Earlier this morning, J Capital Research published a critical report on A.O. Smith (NYSE: AOS), a maker of water heaters, boilers, water treatment, air purification and other products. J Capital's investigative research shows a material undisclosed partner that functionally acts like AOS in close regards, and allows it to stuff distributors and inflate gross margins. We're sharing our opinions and conclusions more thoroughly on Twitter @sprucepointcap
Spruce Point has also been researching and following AOS for some time, and has had success shorting off-the-radar U.S. industrial companies that are misunderstood by analysts and investors. (eg. Ametek, Ceco Environmental, Greif). A common theme is that these companies have an international component that U.S. investors are failing to understand.
In the case of AOS, it's business rode the tide of strong early success in China, and caught the housing boom demand for 'premium' water heaters with a taste for a luxury American name.
Spruce Point has always had concerns that AOS's gross margins, which dwarf competitors margins by 10% for seemingly commodity-like products, are either being inflated by management with aggressive accounting, or could not be sustained as local competitors caught up to AOS. Based on J Capital's investigative research showing a material undisclosed partner that functionally acts like AOS in close regards, this appears to be the case.
We've also had success linking capital expenditure and gross margin anomalies to successful prior shorts, notably Caesarstone (CSTE) and Gentex (GNTX). In the case of AOS, it is very clear that management has consistently mis-forecasted its China capital expenditures by an average of 50% annually over the past four years! Are we really to believe that AOS has world leading margins when it's clear it has no firm handle on its capital planning?
With the China story unraveling, and AOS's CFO having recently left ahead of disclosing a revenue recognition change and also rising allowance for doubtful accounts, we see the potential for significant downside risk. Coupled with J Capital's findings of stuffed channels, high interest rate loans to distributors, and trapped cash that's been pledged, we think investors will really have to reassess both AOS's business prospects in China (and India where they received an auditor remark for bad fixed asset accounting (think capex) and failed to ever achieve profitability).
We value AOS's Rest of World (China and India) at a substantially lower multiple, closer to Asian peers, and apply a higher multiple to its other businesses, albeit at a slight discount to stronger U.S. industrial peers with better governance, higher quality management, and faster growing end markets. Our price target is $17.70 to $27.30 or approximately 45% to 65% downside.
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Disclosure: I am/we are short AOS.