RoW. They've built a large Chinese business over the past 2 decades, growing from $50M in revenue in 2003, to $1.05B in FY 2017. The US market is a profitable oligopoly with AO Smith at roughly 50% mkt share, the rest split between 3 other players, and AO Smith has 27% market share in China in a highly competitive market. Key Thesis Points:
AO Smith has grown their Chinese revenue at a 21% CAGR from 2003-present. However, given the structure of the replacement cycle of water heaters, AO Smith's Chinese revenues are very vulnerable to a Chinese real estate turnaround. Water heater sales are split between newbuild and replacement water heaters. Replacement heaters are sold when an old one breaks down, so this volume is tied in effect to the number of heaters in operation. Newbuild heaters are sold when new buildings need a water heater. Water heaters are replaced on average every 14 years according to AO Smith (interestingly enough, because of improvements in technology, heaters are now lasting longer, decreasing AO Smith's available revenue). AO Smith's Chinese business grew from $50M in 2003 to ~$1B TTM and I think that most of this growth is tied to newbuild residential construction growth in China. Given that AO Smith had ~7.5% Chinese mkt. share in 2003, and their revenues were $50M, overall China-wide revenues from water heaters was ~$650M. In 2017, AO Smith had 27% mkt. share and $1.05B in revenues, for ~$4B in total Chinese revenues. Given the fact that replacement volumes are driven solely by water heaters in operation, I believe that maximum water heater revenues are roughly $650M, at most say $1B. The rest of that $4B, $3B+ is extremely vulnerable to a slowdown in construction. In the US from 2007-2009, in a much less bubbly housing market, newbuild sales fell 66% (house price/income ratios of 3-4x, not the 10-30x of China). I think that in a Chinese real estate slowdown that newbuild sales would fall more than that 66% number. In addition, AO Smith owns the high end portion of this market, so I believe their sales are more vulnerable.
US water heaters are split roughly evenly between commercial and residential sales. Residential sales are driven by the same replacement cycle, 12-14 years. I believe that both residential and commercial segments are lapping large increases in sales that have set expectations too high and will mean revert There are two parts to this point – first, US residential replacement volumes are beginning to lap the high newbuild volumes from 2005-2007. While newbuild revenues are a smaller portion of US revenues, the lap is significant. In 2006, 9.5M units were sold, with roughly 2M of those newbuild. In 2009, 7.9M were sold, with only ~600,000 newbuild units. That decrease should start lapping over the next couple of years, and replacement sales should start decreasing slightly. Second, AO Smith is losing market share in their commercial segment, in addition to lapping a 2015 regulation change that heavily boosted sales growth. Because AO Smith doesn't break out revenues by gas or electric, I assume that they roughly mirror the industry mix of gas vs. electric. Modeling out the respective breakdowns, I find that almost all of AO Smith's revenue increase since 2014 was due to higher volumes in the commercial electric storage water heaters in the US. Please check the trade industry web site:http://www.ahrinet.org/statistics under monthly shipments and historical data for more charts. Here's the most pertinent one, of commerical water heater volumes :http://www.ahrinet.org/Resources/Statistics/Historical-Data/Commercial-Storage-Water-Heaters-Historical-Data This is clearly unsustainable – with all water heater purchases, there needs to be a reason for the water heater to exist – you need to build a new school that needs one or replace an old gas water heater in an existing school. All this recent increase in revenue did was pull forward sales, but management has made no comment about this. I believe there is no reason for sales to not to dip back into 100,000 units a year territory. If you look at AO Smith's 2017 10-K MD&A, they even admit that a lot of the recent strength has been due to pre-buys, or pulling revenue forward. Over the next 2-3 years I predict a 25-35% decline in commercial electric revenues over the next year or two, a decline of roughly $200M in revenues. Valuation: I believe AO Smith should be trading at roughly 9x 2020 EBITDA. There are two scenarios – the US part of the thesis will execute regardless, but I have no real ability to predict Chinese macro conditions, and I'm just stating that if China falls into a recession, the consequences for AO Smith will be worse than the market predicts. China: I believe this segment will turn deeply unprofitable and will be lossmaking or EBITDA breakeven, removing the roughly $140M it currently contributes to EBITDA. US: I believe the incremental $200M in commercial sales generated roughly $50M in incremental EBITDA. There will be roughly 33% drop in total EBITDA to $400M, and at 9x EBITDA, AO Smith should be worth around $3.5B for roughly 45% downside. Risks: Price increases - highly unlikely, in my opinion. They already raised prices a lot in 2015, which accounted for most of their OM% from 14% to 21%. I don't believe that they'll try raising prices into a declining market. I've also found info that some of their competitors will be ramping investments in the US. China - I think the biggest risk here is that China will keep performing, which is entirely possible. Too many people much smarter than me have more insight on this issue. What I'm saying specifically about AO Smith is that from a long perspective, AO Smith is as levered as you'd expect to Chinese housing stability+growth, but that leverage is magnified on the downside. Caveat Emptor on this part. Commercial electric revenues continue ramping - Unlikely. The cracks already started to show 3 months prior, as you can see in July's data at the AHRI site. Volumes are now regularly comping 10-20% down YoY vs. 2017, and this was the source of the company's recent weak guidance. Thoughts? Criticisms? I don't know how to feel about the China angle, as I think it's very important and something I think the rest of the market isn't seeing, but the timeline for that is unknown and I could just be wrong that China is risky anyways. The US stuff alone is nice, but I'm worried it's not a big enough factor to contribute to real downside. If you take out the China factor, most of the downside I project is due to multiple compression, which I believe will happen as AO Smith has traded at elevated multiples for a while, but is not something to stake a thesis on. I came into this a long, but after taking a deeper look I thought the short was better. [link] [comments]  |
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