A.O. Smith

A.O. Smith reported a mixed set of results in the second quarter, as adjusted EPS was reported at $1.03 per share, down 4% compared with the previous year. The North American segment held up well due to pricing action and boiler growth, but the international segment remains under severe pressure.

Why it matters: Sales grew by 3% in North America on an organic basis, driven by 21% boiler sales growth and pricing actions, which were partially offset by lower residential water heater volumes. We expect water heater volumes in North America to remain under pressure in the near term. Boiler and water treatment segments are supporting growth in the near term, but water heater volume recovery remains key to the firm's long-term growth story. We were encouraged to hear that the firm is stabilizing its market share in a more competitive environment, especially in the wholesale channel. North American adjusted operating margins declined 100 basis points compared with the previous year and were reported at 24.4% as pricing was not able to fully offset higher input costs, given that steel costs increased by 20%.

The bottom line: We are maintaining our $72-per-share fair value estimate. The impact of time value of money largely offset slightly lower near-term projections and a lower terminal EBIT margin projection of 7% for the international segment. The profitability and cash flow growth of the firm should inflect once the water heater volumes recover in North America.

Between the lines: The rest-of-the-world segment continues to be severely challenged, with sales declining by 19% and margin contracting by more than 500 basis points to 5.2% during the quarter. Management commented that the strategic assessment of the China business is nearing completion. Our thesis on A.O. Smith is not based on a recovery within the international business. We estimate that international business accounts for only about 5% of our fair value estimate.

Management slightly lowered its 2026 guidance due to continued softness in residential water heater industry volumes. Revenue growth is now expected to be in the 2%-3% range (from 2%-4%) and adjusted EPS is expected to in the $3.70-$3.85 range ($3.85-$4.00).

We note that the second quarter results benefited from customer pre-buy activity ahead of the announced water heater and boiler price increases in North America, which lead a portion of Q3 demand coming into Q2. Due to theses reasons, results in the upcoming quarter should be somewhat lower than normalized seasonal levels.

The North American water heater and boiler industry is expected to take another chunky pricing increase (about mid-single-digit) in the upcoming months to cover inflationary input costs. In our opinion, the ability of the firm to pass on higher input costs reflects pricing power and stable competitive dynamics, reinforcing our Wide moat rating for the firm.

For more details on our long-term thesis on the company, please refer our recently published special report titled "Heating Up Value: A.O. Smith's Wide Moat Is Not Reflected in Price".

Our fair value estimate is $72 per share, which equates to about 19 times our 2026 earnings per share estimate and an enterprise value/2026 EBITDA multiple of 13. We use a weighted average cost of capital of 8.2% based on an 8.7% cost of equity, 4.7% cost of debt, 24% long-term tax rate, and a 90% equity weighting in the WACC calculation.

We expect sales to grow roughly 2.0% in 2026 as higher prices (to mitigate incremental tariff and inflationary costs) offset another sluggish year of water heater shipments in North America and a challenging Chinese market. Water treatment has a long growth runway, and management expects sales to grow 5%-6% for this product line in 2026 after the recent channel restructuring. We see another solid year for boilers in 2026 as high-efficiency condensing units continue to gain share.

We forecast consolidated revenue will grow at about a 4.1% compound annual rate over the next five years, reaching $4.7 billion by 2030. We expect the North American water heater business to benefit from stable replacement demand and incremental growth opportunities stemming from secular demand for more energy-efficient products. We think boilers can continue to outgrow the water heater market over the next five years due to a continued demand shift for high-efficiency condensing boilers. North America water treatment presents the most significant growth opportunity for A.O. Smith, in our view, and we assume higher growth in this market, as management invests in scaling the business both organically and through further acquisitions.

We project a 6% compound annual growth rate in revenue in the North America segment over the next five years, which includes a 1% contribution from acquisitions. We have a fairly pessimistic outlook on the firm’s international business. We expect the Chinese housing market to start recovering by 2027 and better operational execution by management, but do not expect the firm to achieve its former position in this market. The rest-of-the-world segment should benefit from A.O. Smith’s expanding presence in India. Overall, we expect international revenue in 2030 to be lower than the 2025 level.

Since divesting the lower-margin electric motor business in 2011, A.O. Smith’s operating margin has improved considerably, from around 8% in 2010 to 19.0% in 2025. The uplift is mostly attributed to North America, which has benefited from a more favorable product mix (including the addition of Lochinvar boilers in 2011), higher consolidation, strategic pricing actions outpacing input cost inflation, and scale-based profit gains. However, challenging market conditions in China have weighed on A.O. Smith’s profitability in recent years. We expect the margin profiles of the North American and international businesses to remain divergent, given the different competitive environments and industry dynamics.

Our midcycle projections account for A.O. Smith’s cyclicality and changing revenue mix but still give the firm credit for operating leverage and improving water treatment margins. In our view, water heater and boiler margins peaked in 2023. Therefore, our midcycle margin assumption factors in potential downside risks through the economic cycle. We expect the competitive environment in the North American market to remain stable and project midcycle operating margins to be around 24.5%. Higher competition in the Chinese market and a secular shift to e-commerce will weigh on margins; we expect midcycle margins in the international segment to be in the high single digits. After incorporating corporate costs of around 2% of revenue, we project consolidated midcycle margins to be around 20% for the firm.

The second stage of our valuation model assumes that A.O. Smith can generate an average of 20% return on new invested capital and 4.5% earnings growth for 15 years after our five-year explicit forecast period. The second- and third-stage assumptions in our DCF model imply a terminal EV/EBITDA multiple of 11.6 times.

We assign A.O. Smith a Wide Morningstar Economic Moat Rating. In our view, the firm’s competitively advantaged North American water heater and boiler businesses, which we estimate account for roughly 70% of consolidated revenue and about 80% of consolidated profit, benefits from intangible assets and switching costs that have supported steady 20%-plus operating margins. A.O. Smith holds the leading share in commercial as well as residential end markets in a highly consolidated North American water heater market, which we see as a rational oligopoly.

We argue that the intangible assets moat source is supported by A.O. Smith’s brand power and its technical know-how, but an equally important part of our moat argument is the unique dynamics around entrenched relationships with retail partners, distribution networks, and trade professionals (plumbers). The intangible assets and switching costs make it difficult, even for a technically savvy and well-capitalized new entrant, to grab market share and afford strong pricing power to the three dominant players in the industry. A.O. Smith has been able to increase the prices for its products at a rate higher than inflation on average over the past 12 years in North America.

Industry Dynamics: A.O. Smith is one of three primary players in the North American water heater market, alongside privately held Rheem and Bradford White. Together, these three companies hold more than 90% share in the residential and commercial end markets. The highly concentrated nature of the industry makes it more conducive to moats. In this oligopolistic market structure, all three players sell products at approximately similar price points, and differences in price typically arise from variations in product specifications such as capacity, warranty, fuel type, and energy efficiency. We’ve observed rational pricing in the industry for over a decade, with price increases aimed at offsetting input cost inflation and maintaining profit margins.

The majority of water heater sales volume in North America is tied to replacement demand. On average, roughly 80%-90% of the roughly 10 million annual unit shipments are used to replace existing water heaters, with the remaining balance coming from new construction. We calculate that water heater replacement rates (replacement shipments divided by total housing stock) have been remarkably consistent over the past two decades, around 6% on average.

Brand and Technical Know-How: We think the most significant barrier to entry for the domestic water heater market is developing technological expertise to design and manufacture high-quality water heating products that evolve with regulatory changes and consumer preferences, as well as brand equity with channel partners (distributors and retailers), contractors, and ultimately the end user. A.O. Smith consistently ranks in the top two among contractors for brand familiarity, brand usage, and product quality. It also has long-standing relationships with retailers, selling to four of the six largest national hardware and home center chains, including an exclusive agreement with Lowe’s.

Deeply Entrenched Distribution Relationships: Most water heater sales are nondiscretionary replacement sales, and the equipment is generally installed by a plumbing contractor. End users (home or business owners) often rely completely on trade professionals for choosing their water heaters. Given this dynamic, contractor relationships cultivated over decades and the distribution infrastructure of incumbents play an extremely important role. Given the reliance on trade professionals, competition among water heater companies relies on contractor relationships rather than marketing to end customers. There are also subtle switching costs, since contractors trained on a specific brand, familiar with its product features and service requirements, would have limited incentive in switching to a new brand.

Established distribution channels further strengthen incumbent moats. A distributor that has built its commercial water heater inventory, training, repair capabilities, and technical support infrastructure around A.O. Smith will be reluctant to move to a different brand, even if it offers marginally better pricing. There is a symbiotic relationship between A.O. Smith and distributors, and both are reliant on the other for success. A symbiotic relationship also exists between equipment manufacturers and large players in the retail channel (Home Depot, Lowe’s, Ace Hardware). Each of the big-box retailers has historically worked with a primary water heater supplier that occupies the dominant shelf position in their stores, an arrangement that benefits incumbents enormously. Home Depot has a strong relationship with Rheem, and A.O. Smith has an exclusive relationship with Lowe’s. These relationships have lasted for several decades, and given the industry's consolidated nature, its distributors rely on each other; we do not anticipate major changes.

In our opinion, what makes the distribution moat strong is that, to gain market share, a new entrant must not only build a wholesale distribution network and secure retail shelf space by dislodging decades-long relationships, but also train and convince contractors to adopt its product.

Cost advantage: We think the large incumbents do have a natural scale advantage over smaller players, but we do not see evidence that A.O. Smith can manufacture units at a materially lower cost than its large peers. Manufacturing costs fluctuate with the prices of raw materials, such as steel, which is usually purchased at market prices with little bargaining power for manufacturers. Transportation costs associated with moving large, cumbersome storage tanks are the second-largest input cost for manufacturers. This gives local players in conventional tank-based heaters an advantage over foreign brands that manufacture their products overseas.

Secular demand for energy-efficient products and a dynamic regulatory environment are likely to increase demand for more-efficient water heaters and boilers. A.O. Smith is in a good position to capitalize on this trend.

Growing concerns about PFAS and other water contaminants could result in greater adoption of the firm's water treatment products.

A.O. Smith has plenty of dry powder to boost growth through acquisitions. Restructuring or divesting the China business would result in stronger profit margins.

A.O. Smith has turned to international markets and new product categories for more growth, but this strategy could dilute its profit margins and economic moat. Its recent performance in China has been very disappointing.

Increasing consumer demand for tankless water heaters in North America could threaten A.O. Smith’s market position. Regulatory-driven changes to heat pump technology could also disrupt the incumbents.

Water treatment is a highly fragmented market that requires regional expertise, and it will be difficult to develop long-term competitive advantages.