Check out the latest A. O. Smith earnings call transcript.

If we were to only look at A. O. Smith's (NYSE:AOS) earnings for the fourth quarter, then this most recent earnings report would look absolutely fantastic. Once you start to consider some of management's commentary on the situation in China and guidance for 2019, though, the picture starts to look less optimistic. 

Let's take a look at what went right in the fourth quarter for A. O. Smith and why that strong performance is overshadowed by muted expectations for 2019.

Hot water coming from faucet.

Image source: Getty Images.

By the numbers

Metric Q4 2018 Q3 2018 Q4 2017
Revenue $812 million $754 million $768 million
Operating income $154.8 million $131.5 million $140.8 million
Net income $126.3 million $104.6 million $22.7 million
EPS (diluted) $0.74 $0.61 $0.13

Data source: A. O. Smith earnings release. EPS = Earnings per share. 

Any investor has to be pleased to see these most recent results. Sales grew considerably in the company's most profitable segment, North America, and it was able to pass on price increases to offset the impact of tariffs on steel and aluminum that have been nipping at its bottom line in recent quarters. Those strong North America results also helped to offset the economic slowdown in China that has affected sales. The strength of North America is largely what led to the company's beating earnings expectations for the quarter. 

Bar chart of AOS earnings by business segment for Q4 2017, Q3 2018, and Q4 2018. Shows jump in North America offsetting rest of world decline.

Data source: A. O. Smith. Chart by author. Numbers in millions. 

2018 ended up being a record year for the company in terms of sales, earnings per share, and free cash flow. The company produced $435 million in free cash flow for the year and ended 2018 with net cash (cash minus debt) of $420 million. That incredibly strong financial position is what allowed management to increase its dividend payment by 30% and buy back $202 million in shares this past year. At the company's most recent investor day presentation, it announced the board had authorized the repurchase of an additional 5 million shares. In total, management has the authority to repurchase 6.1 million shares (about $290 million at current stock prices).

What management had to say

All of the company's good news seemed to end at its quarterly review. Once the company started to discuss its expectations for 2019, things started to go south. According to CEO Kevin Wheeler, 2019's results are going to be affected significantly by an expected slowdown in China. 

North America boilers and residential water heaters performed well in 2018, and we expect this trend will continue in 2019. We believe our business model in China is solid, although we have some near-term challenges to navigate through as the China economy remains weak. Assuming relatively flat consumer demand in 2019 and without the impact of the previously disclosed channel inventory build we experienced in 2018, which we estimate was at least 5 percent of 2018 China sales, we project China sales will decline by 3 to 6 percent in 2019 in local currency terms and 7 to 10 percent in U.S. dollar terms. Since the inventory build primarily occurred in the first quarter of 2018, we anticipate the majority of the related China sales decline will occur in the first quarter of 2019.

Management expects 2019 sales to grow between 1% and 2.5% in U.S. dollars and for EPS to land between $2.67 and $2.77. For reference, 2018's earnings per share came in at $2.58. 

AOS Chart

AOS data by YCharts.

A slowdown isn't great, but it's not a game changer

Tepid growth numbers like this aren't going to inspire a lot of investors to hit the buy button for A. O. Smith's stock, especially since its shares trade at a price-to-earnings ratio of 23 times today. Even after the stock's 30% decline in the past year, that is a considerable premium for such slow growth, and we see no signs that the Chinese economy is going to get better soon.

At the same time, though, A. O. Smith has an incredibly stable business in North America that will likely continue to produce at high margins and throw off considerable amounts of free cash flow. What's more, its balance sheet is too strong for investors to worry about short-term issues. 

It may not be the best time to buy the stock, because there may still be some bad news on the horizon if we see even slower sales in China or if it struggles to make inroads in the Indian market. At the same time, though, there's no reason for current shareholders to panic.