Initiation: May 16, 2019
J Capital Research ("J Cap") is an investment advisor to private funds. J Cap has analyzed the U.S.-listed company A.O. Smith (“AOS”) and is hereby publishing the outcome and the conclusions of our analysis, based on publicly available information. We or some of our clients may be short shares of AOS, and, for this reason, there might be a conflict of interest.
  • Pleading the fifth on China operations: Despite never appearing in the financial filings or being mentioned on conference calls, Jiangsu UTP Supply Chain is involved in almost every aspect of A.O. Smith’s China business. The relationship is public knowledge in China. UTP’s involvement spans the acquisition of raw materials, the hiring of labor, potentially co-owning factories, marketing, and most notably “accepting” inventory and financing AOS distributors. We estimate that UTP may be responsible for as much as 75% of AOS China sales. 
  • The UTP relationship has obscured China business performance and financial statements: The UTP partnership has allowed AOS to inflate gross margins and mask the actual China revenue slowdown through distributer-financed channel stuffing. We also believe that the irreconcilable capex, R&D and asset inventory accounts are being used as cookie jars to preserve the “integrity” of the financial statements while hiding UTP’s involvement. Our detailed distributor channel checks indicate China revenue will fall 21% in 2019 vs management’s claims of a 6-8% decline.
  • Is the cash really there? We believe that A.O. Smith does not actually have access to $539 mln that reportedly sits in China—about 84% of the company’s total cash at yearend 2018. We have conducted dozens of interviews in China and believe that AOS may have used its cash for distributor loans to prop up sales. That would mean the money is in escrow and cannot be touched until loans are repaid. What’s more, distributor loans are at risk in a weakening market. Chinese distributors of AOS products—financially imperiled companies--are being financed at 18% to take AOS inventory, and many are holding six months of inventory. These companies are at risk of default—and AOS could be on the hook.
  • China headwinds are everywhere: In Q1, AOS reported a 66% drop in Rest of World earnings, with the drag coming from China, but said the drop is temporary. We disagree. During China’s boom years, AOS benefited from selling a premium product at a mid to high price point through direct channels in Tier 1 cities. To offset numerous steel and rental price increases, AOS has continuously increased the price of its heaters, until the appliances reached a price point unobtainable for some of the original purchase base. The higher-priced product has been a particularly poor fit for Tier 2-4 cities, the next leg of AOS’s China growth strategy, and the cost-sensitive online channel continues to take share from the direct channel. AOS has recently launched new products at their original price points, but these “startups” are just ramping up and will carry much lower margins for the foreseeable future. Distributors believe the new product releases are just a way to discount old stock and force new inventory into the channels. These product/channel challenges are presently being compounded by a weakening Chinese economy and the U.S.-China trade spat’s impact on selling an American-branded product in China. 
  • Limited U.S. organic growth, fundamental challenges on the horizon: Concurrent with a booming Chinese economy, AOS U.S. sales were boosted by a series of acquisitions in the water-purification space. We believe that AOS’s North American organic growth rate has averaged less than 5% over the last three years. Furthermore, this growth was underpinned by strong housing starts in recent years and, more importantly, a strong replacement cycle related to home sales prior to the financial crisis. We expect North American organic growth to shift down a gear, as housing starts have begun to show weakness, and the replacement cycle weakens over an extended period as it laps the financial crisis.
  • Accounting anomalies, burying the loss on an acquisition and poor governance: Beyond the UTP-contrived Chinese financial statements, we highlight financial irregularities in other regions as well. Most notably, a rare “unfavorable” mark was given to AOS’s Indian operations by their local auditor. Our research has also uncovered the undisclosed fact that AOS was fleeced of $50 mln as a result of a 2010 acquisition in China. In addition to the potential concerns raised by the recent timely exit of AOS’s long time CFO, it’s worth noting that AOS’s ISS governance score is a 10, the worst possible score. 
  • Crisis in Management Confidence Poises Stock for Significant Downside: We’re challenged to understand how investors with an appreciation for the breadth of Chinese operational and financial obfuscation can get comfortable investing with a management team that was either this in the dark or complicit. We anticipate the multiple of the stock to re-rate materially in the near term as a result of a crisis in confidence and expect that 2019 revenues will eventually disappoint based on below-expectation results for China and U.S. water heaters.  We are short AOS and value the company at $22.68, a discount of 53% to the current share price, based on a 1.2x multiple of our estimated 2019 sales and an assessment that steady-state growth will be around 2%.
On May 29, we responded to the brief and inadequate press release AOS published called "A. O. Smith Sets the Record Straight on J Capital Research Report," in which the company did anything but. Read our flash survey and response to the response here.
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