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When Investing in a Water-Related Business Sounds Rational

- By Mark Yu

Small-cap stocks have recently entered a bear market. Small-cap companies are down as a group brought due assumptions of higher valuations, leveraged balance sheets and less immunity to global trade concerns than large caps.

A.O. Smith Corp. (AOS), in particular, looks like it has suffered more than what it should have.

The company was founded in 1874 as a baby carriage and bicycle parts manufacturer and is now the largest manufacturer and marketer of water heaters in North America. As of early this year, A.O. Smith was named the primary supplier of water treatment products to all Lowe's stores in the U.S.

The $7.5 billion global industrial company also manufactures and markets comprehensive lines of residential and commercial gas, gas tankless and electric water heaters, as well as water treatment products.

At the time of writing, A.O. Smith stock has suffered worse than the small-cap index, falling 37% from its peak to $42.71 per share.

Except for the recent quarter performance, where A.O. Smith failed to meet earnings estimates (earnings per share were 61 cents versus 63-cent estimates), the company has beaten Wall Street projections in the past seven quarters.

Despite not meeting estimates, A.O. Smith delivered a 6.6% revenue increase to $2.38 billion and 16% profit growth to $318 million so far this year. These growth figures altogether surpassed its recent annual growth averages in recent years.

A.O. Smith is also on track to beat its own expectations of 50% sales growth on its recent expansion in the North American water treatment market. This segment grew 66% to $61.7 million in sales year-to-date.

A.O. Smith also has operations in China that go back 20 years and has exhibited strong growth so far this year until its recent quarter.

Although everything appears great at A.O. Smith' s North America business, the company had to trim its expectations in its China business.

Early this year, A.O. Smith expected approximately 13% growth in China, but it had to trim that down 10 percentage points to just 3% in its recent earnings report. A.O. Smith 's China sales represented 34% of its total sales so far this year.

"We believe our China sales will continue to be negatively impacted by significantly slower housing growth caused by deteriorating consumer confidence related to a weakening economy and international trade issues," A.O. Smith president and CEO Kevin Wheeler said.

As a result of these challenges, A.O. Smith also had to lower its overall sales growth projections to 7% from the 8.5-9.5% it previously targeted.

To its credit, the company carries minimal debt on its balance sheet.

A.O. Smith also expects its full-year 2018 earnings per share to be between $2.58 and $2.60 compared to $1.70 in 2017. Wall Street estimates for A.O. Smith earnings to be within $2.55 and $2.57.

At 17.6x earnings and 4.2x book multiples, A.O. Smith is at bargain levels for most investors. Knowing that these multiples are now 25% lower than its recent-year averages indicate that A.O. Smith is being undervalued.

In addition, Wall Street values the company nearly 35% higher at $57.44 per share from today's share price of $42.71.

Slowing China sales may certainly dampen growth but as long as A.O. Smith 's primary customers -- North America and China households -- will need access to safe drinking water, A.O. Smith will stay in business and continue to grow, albeit slowly.

Disclosure: Long A.O. Smith .

This article first appeared on GuruFocus.