What happened
Shares of water heater maker A.O. Smith (AOS 0.08%) rose 16% in June according to data provided by S&P Global Market Intelligence, reversing course from a brutal May, when they fell nearly 23%. The May decline, however, was a continuation of a trend that started in mid-April, which left the stock off its April highs by nearly 30%. You can mostly thank short-sellers for the drop and the company's response for the June reversal.
So what
In early to mid-May, short-sellers released a report questioning A.O. Smith's foreign business. That operation largely consists of water heater, water purifier, and air purifier sales in China (a country that accounted for 34% of revenues in 2018). Smith's sales in China have grown at a compound annual rate of 19% over the past decade, so questions about the sustainability and past financial success here were and remain a very big deal. That added to existing concerns over a sales slowdown in China that has followed along with the country's cooling economy. The ongoing U.S.-China trade war hasn't helped investor sentiment any, either. Investors were obviously spooked by the May short report and sent the shares of A.O. Smith sharply lower.
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In many ways, that's an understandable response, given that the company is counting on foreign sales to boost its long-term growth. Smith's core North American business is driven by replacements and is only expected to grow in the low single digits over time. And if there were issues in China, that would logically lead to questions about the company's plans to repeat the success it had in India, a burgeoning market for the company.
To management's credit, it quickly hit back, disputing the short-seller claims. The mid-May news release laid out management's points, highlighting that the company has operated in China for two decades, follows normal business practices in the country, and adheres to generally accepted accounting principles (GAAP). That still wasn't enough to reverse the downtrend, so in early June, the company announced it was increasing its 2019 stock buyback program by 50%. Effectively, it was telling investors that it was planning to take advantage of the stock sell-off precipitated by the short-seller report. That appears to have gotten the attention of Wall Street, leading the shares to start their month-long rebound.
Now what
A.O. Smith is still facing headwinds in China that are expected to lead to slower-than-historical earnings growth in 2019. And the trade war remains a major wildcard, though this issue didn't actually change much in June. However, the company believes the long-term outlook for water heaters, water purifiers, and air purifiers remains strong in China and India. Assuming management is correct (and short-sellers are wrong), the stock remains an attractive option for investors looking for long-term growth.
