Welcome to the AAON, Inc. First Quarter Sales and Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded, Thursday, 5/2/19. I would now like to turn the conference over to our host, Mr. Gary Fields. Please go ahead..

Good afternoon. I’d like to welcome you to the AAON Investor Conference Call 2019 First Quarter Earnings Announcement. I’d like to read a disclaimer to begin with. This is a forward-looking disclaimer.

To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the Safe Harbor provisions of the securities litigation Reform Act of 1995.

As such, it is subject to the occurrence of many events outside AAON’s control that could cause AAON’s results to differ materially from those anticipated. Please see the risk factors contained in our most recent SEC filings, including the annual report on Form 10-K and the quarterly report on Form 10-Q.

Now I would like to turn it over to Scott Asbjornson, our CFO..

Welcome to our conference call. I’d like to begin by discussing the comparative results of the three months ended March 31, 2019 versus March 31, 2018. Net sales were up 14.9% to $113.8 million from $99.1 million in the preceding period – preceding year.

Net sales for the quarter are up due to our price increases from 2018, along with increases in the volume of rooftop units sold. Our gross profit increased 67.6% to $25.8 million from $15.4 million. As a percentage of sales, gross profit was 22.7% in the quarter just ended compared to 15.5% in 2018.

The company continues to experience challenges in obtaining and retaining talented workers at the entry-level. Selling, general and administrative expenses increased 7.7% to $11.0 million from $10.2 million in 2018. However, as a percentage of sales, SG&A decreased to 9.7% of total sales in the quarter just ended from 10.3% in 2018.

Income from operations increased 180.2% to $14.5 million or 12.7% of sales from $5.2 million or 5.2% of sales in 2018. Our effective tax rate increased to 24.8% from 18.7%. The company’s estimated annual 2019 effective tax rate, excluding discrete events, is expected to be approximately 27%.

The company had a larger excess tax benefit related to our stock awards in the first quarter of 2018 compared to 2019 that caused the effective rate for that quarter to be lower than expected. Net income increased to $10.9 million or 9.6% of sales compared to $4.3 million or 4.3% of sales in 2018.

Diluted earnings per share increased by 13.0% to $0.21 per share from $0.08 per share. Diluted earnings per share were based on 52,397,000 shares versus 52,910,000 shares in the same period a year ago. At this time, I will turn the call over to Rebecca Thompson, our Chief Accounting Officer and Treasurer to discuss our balance sheet..

Thank you, Scott. If you look at the balance sheet, you’ll see that we had a working capital balance of $102.8 million versus $92.8 million at December 31, 2018. Cash totaled $7.1 million at March 31, 2019. Our current ratio is approximately 3.3:1. Our capital expenditures were $8.8 million.

We expect capital expenditures for the year to be approximately $40 million. The company has stock repurchases of $5.1 million year-to-date. Shareholder’s equity per diluted share is $4.95 at March 31, 2019 compared to $4.70 at December 31, 2018. We continue to remain debt-free. I’d now like to turn the call over to our President, Gary Fields..

One is to serve the local market more thoroughly than what we currently do, but the other one is so that this is a prototype of what we expect our sales channel partners across North America to duplicate in one form or fashion. It’s a great example given best practices for a parts store business.

Our gross profit, we believe, will be improving throughout the year quarter-over-quarter, with direct impact coming from the price increases that I described earlier and how they’re affected relative to the backlog. We believe that the majority of material prices have stabilized.

While there could still be some that are moving around a little bit, there’s nothing on the immediate horizon telling us there’s any shakeup like there was back when we had the tariffs and so forth imposed.

Labor, we have some small escalation planned in our labor rate on the plant floor to keep pace with the needs in the market so that we keep bringing in qualified people for our expansion and that we retain these people. Salaries, I think, are set for the year and are stable, so we’re not seeing anything there.

So there’s some upward pressure in entry-level for any new hires that we might need. CapEx for 2019 is still looking like $40 million. Like normal though, some of these things are a little longer lead times but they don’t actually get the bill in, so I’m hesitant to say we’ll actually get the $40 million extended.

But we’ve certainly written purchase orders to allow that to occur. So now, I’m going to turn it over to Norm for any additional comments that he might have..

A lot of you were quite concerned about the turnover of my management to the new management. And I’m very pleased with what has taken place. Not only was I backing out, which I’ve done, and I’m still advising but not doing every work that Gary is doing now. But also, many of the people who have joined us originally retired or are no longer with us.

And so we’ve had quite a changeover in a generational changeover in a number of areas of critical importance to the company. And I’m pleased to say that we’re probably 90% in the way towards the next generation of management throughout the entire company, and it’s been effected over the last 2.5 years.

So that’s been an issue for many people concerned about when that was going to occur as it has already occurred. Now it’s not without some weakness that, that occurred. The majority of our problem which is still with us has to do with productivity.

We lost a lot of talent and people who knew how to get the maximum results out of the personnel and the company. And we’re rebuilding that, and of course, that’s a very time-sensitive issue. You learn that over a number of years. That’s not something that’s taught or learned already.

It’s a very individualized situation on how to manage people with any given company. And our new management is picking up on that quickly. So we are expecting to see over the next year or so a continued improvement in productivity, which is just as effective on the bottom line as is the price increases.

So if you’ve been following us on the cost of our labor relative to sales, you’ll notice that we’ve had some slip-ins for the past two or three years while we’ve been undergoing this transition.

And we are pleased to tell you that we’re through that, and now, we’re on the upswing and our productivity should start realizing additional benefit to our bottom line. This, of course, is not an instantaneous quick fix. This is a long-term thing.

But it is a major thing which the company has now completed for all practical purposes, and there are no major changes that are going to have a material effect on the bottom line in a particular way.

So we’re pretty much into a routine management challenge to make things occur, and we are very optimistic about the ability to bring ourselves back up to our historic profitability level.

And we’ve added a lot of capability to our ability to get orders, and that’s well-represented by our increase in our backlog, which our customers have been pleased with what we’ve been sending and have given us a great deal of growth in that. So the transition from the one group of people to the next is, as I said, very well completed.

Along the way, we’ve enhanced our pipeline and our desirability of our product to our customers. And our biggest challenge at this point is internal management to gain our productivity back. With that, I’d like to open it up..

We’d like to open it up to questions now..

[Operator Instructions] Your first question comes from the line of Joe..

Hi, good afternoon guys. So I was wondering if you could talk about the driving factor, the biggest driving factor to the orders and the backlog, what you see that’s driving such robust growth..

Joe, I think we’ve been working on various aspects for nearly six years now. In mid-to-late 2013, Norm recruited me to consult with the sales channel partners across North America. There’s 62 individual firms; I consulted with 32 of those firms.

This was an attempt to share with them the successes of my former company, which was a marquee performer in the industry. A company that was admired not only by AAON, but all the other manufacturers that, that company represented. And so we began that consulting.

In doing so, we identified five firms out of those 32 firms that didn’t have it in their inherent behavioral characteristics and DNA to be in alignment with AAON’s expectations for growth opportunity. So as time went on and I was appointed president, I replaced five of those firms.

And the firms that I replaced them with were firms that were more in alignment with our objectives, and that is continuous and perennial growth. And there’s a key strategy for those sales channel partners that enables that to occur. It’s something that I have 30 years of experience with.

So I think helping those people to understand why Texas Air was successful in getting people in alignment was very instrumental. So that goes back quite a few years to laying some groundwork for that.

The next thing that I think occurred was that there were people that were unwilling to tie a major stake of their business to AAON in the face of the unknown about what was going to happen when Norm retired or moved on. And so that uncertainty gave them reservation to dedicate the effort and time to AAON.

Well once that succession plan was revealed, and I found, not only myself, but other key leaders, become more visible.

Scott, right here next to me, and then other people throughout the company, when they started seeing the succession plan and they started gaining confidence in these people, then they had confidence to spend more time, effort and dedication on AAON’s behalf. Because keep in mind, these people are independent and they are representatives.

So when they get up in the morning and go to work to sell air conditioning equipment, they have multiple choices. Not all of which are necessarily competitive to AAON product-to-product, they’re competitive for the time. So AAON has developed a reputation as being a company that is very worthwhile spending their efforts on, very rewarding for them.

So I think that was key. Then the next thing was when I came in here, having been on the other side, on the sales channel partner side, there were aspects of AAON that I saw as low-hanging fruit, areas that we could improve with a reasonable amount of effort and become more attractive yet to these manufacturers, reps or sales channel partners.

So those three aspects right there are significant. Those would have improved this company absent of this great economy that has been turned loose by the current administration in the U.S. government, with their reduction of taxes and their relaxation of certain onerous regulations.

So you’ve got a better business environment to operate in, you’ve got a better economy to operate in, but then you’ve got six years of preparation that Norm initiated with strengthening our sales channel partners, themselves, strengthening their planning and activities, and making our company the most attractive company on their line sheet to sell and represent..

Okay. So the one thing that I’m trying to sort of grasp or figure out is the massive – I mean you guys have seen incredible growth over the last 5, 6 quarters. And if you look at sort of your orders on a quarterly basis, in the backlog on a quarterly basis, it really started accelerating in the fourth quarter of 2017.

And I – that was right around the same time when we started seeing very significant inflation and when your peers and such started to put in very aggressive price increases. And those peers, over the last year or so, have not seen anything compared to the growth rates that you’ve seen.

And I know you guys have fallen behind early in 2018 and you’ve since started picking up, and obviously, you’ve done a good job with price increases.

But I guess the one thing that I’m just trying to figure out and I was wondering your thoughts on, are over this period of time, have your pricing – the gap between your pricing and your peers, changed at all considerably, that have been driving a lot of this demand that we’ve seen over the last handful of quarters?.

I would say initially, if you want to go back to Q4 of 2017 when you saw this begin to accelerate, yes, the peers did get out in front of us with more substantial price increases. That is one thing that I – if I had a mull again to go over, I would redo that.

But somewhere around the June 2018 price increase, we began to be in that same alignment that we’ve historically been with regards to our pricing levels versus our peers' pricing levels. We started catching up with them at that point in time.

So I don’t think beyond the June of ‘18 price increase, I don’t believe that there was any advantage to our sales channel partners in having a lower-priced offering relevant to what they’ve had historically. And then as we continued to increase the prices, we actually passed up the overall price increases that these peers had.

And so they were still able to get these orders. Well, like I said, some of these things were them having just more dedication to spending time on selling our products. But we’ve also improved the products, both with efficiency and operating strategies and quality. You’ve seen the warranty expense being reduced.

It peaked out early on, and then it’s consistently been moving in a positive direction, which shows that we put some efforts into redefining what we meant by premium quality. And we’re delivering on that promise.

So I think that I would not categorize our growth as being – that we’re behind on price increases and we’ve given up some of the premium that we had historically employed..

Okay. And I wanted to ask, I know you’re sort of still – the price cost issue is still weighing on things, but that’s going to improve as the year goes along. Productivity should, over time, improve.

I’m just curious, has anything structurally changed that you cannot get back to sort of those peak 31%, say, gross margin, 21% op margins? Has anything changed structurally? Or can we sort of assume at some point in time, in 2020 or 2021, that eventually, we’ll return to those levels, hopefully?.

I believe that we’ll return to those levels no later than what you just stated. I believe that when I look at the price of the backlog, that we see accretive measures in there, and we’re going to continue to see an acceleration in our gross margin percentage.

The other thing is that we’ve only recently, in the last few weeks, achieved an ideal headcount out on the plant floor. While the turnover rate is still higher than we’d like for it to be, it’s substantially improved over what it was 12 months ago. Our onboarding and training has improved substantially.

So I believe that our productivity is already showing evidence of improvement. We looked at some figures that came in as recent as yesterday, and those tell me that we are making progress in that regard.

So with the improved pricing position and seeing some results from our training and onboarding initiatives and having an ideal headcount, I believe that we are on the right path to make all of this happen, to get back to historic levels. We’re targeting maintaining between 28% and 32% gross margin.

The next thing I want to say about that is somewhat related is historically, Q4 and Q1, in any particular year, were as much as 20% lower demand rates, production rates, than were in Q2 and Q3. Well, with this strong input, we’ve not seen those drop-offs, Q4 and Q1, as far as demand rate.

You’ve seen the backlog increase, so you know that the demand rate is increasing if it’s not having its historical path of a peak in two and three. One of the fallouts from that I don’t think was easily understood and anticipated, was machinery magnets.

When we would have the fall off in Q4, historically, then it was much easier to schedule doing major overhauls, major repairs on some of our highly automated sheet metal equipment. And that would go into Q1, and those machines would be in tip-top condition as a complete fleet of machines to perform at that higher level for Q2 and Q3.

Well, we are now running at maximum rates in every quarter with, actually, acceleration required in every quarter. So we found ourselves a little behind the curve on how we went about overhauling and maintaining a machine that was running at 100% required capacity.

So we’ve been working hard on not only revising that, but also in putting in more surplus manufacturing capability so that we have the ability to provide 100% of the required sheet-metal components but at a less than 100% capability of the machinery..

All right. And then so I sort of – I mean, maybe sort of related to what you’re saying right now, I wanted to ask about just sort of this incredible growth and backlog and the fact that you’re trying to push through as much volume as possible through the plant.

Is there any risk over the next several facilities – several quarters to sort of your internal projections that because of sort of the productivity issues that you’re still dealing with, that maybe because of that and maybe because of you have to pay overtime to achieve certain delivery dates or anything like that, is there a risk to achieving sort of the margin improvement because of higher costs or productivity issues because there’s so much volume going through the plant..

Joe, I think there’s always risk. And I think that we have to be astute at managing those risks. Now the overtime risk is probably not substantial in the fact that we run the plant, the vast majority of it, 24 hours a day, seven days a week.

So we do have – we only run assembly currently 12 hours a day, seven days a week because we don’t have the ability to supply enough sheet metal to assemble 24 hours a day. So one of the things that I was speaking to was adding sheet metal manufacturing capacity.

Part of that $40 million CapEx is additional automated sheet metal manufacturing equipment. We’ve talked about it for years, the Salvagnini machines. We’ve placed considerable orders. We’ve got machines coming in as we speak.

I think that all of the machines that we have on order now will be in operation in 2019, and they will supply us with additional capacity, such that we’re anticipating that before the end of the year, we’re going to go to 24 hours a day assembly on our first half of the week shift.

Our second half of the week shift will still remain 12 hours a day, probably, for the near term within the next year or so. But that will give us roughly 25% more assembly time than what we currently have. So that’s another area where we’ve identified what the hurdles are or the chokepoints are to being able to employ that.

And it was the sheet metal machines, meaning more of them and having – they don’t have 100% dispatch rate, meaning they don’t run for 12 years, 24 hours a day, 365 days a year without breaking down.

You’ve got to have some scheduled time, and so we’re looking at some ratios that makes sense as far as what kind of dispatch rate we think is reasonable, and we’re building in additional machinery to achieve that.

While we’re doing that, we’re also looking at our growth projections based on all the intelligence gathering we can do with our sales channel partners plus within the house now, and making these decisions on purchasing this equipment in order to get this particular chokepoint out of the way.

And then once we get that sheet metal equipment chokepoint out of the way, which is occurring as we speak, then the next thing will be getting an assembly crew put together for that first half of the week, p.m. to a.m. shift.

And we’ve already made considerable strides with that over the last year in putting other – not assembly, but other functions of the company necessary such as brazing, wiring and painting, we’re already running that.

We’re running painting 24/7, correct?.

Not fully. We’re probably about 75% in there..

Okay. So we’ve moved quite a ways towards getting some additional capacity through the 24/7 function..

[Operator Instructions] Your next question comes from the line of Zane..

This is Zane Karimi on for Brent Thielman. Just thinking – starting things off, I was hoping to get a little more detail on the lab specifically. Can you quantify the drag on P&L? Like, Is that putting pressure on the margins? I’m trying to get a better feel of the underlying businesses there..

Well, we have had research and development personnel on staff – I don’t know the exact number of expanded positions over what time period. We did segregate the lab function into its own department. So we know definitively how many people are in there.

And the last time I looked, the population was – what was it, just under 50, isn’t it?.

[Indiscernible].

Yes. And so I don’t know historically what that’s been to give you a clear definition. There’s no doubt that there’s expense related to running the lab. There’s going to be expense related to depreciation of those assets. As we bring more and more functions on board, there will be higher utility costs related to it.

So it would be naive to believe that it didn’t have some effect on it. But once again, I think that what we’ve done to grow the opportunity for ourselves and representatives to sell more equipment at this premium price, I think the lab enhances that a lot.

We have already seen evidence of multiple projects that were awarded to AAON because of the lab facilities. Jacob Javits in New York City, Nike World Headquarters in Merchandising Building, One Willoughby tower in New York City.

These are projects that were absolutely awarded to us because of what we were able to demonstrate to them and develop for them in the laboratory. So it is, in that regard, an expense – a sales expense, which is a burden to the overhead.

Then about 1/3 of the activities of the lab is maintaining our certifications with the certification agency, the AHRI. So AHRI has multiple programs, some of which they select equipment from your plant floor, they ship it to their laboratory and test it.

Well, you want to make sure that you have confidence in your performance data that you publish, so you have to test your equipment to make certain of that. The other thing is, is there are certain categories of equipment that AHRI comes here and certifies the equipment performance here in our laboratory.

That’s primarily the way they do chillers, for instance. So we formerly only had the ability to test that to a 210-ton chiller. And now, we have the ability to test that to a 540-ton chiller. So we’re able to do that here in our facilities.

So about 1/3 of the activity is anticipated to be for development of new product or – and 1/3 is anticipated to be for the AHRI proof of concept. And then 1/3 is dedicated to activities such as I mentioned with Jacob Javits and Nike and One Willoughby projects of that nature..

Great….

And those are all activities that are – that we charge for. So it will have some direct revenue..

Okay. And then it seems like design firm contractors and other product benefactors are universally positive about the state of the non-residential construction market. But you’ve been running around 50-50 replacements in new construction.

Do you think your mix can materially shift toward the new construction market in 2019? And are you guys actively trying to control that mix?.

Actually, I think that there is a lot of untapped opportunity amongst our sales channel partners for replacement business. And we just recently – well we have a gentleman that we hired about one year, 1.5 years ago, to focus him on some strategic accounts.

And just recently, I gave him additional assignment that he was to consult with and assist in the sales process with our sales channel partners for the replacement business.

So I’m going to tell you that where the new construction business has not shown any weakness yet, but if you use Architectural Billing Index as any kind of an indicator, the latest data from them showed a little softening of that market.

So you normally have about a nine to 10-month lead time from that day to be in publish to seeing any kind of material effect on the business. So that being the case, I wanted to be well ahead of this and work on developing additional strategies for replacement market.

It’s one that I don’t believe our sales channel partners as a whole are extremely adept at. I think they do a good job, but not a great job. There are certain representative firms out there that are great examples for doing a great job of it. But across-the-board, I think that there’s room for opportunity and room for improvement..

Got you. And a follow-up on that notion.

Can you discuss geographically where you’re seeing the fastest growth and demand for products? And how much of that is more internal efforts to improve penetration versus the regional demand environment?.

Okay. I’m not seeing any material change in the regional demand environment. But the internal efforts, some of the firms that we improved is, both coast, were weaker than we desired going back five, six years ago. So we spent more effort on both coast than we did anywhere in the middle.

The middle of the country was relatively well-positioned for AAON’s needs. The West Coast has grown at a – I don’t have the percentages in front of me, but a huge rate. I’m going to say in the last five years, it’s probably 2.5 times, what it was, in that relative order.

And the East Coast has grown probably at about 15% to 20% compounded annual growth rate over that period of time. So both coasts have provided a lot more results for us. In the Southeast region was where AAON’s equipment was particularly attractive, but we weren’t seeing the success that we believe we should see in those markets.

And a substantial number of those rep firms that were replaced were in the Southeast region. That’s a hot and humid region that really sit – it sits real well with our product offerings. Then of all things, it’s not hot and humid at all, but Canada. We had two representative firms that we changed out in Canada over the last two or three years.

One of those in the Montréal section of Canada. They handle more than Montréal but that’s where they’re headquartered. They have been on board for two years now, and they are four times the volume their predecessor was in just two years.

So we have – I call this internal effort, in that we got better sales channel partner engagement and we also got better sales channel partners in those areas that we saw as weak..

There are no further questions from the phones..

All right. We thank you for your listening to the call today. We look forward to talking to you again in August for our second quarter results. Good day..

This concludes today’s conference call. You may now disconnect..