Why Shares of A.O. Smith Plunged on Thursday

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What happened

Shares of A.O. Smith (NYSE: AOS) were down more than 8% on Thursday after the manufacturer of water heaters, boilers, and related products was the target of two separate short-seller reports questioning the company's international business and suggesting that the company's profitability was either the result of "aggressive accounting" or unsustainable.

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So what

J Capital Research analyst Anne Stevenson-Yang in a report released Thursday said A.O. Smith uses an undisclosed partner, identified as Jiangsu UTP Supply Chain, to stuff inventory and inflate gross margins. Stevenson-Yang said that although Jiangsu doesn't appear in A.O. Smith financial filings and hasn't been mentioned on conference calls, it accounts for upwards of 75% of the company's Chinese sales.

She also questioned whether A.O. Smith really has access to the $539 million in cash it says it holds in China, which is about 84% of the company's total.

"We have conducted dozens of interviews in China and believe that AOS may have used its cash for distributor loans to prop up sales," Stevenson-Yang wrote. "That would mean the money is in escrow and cannot be touched until loans are repaid."

Another firm, Spruce Point Capital Management, piled on soon after with a series of tweets, saying, "We've had grave concerns about this company's margins/capex [capital expenditures]/China story for a while."

Spruce Point also questions A.O. Smith's 40%-plus gross margins for what is a commodity product, arguing that even if it is accurate, it's unsustainable. The short-seller says it sees 45% to 65% downside in the stock.

Now what

A.O. Smith has long been praised for its ability to methodically expand into emerging markets. These reports raise serious questions about that growth, or at least about how sustainable it is, that the company needs to address as soon as possible.

Shares of A.O. Smith were up more than 30% year to date heading into May, but the combination of increasing trade tensions with China and today's reports have erased most of the gains. Investors should wait for the company's response and evaluate it closely before jumping in.

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Lou Whiteman 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.