Water heater and boiler manufacturer A.O. Smith Corp AOS has a material undisclosed partner, Jiangsu UTP Supply Chain, that acts like the company and allows it to "stuff" distributors and inflate gross margins, according to a short report issued Thursday by the firm J Capital Research.
The Chinese company is not mentioned in A.O. Smith's financial filings or conference calls, but "is involved in almost every aspect of A.O. Smith's China business," accounting for as much as 75 percent of its Chinese sales, JCap analyst Anne Stevenson-Yang said in a Thursday note.
Benzinga has contacted A.O. Smith for comment on the short report and will update this story with any response from the company.
JCap values A.O. Smith shares at $22.68; the stock was down nearly 8 percent at $44.27 at the time of publication Thursday.
The Short Report
"Irreconcilable" capex, R&D and asset inventory accounts are being used as "cookie jars" to preserve A.O. Smith's financial statements while shielding the involvement of UTP, Stevenson-Yang said.
"Our detailed distributor channel checks indicate China revenue will fall by as much as 21% in 2019 vs management’s claims of a 6-8% decline."
The boiler maker does not truly have access to the $539 million in cash it reportedly holds in China, which amounts to roughly 84 percent of the company's cash on hand at the end of 2018, according to the short report.
"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."
A.O. Smith has accounting irregularities outside of China, Stevenson-Yang said, highlighting an "unfavorable" mark she said was given to the company's Indian operators by an auditor.
Spruce Point Says It's 'Always Had Concerns'
Spruce Point Capital Management issued a separate report Thursday in support of JCap's thesis and said it is also short the stock.
"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," the firm said.
Spruce Point's price target for A.O. Smith is $17.70 to $27.30.
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