Growth in the pipeline

A.O. Smith plots acquisitions

Most Americans take the water heaters in their homes for granted. They probably don’t know the brand or think much about how it works.

But when it breaks, most consumers are willing to spend a considerable amount of money to buy a new water heater instead of taking cold showers. For most people, even during a recession, a water heater is a necessity.
This fact has contributed to sustained and positive growth for Milwaukee-based A.O. Smith Corp., the leading water heater manufacturer in the United States.
The company is under new leadership and has narrowed its focus on water technology. And it has about $800 million to invest in acquisitions of similar companies in the near future.
Demand for A.O. Smith’s energy-efficient products and expansion to new geographies drove record growth for the company in 2012.
Ajita Rajendra, the newly appointed CEO of A.O. Smith, said, “This is an exciting and transformative time for our company. We have cash and borrowing capacity for additional acquisitions and our pipeline of acquisitions supporting our stated growth strategy to expand our global footprint in water heating and water treatment solutions is active.”
Record growth
The company reported $1.94 billion in sales in 2012, up 13.4 percent from 2011. Sales in China were up 20 percent year-over-year, and the company sees great potential in developing markets.
The company also reported earnings of $162.6 million, or $3.49 per share, from continuing operations for 2012, up 51.4 percent from $111.2 million in 2011.
A.O. Smith weathered the economic downturn better than most businesses, since about 80 percent of its North American revenue comes from replacement water heater sales.
“Even when the market was declining, the replacement part of the business didn’t decline,” Rajendra said.
The company has been able to grow in North America by selling high-quality products and focusing on customer service and the supply chain, Rajendra said.
A.O. Smith makes its products in the geographic markets where they will be sold to realize efficiencies on wages and shipping costs, he said.
“We are always driving for productivity and efficiencies because it’s a global economy,” Rajendra said.
The dip in new home construction over the last several years hit the company’s new product sales, but they started to recover in 2012. Partly, that was due to the devastation of Hurricane Sandy on the East Coast.
Rajendra expects new housing starts will be up by about 150,000 this year, and A.O. Smith hopes to capture 40 percent of those residential sales.
“When consumer confidence improves, that’s when people will start making an investment in housing and all the rest of it,” he said.
The company also has a healthy and expanding presence in commercial water heaters, with more than 50 percent of the market share.
Domestically, A.O. Smith’s sales grew 11 percent in 2012 and will likely be up about 8 percent in 2013, said Charley Brady, director of diversified industrials equity research at BMO Capital Markets.
A.O. Smith’s sales in the non-North America segment were up almost 20 percent in 2012, and Brady estimates the rest of the world segment will experience about 13.5 percent growth in 2013.
“The company’s stated target is that they can grow their Chinese revenues by two times China’s GDP,” he said. “They’ve been exceeding that target.”
Leading the future
Rajendra became CEO on Jan. 1, taking over for Paul Jones, who will continue to serve as executive chairman.
Rajendra has been a part of the leadership team at A.O. Smith since 2005, serving as president and chief operating officer since September 2011, and he plans to take over where Jones left off.
“We pride ourselves as a corporation on a very smooth succession from one leader to another,” Jones said. “He’s been with the company for eight years and he’s done an absolutely incredible job running what was our water products company.”
Rajendra previously worked at glass and ceramic manufacturer Corning Inc. in Corning, N.Y., for 18 years, where he held a number of positions including head of the Pyrex division. He then served as senior vice president at Latrobe, Pa.-based tooling and industrial materials provider Kennametal Inc. There, he briefly worked with Jones after Kennametal acquired Greenfield Industries, where Jones was CEO.
Through his other leadership roles, Rajendra has gained valuable manufacturing experience and developed a customer-centric mentality toward doing business.
“Identify your customer, understand your customer’s needs and meet them,” he said. “Thankfully, I’ve always worked for companies that not only understood that, but encouraged that.”
By first taking care of customers, everything else will fall into place, and the company will create value for shareholders, Rajendra said.
He is surging forward with A.O. Smith’s plans to surpass $3 billion in sales by 2015, with $1 billion of that coming from emerging regions.
Rajendra’s challenge is to reposition A.O. Smith as a portfolio of global water technology businesses with more of its revenue coming from high-growth areas and products.
“We are actively looking at acquisitions that fit this strategy,” he said. “How do we get into new businesses in a manner in which we can leverage our core competencies and create value?”
Flush with cash
A.O. Smith sold its electric motor business to Beloit-based Regal Beloit Corp. in 2011 for $890 million. That left the company with extra cash, which it has been openly working to deploy on acquisitions.
Later in 2011, A.O. Smith acquired Lebanon, Tenn.-based boiler manufacturer Lochinvar LLC for $418 million. It was the largest acquisition in the 139-year-old history of A.O. Smith.
The new segment saw 10 percent growth in 2012, a growth rate the company expects to maintain.
“Lochinvar has been a terrific acquisition for us,” Rajendra said. “The reason they’re growing faster is because there is a shift going on between lower efficiency products to higher efficiency products.”
Lochinvar’s high-efficiency boilers are some of the most effective on the market, providing a return on the investment in three to four years, he said.
A.O. Smith still has about $800 million in dry powder to spend on acquisitions, but it hasn’t yet found just the right match, Rajendra said. Ideally, the target company would be just like Lochinvar — in a water-themed adjacency and growing faster than the market.
“Our pipeline for acquisitions is very active and…it’s been a year and a half. I wish we could have had acquisitions behind us,” Rajendra said in the company’s fourth quarter conference call. “But we’ve laid out various clear financial and strategic guidelines in terms of what type of acquisitions we’re going to be after and we’re going to be pretty disciplined in our process and we want to make sure that any acquisition we make is strategically relevant and creates value for our shareholders. And we want to make sure we don’t make the wrong acquisition. So it’s been active. We’ve looked at a number of them. We’ve turned down a number of them and we continue to look within the guidelines that we’ve provided. I wish we could have had one under our belts, but we’ll do the right one at the right time.”
The decision to walk away from some targets has been a result of issues that came up in due diligence and a desire to meet the criteria A.O. Smith has set out, not because of market conditions, he said.
Michael Halloran, an analyst at Milwaukee-based Robert W. Baird & Co. Inc. who covers A.O. Smith, said the company will likely complete an acquisition in the next three to six months.
“They’ve been looking for over a year. It doesn’t feel to me like anything’s imminent,” Halloran said. “A lot of the cash is still sitting overseas. That shouldn’t be an issue, because I think they are planning to look overseas anyway.”
It can take a long time to get suitors to the “altar” and complete a deal, Halloran said. A.O. Smith is likely looking to expand its geographic reach and target some areas that are tangential to water heaters and boilers.
Developing markets
While Americans typically don’t even notice their water heaters until they break, they are an integral part of the home in China and India, two markets A.O. Smith is working to develop.
“In China and India, it’s in your living space,” Rajendra said. “It’s like a kitchen appliance. The aesthetics are really important.”
That means the company must take a completely different approach to marketing and branding in those countries.
A.O. Smith entered the China market in 1995 and now has great brand recognition, channels to market and an established sales network, Rajendra said.
The goal is to develop the same type of success in India, but that market is in the beginning stages. Each unique market will drive the technology there, he said.
“The products are different,” Rajendra said. “We can’t just take the U.S. products and go to China and say, ‘Here we are.'”
An appliance-style water heater should look good, blend in with the environment and remind users which company makes it, he said.
In the United States, water heaters are marketed to contractors. Water heaters and purifiers are sold directly to the customer in China and India.
The company has 5,400 A.O. Smith branded retail stores in China and plans to add 200 each year through 2014, targeting tier two cities.
As consumers in emerging markets start moving to bigger cities and higher income brackets, they are more likely to make discretionary purchases like water heaters.
“Having running hot water is a luxury that when people start having disposable income…hot water is pretty high on the list,” Rajendra said.
Loyal Milwaukeeans
Founded in 1874 as a small Milwaukee machine shop, A.O. Smith manufactured bicycle parts and car frames, was the largest bomb maker in the United States during World War I and was a major supplier for the military during World War II.
The company pioneered several welding techniques, including fusing glass to steel to make glass lined tanks used in breweries.
A.O. Smith entered the water heater business in 1946 but continued its diversified production model until recently.
The firm sold off its automotive products division to Livonia, Mich.-based automotive component manufacturer Tower Automotive in 1997 and the electric motor business was sold to Regal Beloit in 2011.
Now, the company is focused on only water technology businesses. The company’s core products are water heaters, and the firm has added water filtration products. The Lochinvar acquisition added boilers to its hot water-powered product line.
The water technology-focused approach is a good way to strengthen the core business and improve upon A.O. Smith’s existing product technology, Halloran said.
“I think the approach is paying off for them, and I would be very disappointed if they took a different path,” he said. “You tend to be rewarded from a public market standpoint by being very good at what you do.”
The company’s largest manufacturing facilities are in the Nashville, Tenn. area.
While the company has no manufacturing operations in Wisconsin anymore, A.O. Smith keeps its headquarters and corporate technology center, which is dedicated to research and development, in Milwaukee. That commitment to Milwaukee won’t change, Rajendra said.
“This is where the heritage is, this is where the company was founded and that’s where we’ll always be headquartered,” he said.

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