Is A. O. Smith in Hot Water?

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Despite an impressive historical track record of growth, A. O. Smith (NYSE: AOS) is looking iffy recently following the release of a short-seller report. Further, the company has shown meaningful declines in earnings quality metrics that call into question its sustainability.

In this clip, Motley Fool Analyst John Rotonti and Industry Focus: Energy podcast host Nick Sciple break down the issues facing the company and what it means for its investment prospects.

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To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on May 16, 2019.

Nick Sciple: Off the bat, as we dive into some of the risks surrounding A. O. Smith, I think we have to mention the short report that came out this morning. We've only had a few minutes to look at it before we got on here to record the podcast. But from what you saw on there, and talking before the show, you said some red flags from that short report lined up with some things you'd seen about the business. Can you give us an overview of what we're seeing from that report and it what you'd seen in your own independent looking at the company?

John Rotonti: Like you said, this is an exciting time to be talking about A. O. Smith because a short report came out this morning. I had about two minutes to quickly review it. Basically, the report talks about a relationship with a distributor that A. O. Smith has in China. It mentioned some channel stuffing. And it mentions that a lot of A. O. Smith's cash is trapped overseas in China, and that it won't easily be able to access that cash, among other things.

Honestly, I was completely familiar with A. O. Smith's go to market strategy in China by using distributors. I was completely unfamiliar with this particular distributor relationship. It sounds like the authors of the short report did a lot of on-the-ground channel checks and scuttlebutts in China, which I have not done yet.

That being said, I own A. O. Smith. I've owned it for a while. But I have been monitoring some of my own red flags in my own research lately. Some of those are its revenue growth, its organic revenue growth, has been slowing. One thing I like about the A. O. Smith management team is, they provide long-term guidance for revenue growth. Very few companies provide long-term guidance. They either provide quarterly or yearly guidance. A. O. Smith takes a long-term view, which I like. And they recently lowered their long-term organic revenue guidance from 8% to 7%. That's their long-term guidance. But then, you see that revenue in the first quarter of 2019 fell 5% because its revenue in China fell 18%, and China accounts for 34% of companywide revenue, so it weighed down the total. So, an overall slowing in revenue growth is a red flag that I pay close attention to.

The second one. Over the last five years or so, free cash flow has been growing slower than GAAP earnings. The free cash flow conversion ratio, or free cash flow divided by net income, is one measure of earnings quality. I have done some earnings quality look on the business. It appears to me that the reason free cash flow at A. O. Smith has been growing slower than net income is because of working capital investments in China to grow its business in China, and because of what looks like deferred tax assets, which are taxes that you pay today, but you will not owe down the road. And since it's a cash outflow today, that's impacting free cash flow. It seems OK to me that free cash flow is not growing as fast as net income; or it seems explainable to me. But it's not something I like to see. I like to see free cash flow growing in line or even faster than net income. So, that's the second thing. Falling revenue growth is No. 1, free cash flow not growing as fast as net income is No. 2.

And then thirdly, and perhaps most concerning, is their days sales outstanding has been rising. When DSOs rise, it can sometimes -- not all the time -- be an indicator that demand for the products is slowing and that the company has to provide more favorable terms to sell the product. I'm not saying that's what's going on here. I am saying that these three red flags have caught my attention.

Sciple: So, when we look at A. O. Smith today and how we need to evaluate this company, obviously, sales are slowing in China. Is this a Chinese economic story? Is that what's driving the success or failure of A. O. Smith today? Or are there other things at work driving the way the business's revenue and free cash flow growth trends are moving?

Rotonti: It's going to take me weeks or months to really get to the bottom of what's behind this short report that came out today. Like I said, I'm not on the ground in China, so I'm going to have to rely on a lot of third-party analysis to really find out what's going on.

However, to answer your question, I do think it's largely a China problem. A couple of things are going on in China. One is, the Chinese economy as a whole is slowing. I think its growth is still about twice the U.S. I think it's growing around 6%, their GDP. But, that's the slowest rate in a very long time. Two, the housing market in China is slowing significantly. As you know, water heaters, water purification products, are sold to residential houses. Three, FX, or currency translation, is a big headwind for A. O. Smith since 34% of its revenue comes from China, and the dollar has been strengthening. We've got a weakening overall Chinese economy, we have a weakening housing market in China, we have very strong FX headwinds because of the strengthening U.S. dollar and A. O. Smith's very large exposure to China.

And last but not least is, we have negotiations with China over a new trade agreement. And recently, the rhetoric has been getting more intense. And the U.S. recently announced that it's going to do a second round of higher tariffs on China. This is not good for A. O. Smith, at least in the short term. It could decrease demand for A. O. Smith's products. In the very least, Chinese consumers may want to buy local domestic Chinese products out of a sense of national pride during the time these trade talks are going on.

There's also a company-specific issue in China, an A. O. Smith-specific issue. They had some elevated inventory levels. Basically what I think happened there was, the Chinese economy slowed, the housing market in China slowed, and A. O. Smith has always had a premium price point product in China. I think the Chinese consumer started to trade down to a lower price point product, and A. O. Smith did not have a lower price point product. So they had been quickly trying to ramp up research and development and to launch a mid-price point product to try to meet consumer demand in China. They had been playing catch up there a little bit, I would say. So, there's some broader economic concerns in China and some company-specific, A. O. Smith-specific concerns in China as well.

Sciple: Sure. John, as we look at these concerns, obviously, in the near term, it appears China's economy has been slowing. You see that, as you mentioned, trickling down into parts of A. O. Smith's business. But the long-term trend that we laid out in the first half of the show of more and more people across the world entering the middle class, and having demand for this, wanting to have a hot shower every morning, at what point would this narrative that we're seeing in China and the slowing economy overwhelm your conviction in this long-term thesis enough to sell the stock? How should we think about these two sides of the risks of the business as well as these clear long-term drivers and long-term demand for the fundamental product that the business sells? How are you weighing that in your head as an analyst right now looking at A. O. Smith?

Rotonti: If the problems in China are only around a slowing Chinese economy, that's not a big concern for me. It's not an overwhelming concern for me. If the problems in China run deeper, into some of the issues discussed in the short report -- which, like I said, I only had a couple of minutes to review before I got on this podcast -- that would be a deeper concern. If they have been stuffing the channels or something like that, or if they can't access that cash, or whatever it may be, those would be larger concerns for me.

The biggest risks for me are these earning quality metrics that I discussed. Earnings quality is often a sign that there's deteriorating fundamentals, and that demand for the company's products are maybe not as strong as past financial results may suggest. Like I said, I've identified in my own research slowing organic revenue growth, free cash flow conversion that is not at 100%, rising DSOs, which can often be a sign of falling demand. I need to dig deeper into these earnings quality metrics. That would be a big risk for me.

Another risk for me is, A. O. Smith is a 145-year-old business, and they have a century-long tradition of consistently investing in research and development and capital expenditures to drive long-term growth. If you look back over five or 10 years, they spent pretty much consistently 3% of their revenue every year on R&D and 3% of their revenue every year on capex. But A. O. Smith missed the tankless water heater innovation. Tankless water heaters are different to tank water heaters in that they don't have a tank, so they require much less water and are much more environmentally friendly. And because they don't have a tank, they're smaller, they can hang on the wall. They run on gas or electricity, just like a tank water heater does. But the other benefit is that you can have an endless supply of hot water. The hot water doesn't run out when the water in the tank runs out. Although tankless water heaters are a little more expensive on the front end, when you factor in energy savings and less maintenance and upkeep over time, the price is favorable, in my opinion, and they're more energy efficient. A. O. Smith, the leading water heater company in the world, was late to the tankless market. That concerns me a little. Maybe their innovation engine is slowing a bit. Or maybe not. They are catching up. They have formed a partnership with a Japanese manufacturer. They have, I think, exclusive rights to sell that Japanese product in North America, or at least in the U.S. and Canada. And I think they have 10% to 12% market share in tankless now. So they're gaining. The tankless market is interesting. It's currently only about 8% of the total addressable market in North America, but it's growing faster than the tank market.

I'm worried they missed that product. They're there now, but they were late to the game. I'm worried about some of these earnings quality metrics that I do need to dive deeper into.

And then lastly, a broader economic slowdown in the U.S. would hurt them. We see what an economic slowdown in China is doing to their sales. Sales fell 18% in China in the first quarter. A broader economic slowdown in the U.S. would obviously hurt them in the short-term. I think their sales fell 38% in 2008, or 2009, during the depths of the global financial crisis. To be fair, that was the worst financial crisis in almost 100 years. And to be fair, A. O. Smith grew its net income, its free cash flow, and increased its dividend in that year. But sales did fall 38% in the depths of the crisis.

Sciple: Yeah. So, takeaway, wait and see how things shake out. Would look into this short report, maybe have you back on as we get more details of what's going on with A. O. Smith's business. Again, I think the long-term drivers of demand for the product they sell are going to be there. But it's a question of, again, are they going to be able to grow their market share in tankless? Is the economy going to cooperate? We'll just have to see how things go.

John Rotonti owns shares of A. O. Smith. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.