Good afternoon, ladies and gentlemen, and welcome to AAON Inc. Third Quarter Sales and Earnings Call. There will be a question-and-answer period after management's brief presentation. This call will last approximately 45 minutes to an hour. I would like to turn the meeting over to Mr. Gary Fields. Please go ahead, Mr. Fields..

Good afternoon. I'd like to read a forward-looking disclaimer to begin.

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 10-Q.

So one of the first things I'd like to do is, thank all of our employees for their diligence to maintaining a safe work environment here at AAON. Coronavirus has been very challenging for all employers, but especially those that have to work in close proximity in a manufacturing environment.

They've done an outstanding job of maintaining masking, social distancing, cleaning, temp scans and wellness check-ins when they check-in for their shift. We've done very well with that, and we so much appreciate them being diligent in maintaining that safety.

So with that, I'd like to turn it over to Scott and he will talk about the financial performance..

Thank you, Gary. I'd like to begin by discussing the comparative results of the three months ended September 30th, 2020 versus September 30th, 2019. Net sales were up 18.7% to $134.8 million from $113.5 million.

Net sales for the quarter are up due primarily to our increased sheet metal production from the additional sale from Salvagnini machines that were put into operation during the year. Our gross profit increased 49% to $40.8 million from $27.4 million. As a percentage of sales, gross profit was 30.3% in the quarter just ended compared to 24.1% in 2019.

We continue to see overall raw material costs decrease. The company has improved its labor and overhead efficiencies through increased production and absorption of fixed costs. Selling, general and administrative expenses increased 18.9% to $14.7 million from $12.4 million in 2019.

Additionally, as a percentage of sales, SG&A remained steady at 10.9% of total sales in the quarter just ended and in 2019. SG&A is up due to increases in profit-sharing and other employee incentives related to increased earnings. Income from operations increased 73.9% to $26.1 million or 19.4% of sales from $15.0 million or 13.2% of sales in 2019.

Our effective tax rate increased to 21.8% from 4.9%. The company's estimated annual 2020 effective tax rate, excluding discrete events is expected to be approximately 24.4%.

2019 had the benefit of a positive return to provision adjustment related to our research and development credit along with additional credits we were able to capture upon amending our Oklahoma returns. Net income increased to $20.5 million or 15.2% of sales compared to $14.3 million or 12.6% of sales in 2019.

Diluted earnings per share increased by 46.2% to $0.38 per share from $0.26 per share. Diluted earnings per share were based on 53,151,000 shares versus 52,722,000 shares in the same period a year ago. Now for the comparative results of the nine months ended September 30, 2020 versus September 30, 2019.

Net sales were up 14.7% to $397.9 million from $346.8 million. Net sales for the quarter are up due primarily to our increased sheet metal production from the additional Salvagnini machines that were placed into operation. Our gross profit increased 46.8% to $121.9 million from $83.0 million.

As a percentage of sales, gross profit was 30.6% in the quarter just ended compared to 23.9% in 2019. As already noted, we have experienced decreased material costs and improved overhead absorption. Selling, general and administrative expenses increased 17.7% to $45.9 million from $39.0 million in 2019.

Additionally, as a percentage of sales, SG&A increased to 11.5% of total sales in the quarter just ended from 11.2% in 2019. Income from operations increased 73.8% to $76.1 million or 19.1% of sales from $43.8 million or 12.6% of sales in 2019. Our effective tax rate increased to 21.1% from 16.8%.

The company's estimated annual 2020 effective tax rate, excluding discrete events, is expected to be approximately 24.4%. As already discussed, in 2019, our tax rate benefited from additional credits we were able to capture. Net income increased to $60.1 million or 15.1% of sales compared to $36.4 million or 10.5% of sales in 2019.

Diluted earnings per share increased by 65.2% to $1.14 per share from $0.69 per share. Diluted earnings per share were based on 52,955,000 shares versus 52,645,000 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..

Thank you, Scott. Looking at the balance sheet, you'll see that we had a working capital balance of $164 [ph] million versus $131.5 million at December 31, 2019. Unrestricted cash totaled $70.6 million at September 30, 2020. Our current ratio is approximately 3.7:1. Our capital expenditures were $49 million.

We expect capital expenditures for the year to be approximately $73.2 million with $41.3 million directed to our new facility in Longview, Texas. The Company had stock repurchases of $21.4 million during the nine months ended September 30th, 2020.

Shareholders' equity per diluted share is $6.51 at September 30, 2020 compared to $5.51 at December 31st, 2019. I'd now like to turn the call back over to our CEO and President, Gary Fields..

I'd like to have a brief discussion about the current building readiness situation. So ASHRAE, American Society of Heating, Refrigerating and Air-Conditioning Engineers has put together a group they call the Epidemic Task Force.

They published a building readiness guide of which they've updated numerous times throughout this event of coronavirus primarily. Most recently, it was updated on the October 20.

Some of the key things that it talks about in there are related to building operating strategies such as pre-purge and post-purge, meaning in the unoccupied mode of operation that you purge the building. Well, there are some -- certain things that have to be considered there, temperature and humidity control.

So most buildings when they go into this purge have the ability to either heat or cool in order to keep the building in an acceptable temperature range. One of the key factors that ASHRAE points out that maintaining the humidity ratio of 40% to 60% is ideal for minimizing the spread and propagation of viruses.

So if you're in the northern latitudes and you purge this building in the winter mode like from right now going forward, then you'd have a very low dew point. So you'd have to add a lot of humidity. So that's onerous to the operating characteristics.

If you're in the southern latitudes, in Tulsa today, we're at 75 degrees, and if we were to purge the building tonight, we'd have dew points that would be well above that 60%relative humidity, if we didn't control it. So basic operating strategy that AAON brought to the market many years ago and is deemed the gold standard for controlling humidity.

So this is something that's inherent in our characteristics in just this operational strategy that this epidemic task force has recommended. And the next thing, they divide this from building operating strategies to actual HVAC equipment configurations. In this, they give extensive discussion to increased filtration.

Vast majority of buildings use anywhere between a MERV 4 and a MERV 8 filtration level, which has always been acceptable for containing and filtering out your normal average particulates in the air stream, but with this virus, they have recommended going to a minimum of MERV 13 and even higher, possibly a MERV 14.

Well, when you do this, then the air pressure drop across that filter increases substantially, well, in packaged rooftop units, particularly those 40 tons and smaller. In AAON's basic inherent design, we have accommodated that very well with a backwardly inclined direct drive fan.

First off, this fan's speed is easily changed because we have either a ECM motor or a variable frequency drive motor.

This is a programming change to change the speed, provided it was selected with some adequate safety margin between operating RPM and potential RPM, which is again an inherent characteristic of the way we provided software selection advice.

So the vast majority of the time, an existing installation of an AAON unit, they can change the filters from these lower MERV levels to the higher MERV levels with a simple adjustment of the fan speed.

The efficiency of AAON's basic inherent design of the backwardly inclined fan is much, much better than our typical competitors with their forward curve fans, especially their belt drive forward curve fans.

So we have a basic design characteristic that's been in place for many, many years, with AAON, with these direct drive backwardly inclined fans, so those bode very well for this increased MERV level filtration that this epidemic task force has recommended. The next thing that they recommend is UV lights and bipolar ionization.

Again, AAON has a basic design characteristic of the units that has ample space in a standard unit to allow these things to be added.

So if the unit was purchased and put in the field and that option was not selected at that time, it's easily added by our sales channel partners with their service operations and we've seen a fair amount of that occurring.

One of the things that is a very desirable characteristic of AAON is that we have this electronic selection program with a myriad of selectable options to handle all of these various characteristics. So we offer factory installed UV lights, factory furnished and installed UV lights, factory furnished and installed bipolar ionization devices.

So when you look at the total product, project cost, having all of this contained in the unit is very desirable characteristic.

Now once we pass 40 ton units, then the competitors tend to have a little more space, a little more flexibility with their fan design, by the preponderance of units between 2 tons and 40 tons, AAON absolutely dominates that characteristic of the market in our basic inherent design that's been in place for decades.

So the next thing I want to talk about is raw material pricing. Scott mentioned that in the quarter versus the quarter a year ago that we had seen some decline in material pricing.

We have a very progressive and aggressive purchasing group that caught a little low price on primarily copper and steel and got us some contracts that mostly serve our needs through Q1 of '21, maybe a little ways into Q2, but they began to notify me here recently that this low they had caught was behind us, that when they started looking at stretching out contracts further that there was a fairly significant increase in cost of both steel and copper.

So we're going to see material cost on our plant floor increase around the first part of Q2.

Well, to counter that, we had a price increase announced recently and it goes into effect the first part of January and with our now very attractive lead times in our backlog in a much more manageable position, then that price increase that goes into effect in early January will actually be on the plant floor sometime in mid to late March, but totally on the floor in April.

So the increased material cost, of course, 2021 salaries and wages are also going up a bit. So all of this will be well positioned with this price increase that we just put in effect. We're beginning to see the new construction market has tightened up.

Architectural Billing Index has got maybe seven months in a row, Scott?.

Yes..

I believe it's seven months in a row and it normally takes somewhere around eight or nine months for that to manifest itself for us.

Well, I think a combination of the election and the concern over what direction the country is going to go there, coronavirus and this lower ABI, it's not out of the question to believe that we'd challenged on new construction in particular. We're seeing a rise in our success on replacement market, however.

As of today, well, as of the last day of the quarter, let me rephrase that, so as of -- that would be what, September 31 [ph], correct? Our bookings for 2020 trailed 2019 bookings by 3.5%. That gap has been closing because at the end of Q2, that number was closer to 12%.

So we have been closing that, so our efforts for the replacement market are beginning to materialize a bit. Our water source heat pumps, that's a business that I envision struggling under the circumstances of we were positioned primarily for new construction.

Last time I got a data point on this, we were at about 78% new construction and 22% replacement. We analyzed why that was occurring because we believe that it should be the inverse of that, should be more like 25% new construction, 75% replacement. And our product development group did a very, very good job of analyzing what that was.

They are deep into the design of the next generation of water source heat pumps that will address that. Those will be on the market in time for the big surge in replacement market activity.

So I think that we're kind of in a not really a holding pattern, but we're not in a really aggressive growth mode with water source heat pumps at the moment for the reason that the new construction market for water source heat pumps has substantially decreased and our desirable product for the replacement market is soon to be released.

Our commercial and retail, interestingly enough, we're having very good luck with our national account customers that do more of the big box style retail environment and that's going well. We're still doing good steady business with our other customers that are in say foodservice and things like that.

But overall, I'd have to say the commercial and retail is somewhat less than what we expected it to be. Office buildings are very much less than we expected them to be, prior to this coronavirus.

One of the hopes on the horizon and we've seen this materializing with some very good opportunities that have been turning into orders and there is a pipeline full of opportunities for it is medical and healthcare. Coronavirus exposed the weakness in the medical communities, physical facilities with those being primarily outside the urban areas.

When you get outside the urban areas, you get into suburban and rural areas, for healthcare facilities, those become very, very much a target where AAON is very much appreciated in that market. We have very good application opportunities for that. Education opportunities are an interesting one.

We continue to see some parts of the country go forward with bond issues that they had previously issued and they go forward with their construction. We've also seen some that have pulled back a little bit.

I'd have to say overall at this point in time, no, we're about even on that that market is not really -- we've had as many gains as we've had losses. Another market for us that has seen acceleration and looks like it could continue to accelerate is manufacturing. We've seen a good increase in our orders for manufacturing.

Lodging has been a bit surprising to me. I continue to see orders on a regular basis go into lodging facilities. It looks like that these are biased more toward the replacement market than they are in the new market.

So I think a lot of people are upgrading their facilities to be in -- maybe in compliance with ASHRAE's recommendations or their engineering firms have given them good recommendations on that. When you have this increased ventilation, when you have the increased filtration requirements, those fall well for AAON.

So I am still seeing a fair amount of orders for lodging and like I say, this was a bit surprising to me. So that's kind of our outlook on our various market segments. Now, our backlog at September 30th, 2020 was $84.9 million, that was down from $165.3 million a year ago.

Well, $165.3 million was actually a bit troublesome for us because that extended our lead times out where it was very unattractive. And so at this time last year, we were just beginning to get accelerated manufacturing capacity put in, so that we could start burning that backlog down.

We have successfully deployed considerable expansion of manufacturing capacity. We have more manufacturing capacity coming on board. We have a new building in Longview that comes on board for manufacturing first week or two of January.

So we're going to be able to shorten the lead times on the products that we're manufacturing in Longview considerably with that.

In Tulsa, we were able to add quite a lot of Salvagnini machines, we were able to repurpose some areas to more efficient manufacturing processes and the vast majority of those are completed, there is a few of them that are still under way with commissioning and utilization coming on board in the next few weeks.

So we've brought our lead times down a lot and we've won a lot of projects because of that attractive lead time. So AAON had an attractiveness to it that we were able to fulfill, that's what caused the backlog to go up. And now we can fulfill that need for the production.

So we're in balance at this moment, but we need for orders to strengthen a bit more because now we've created a lot of headroom between manufacturing capacity and bookings receipts.

So this is where we design the program to have additional manufacturing capacity and we've proven that and you saw the numbers this month or this quarter, I mean, considerable increase over anything we've ever done in the past, both the number of units and in dollars.

So we're going to be managing this capacity increase very, we've got a very efficient strategies, a lot of metrics that we look at on how to maintain the efficiencies that we have and I'm confident in my operations team that they will manage to this slight softening in bookings.

Now, I will say that we're trailing 2019 bookings by 3.5% right now and the forecast from our sales channel partners is that by the end of the year, we very probably could match 2019 bookings. They are actually a little more optimistic than that, but I'm not so certain about it. There is still a lot of tumultuous things going on right now.

Going into '21, we won't have the backlog that we had coming into '20. So that's going to put some constraints on us for a quarter or two until the momentum gets going back in this economy and until our sales channel is able to recover that momentum. So that's what we're looking at right now.

The next thing is we have not been able to give our people a holiday break shutdown for the four years that I've been here. This is the first time that we've had production has caught up and gotten ahead far enough to where we can give these people some rest and let them have a holiday shutdown.

So we're going to shut down for the Christmas to New Year's holiday this year, because we are very well ahead of our commitments. So that's kind of what we're looking at. Q4, like I said, we came into it with a lower backlog than we did in Q4 of '19.

So we're going to be slowing production down just a little bit here to make sure we maintain this efficiency. And with that, we're open to questions..

[Operator Instructions] And your first question will come from Will Jellison from D.A. Davidson..

Good afternoon, Will..

Mr. Davidson, you may be on mute. I mean, Mr. Jellison..

Well, thank you. Thank you for taking my question. My first one relates to the raw material prices and the price increase that you are implementing in January.

Do you think that those two forces combined, you can sustain that 30% gross margin level you've seen for the last few quarters?.

That is the target. And if our planning comes out in accordance, yes..

That's helpful. Thank you. And then you mentioned some opportunities related to the COVID filtration and equipment upgrades.

Do you have any sense right now of what proportion of new orders that opportunity represents for you?.

You know I didn't do it that way. But what I did do, I maintain very close relationship with sales channel partners. I talked to a sales channel partner that had a job bid two weeks ago, two weeks ago on Tuesday. This particular school district has a $1 billion bond issue and this was the first project for that bond issue.

The school district has extensive installation of AAON equipment, so they listed AAON as their basis of design, they had two other manufacturers as alternates that had to be listed separately how that affected the project cost.

When they put all the coronavirus mitigation devices in the unit that they wanted, this was the higher level of filtration, UV lights and the bipolar ionization. For the first time that we've seen this kind of configuration go head to head in that regard, AAON was actually the most attractive not only in value, but in absolute price.

They had an extensive list of bidders that listed AAON as anywhere between $50,000 and $100,000 less cost on this project, which was maybe, I'm going to say that bill of materials had closed in on $2 million. So that's inconsequential in percentage.

But the thing is, is that the school district was accustomed to paying 10% to as much as 15% premium for AAON. So when you put these mitigation procedures in the unit and they have to be factory installed, all of a sudden that gap narrows considerably.

So they were able to get all the value features that they had traditionally awarded AAON contract at a premium, they were able to get those at a level price.

So, I think that news will travel fast and I think that on these new project installations where people want to have all of these mitigation procedures installed that they'll find out that they get those at little to no cost premium, maybe no cost premium and that they get all of the other value features that they're accustomed to paying a premium for AAON.

So I think that bodes very well for us..

[Operator Instructions] You have a follow-up question from Will Jellison from D.A. Davidson..

Hello, again. I'm wondering, toward the beginning of the call, you gave some really detailed dialog, frankly much of which is over my head about the engineering behind the stance in some of your products. And you mentioned that they have a significant advantage over competitors.

I'm wondering just with the economics of that product, what is stopping your competitors from creating something that can compete with your product?.

That is a great question, Will. Our inherent manufacturing culture and technology was to use software-driven sheet metal manufacturing equipment. This dates back to 1997, when Norm first put in a Salvagnini machine and this Salvagnini machine took the place of various individual station machines such as shears, NC punches, press brakes and so forth.

So this made it affordable to have that kind of flexibility. Well, as you evolve the product, then it's a slight software change in that sheet metal configuration that allows this to be done cost effectively.

The most of our competition from, I would say, certainly 20 tons and below, but maybe even as much as 40 tons in some instances, they use a preponderance of hard tooling to obtain their efficiency in sheet metal manufacturing.

So they buy a very expensive tool, a dye and have a press that punches out very cost efficiently sheet metal, but has no flexibility to it.

So, when they want to change the configuration of the unit to accommodate something like this fan, then it is a major retooling and the other thing is they've got all of these big giant presses that operate these dyes that are just not conducive to that kind of flexibility.

So it would take a major structural change in manufacturing thought process and technology for them to cost effectively put that fan in. Well, up until recently, they had a strong market for the people that had no need for this kind of fan or no real appreciation for it.

So now with this pandemic and everything, it's changed the focus on the type of fan that you have, what the efficiency of it is, and how it operates. So there is a lot generated by this that I would say our strategy of product design all along has been to accommodate the more stringent applications, not the more ordinary applications.

So when you go from that more ordinary application and you try and add to it these recommended mitigation strategies, then they just don't fit well for them.

Does that all make sense to you?.

Yes. That's helpful, thank you. That's a pretty clear picture of the advantage that you have. I have one more question related to the capacity increases that you talked about earlier.

Do you have a sense for how much quarterly revenue threshold do you have with that new capacity if they were to be fully utilized?.

Well, yes, I have a sense -- at this moment -- I understand -- I continue to add capacity, so I'm going to give you a snapshot in time, snapshot in time being today. But I'm still adding capacity.

Snapshot in time today is between what we did in Q3 and what we were capable of doing by just adding headcount, because our headcount is stable with a year ago, I mean almost identical to a year ago, almost to the person.

And so if I was to add headcount, I could probably add 20% to 25% more output right now today with the physical plant that I have, but I continue to add more physical plant here within the Tulsa facility and in Longview, I'm going to double that.

I've already got the building built, and we're going to have a certificate of occupancy next month on that building. So Longview -- do we separate out exactly how Longview comes out for them.

No, so Longview runs about 12% of our finished goods, that's roundabout right, Scott?.

Yes, right..

Yes, about 12%. And we had 234,000 square foot down there, but that also manufactured the coils that come up here and the finished goods equipment. So to manufacture that 12% of finished goods equipment probably takes up maybe 40% of the manufacturing space and I added a 100% addition to what's there in total.

So in other words, we have about 150% increase in capacity coming online, physical plant capacity coming online in Longview. Now, we don't look to have a consistent run rate to require that.

What we do look at is that product that we manufacture in Longview is very sensitive to lead time, very much appreciated when you have a quick-ship availability and so the peak that you build on any one day, week or month really dictates what's the ideal physical plant size.

So you may not have the same utilization of that equipment in Longview that we do here in Tulsa because we're a little less prone to that sort of peaking activity, but that's very good business to have and so we have built it with that in mind and so to give you an overall sense, we have at least 25% more physical plant capacity than what you've witnessed thus far.

We're bringing on another 20% to 25%. So we can easily in the physical facilities that we currently have raised our revenue in the 50% range without too much effort..

And you have a question from Matt McGeary from Eagle Asset Management..

Could you give some more color on the water source heat pump redesign to address the aftermarket, when will that be ready to go and do you have the relationships with the appropriate distribution avenues to address that market in the way that you want to?.

I'll divide those up. First thing is that the products from 0.5 ton through 6 ton, which is the primary need for that backwardly compatible water source heat pump for retrofit installation. It will be ready for production no later than April 1st, that's a very conservative date at this point in time.

Vast majority of it's completed now, but there is no sensibility to piece-mealing that next generation out to the sales channel. It would just be frustrating. So we are going to have the complete line from 0.5 ton through 6 ton ready to go no later than April 1st.

Then the next reason, the thing that we missed, when we designed our product, we looked at what was most desirable in the new construction environment because those are the people that we were accustomed to working with and talking with, we had not yet built a competent sales channel in the retrofit market and didn't have the real expertise and input from the retrofit market going back to 2015 when we designed the product we have.

So a lot of the characteristics we have are very desirable people like them. That's why it's taken off as well as it has, but it did not fit in a backwardly compatible environment.

So things that were critical with regards to where electrical panels were placed, so that you had proper service clearances in this retrofit environment, those were overlooked. So now we've taken looked at it and figured out how to maintain our most desirable upgrade characteristics, while also making it backwardly compatible.

So it will still have the same high desirability on new construction that will be much, much more friendly application in the retrofit.

Then the next thing is, as we got into the water source heat pump business, we recognized that our sales channel partners were not focused on the retrofit, they were focused on new construction plants that kind of work, and so we started working with them going back at least four years ago on how to develop an effective sales and marketing strategy to do that.

A lot of that included them building some warehouse space and having units in stock because in the retrofit market, a high percentage of it is not planned, so if someone's unit breaks down and they decide that it's cheaper to put a new unit than to repair the unit, they don't want to wait days or weeks to get a new unit.

So our sales channel partners had to build out some, and become basically to some degree a distributor in addition to a traditional manufacturer's rep. Well, over this four-year period of time, we've seen a [indiscernible] with that.

I don't know exact percentage right now that are stocking water source heat pumps, but I would say it would approach half that are stocking heat pumps now with more committed to coming online, as we get a product that's more ideal.

We've also engaged a couple of veterans from that market, from that service retrofit market to lead our sales management efforts and both of these gentlemen are very well respected in the industry, they are respected by our sales channel partners and they are helping craft and implement operating plans for these folks to become proficient in this.

So this will be a good opportunity for us to get the water source heat pump business growing again and I have confidence that it will occur. The timing of it is somewhat subjective.

But I think we'll see good progress in '21 with the implementation of the new more desirable retrofit type product along with the strategy that they've been putting in place..

And I have no further questions in the queue..

All right. Well, we thank you very much and we will talk to you again in February with our fourth quarter results. Have a nice day..

This does conclude today's conference call. Thank you for participating. You may now disconnect your lines..