Aaon, Inc. Q3 FY2021 Earnings Call

Good afternoon, ladies and gentlemen. Welcome to AAON, Inc Third Quarter Sales and Earnings Call. 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, sir.

Good afternoon, and thank you for joining us. I'd like to read a forward-looking disclaimer to begin with. A reminder 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, the Securities Act of 1933 and the Securities Exchange Act of 1934, each as amended. 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. Joining me today on the call is Rebecca Thompson, our Chief Financial Officer and Treasurer; Rebecca will open by reviewing our financial performance.

Thank you, Gary. I'd like to begin by discussing the comparative results of the three months ended September 30, 2021 versus September 30, 2020. Net sales increased 2.8% to $138.6 million from $134.8 million. The year-over-year increase was fully driven by price increases and a favorable product mix, partially offset by unit volumes, which were down approximately 11.2%. The decline in unit volumes is mainly a result of a very tight labor market that limited the company's ability to ramp up production. Our gross profit decreased 11.8% to $36 million from $40.8 million. As a percentage of sales, gross profit was 26% compared to 30.3% in the third quarter of 2020. The decline in gross profit was related to increases in material costs and wages rising quicker than our price increases could counteract. Inefficiencies caused by minor supply chain disruptions and COVID-19 absenteeism in the quarter reduced our production of coils. Selling, general and administrative expenses increased 8% to $15.9 million from $14.7 million in 2020. As a percentage of sales, SG&A increased to 11.5% of total sales from 10.9% in the third quarter of 2020. SG&A as a percent of sales increased primarily due to the lower unit volumes. Income from operations decreased 22.9% to $20.1 million or 14.5% of sales from $26.1 million or 19.4% of sales in 2020. Our effective tax rate increased to 22.5% from 21.8%. Net income decreased to $15.6 million or 11.2% of sales compared to $20.5 million or 15.2% of sales in the third quarter of 2020. Diluted earnings per share decreased by 23.7% to $0.29 per diluted share from $0.38 per diluted share in 2020. Turning to the balance sheet, you'll see that we had a working capital balance of $196.4 million versus $161.2 million at December 31, 2020. Cash and cash equivalents totaled $101.8 million at September 30, 2021, up from $79 million at the end of 2020. Our current ratio is approximately 3.6:1. Our capital expenditures were $42.6 million for the nine months ended September 30, 2021. We expect capital expenditures for the year to be approximately $60 million. The company had stock repurchases of $15 million during the nine months ended September 30, 2021. Shareholders' equity per diluted share is $7.46 at September 30, 2021, compared to $6.61 at December 31, 2020. I'd now like to turn the call back over to Gary Fields, our CEO and President.

Overall, as far as sales and earnings go, 3Q performance was disappointing. Labor shortages and supply chain constraints restricted our ability to ramp up production as much as we would have liked. This resulted in lower unit volumes and inefficient leverage of our fixed costs. Material inflation also challenged our margins, but the production constraints really magnified the effect of the higher costs. All in all, the top line was softer than expected due to various production constraints, which resulted in the weaker-than-expected margins. Backlog at September 30 of $181.8 million was up year-over-year by 114% and up 32% from the end of the second quarter. What's really astounding is orders up year-over-year by 60% in the third quarter. This is really impressive, especially when considering our orders were up year-over-year by 18% in the third quarter of 2020. Most of the industry saw much easier comparisons than we did. We see no sign of the demand slowing. The replacement market demand is very strong. New construction actually hit the lowest point since the pandemic started in this quarter. But on the positive outlook, the Architectural Billing Index, Dodge Index, construction starts, and all the various indexes we look at are all very positive. We're looking at the new construction market rebounding. However, we have gained a tremendous amount of market share as the year has progressed. We’re seeing this fairly well distributed across all of our traditional markets. We've seen a little more strength in medical and healthcare and in growth facilities compared to the previous year. We want to give you an update on the sales channel and talk about some product introductions. We hosted a national sales meeting in October. Feedback from the sales channel was it was the most appreciated and best sales meeting that AAON had ever conducted. I think this tells you a lot about the marketing tools that we have been building to strengthen our marketing efforts. One of those tools includes our new mobile marketing unit, which is an 18-wheeler style truck and trailer, very much in alignment with what you'd see at, say, a NASCAR event in their merchandising. The trailer expands on both sides and can accommodate about 40 people inside in an air-conditioned environment. It's got a 26-foot long touchscreen in there that we display videos. We did extensive work to develop videos that will showcase not only our manufacturing style and facilities but most impressively, our Norman Asbjornson Innovation Center. That is our R&D laboratory that we're quite proud of, and it showcases all of that. Aftermarket parts and services continue to strengthen. That's another tool that we have worked with our sales channel. Our training programs are very much appreciated, gaining momentum, and we're seeing a lot of benefit from the training programs we've had in place for the last five years. Regarding new product introductions, we've spoken quite a lot about the next generation of water-source heat pumps. This is not intended to replace the original generation but to supplement it. So now we have two complete lines of water-source heat pumps. One, our original model, is named Ecofit because it has the best performance in the industry for its type of unit. This new series that we introduced is called Profit because it fits in a retrofit environment seamlessly. Our sales channel partners were introduced to that at the sales meeting we had last month, and they said that we hit the bull's eye with it. They're very excited about it. The other development we've been working on extensively is our air source heat pumps in packaged rooftop configuration. We have accomplished units ranging from two tons through 60 tons that can satisfy the load and energy requirements in cold climates, down to 0 degrees Fahrenheit at this time. We're very excited about that. We have development going on to expand this all the way to 240 tons, and we will complete that development by the end of '22. Prototypes are currently in testing now. Some of the operations at both Tulsa and Longview have faced productivity issues, as you can see from the numbers in the third quarter. Headcount was still slightly down in Tulsa; however, it has grown in Longview. We've been able to attract more talent there, and we're turning the tide on that. We've made some changes in our hiring processes and wage rates. We revamped our HR department entirely with new leadership and fresh ideas on how to attract talent, and we're beginning to see improvement in that front. We had some supply chain issues that continued into and through October. We have resolution for most of these, and we're hopeful to see improvement moving forward. However, uncertainties do remain. One issue that caught us recently was a vendor that had been giving us all green lights suddenly informed us that they were not able to proceed. We're finding other vendors to fill that gap and have already secured those, which will address the temporary problem that affected our coil production. The COVID instances we faced, while on a company-wide basis did not result in a high absenteeism percentage like we experienced back in 2020 at its peak, still proved to be burdensome because it focused on a particular area of the company that made components internally for both Longview and Tulsa. We encountered a shortage of those components for a period of time, which hindered our ability to produce more units. Fortunately, this issue has been resolved, and absenteeism is now back to historic norms. Our sales rep network is strengthening quite a lot, and they're gaining market share. I would emphasize that not only have our product innovations become more attractive, but our lead times are also the most competitive in the industry. People who would traditionally categorize us as a niche player may now view us as a reliable option due to our ability to satisfy their delivery requirements. Even with our slight production constraints, we have been able to meet commitments that many of our competitors were unable to manage. An interesting aspect of our business is that parts sales are up year-over-year by 15%. That represents an all-time quarterly record for the second consecutive quarter. In 2020, parts sales were slightly down due to many buildings being inaccessible. However, these are still record numbers for parts sales when viewed in absolute dollar volume. The efforts we've put into strengthening this aftermarket aspect of our business are starting to show positive results. Water-source heat pump sales were down by 23%. We believe that was driven by two main factors. First, the decline in new constructions affected our offerings, and second, customers stockpiling units were waiting for a more attractive retrofit option. Air handlers and condensing units were up by 8%, with a high percentage of those being air source heat pumps. We build these for light commercial and small industrial applications, and they represent a strong growth opportunity for us. Our CapEx investments are slightly behind the expected spend. We were forecasting a little over $70 million this year, and it's now looking like it will be around $60 million due to supply chain constraints. People could not get materials to us, which limited our ability to implement certain things or build additional marketing tools. However, none of this has put us in a dire situation. Some initiatives were nice to have but didn't hinder us significantly. The sustainability of AAON is an interesting story that we're just learning how to communicate effectively. I've been leading this company for five years now, and while we've demonstrated great sustainability and ESG efforts, we previously did a poor job of communicating those. We added key staff to help create that communication and learn how to gather the information objectively. We just produced our second sustainability ESG report, which should have been shared in the last couple of weeks. Many companies talk about energy-efficient equipment innovation, but that is the backbone of AAON. Our unique semi-custom production has allowed us to lead in energy efficiency. Our marketing department conducted a comparative analysis of our key competitors' rooftop units next to our best offerings, and we won in every instance. Our rooftop units are the most energy-efficient on the market, and all are AHRI certified. We have a diverse and inclusive workforce and have recently been recognized with multiple awards from the state of Oklahoma, Tulsa County, and the City of Tulsa. ESG is a focus for us, and we intend to share more moving forward to help investors fully understand our commitments. I encourage anyone interested to read the report we just posted on our website. Now on to the outlook. Orders and backlog trends are strong as we approach the end of the year. Historically, we see a drop off in orders toward the end of the second quarter entering the third quarter, but we have not observed that this time. The near-term biggest concern will be with production. Positively, headcount is improving. Price cost is expected to improve as we work through the backlog since it has an improving margin profile due to the previously announced and effective price increases. Many of the production inefficiencies will fade as we resolve the minor supply chain interruptions, which have not manifested into major issues. As those resolve, we have the manufacturing infrastructure and the headcount capable of producing beyond expectations. A few production constraints did carry into October, but we're seeing resolution on those now and expect further resolution later this month. For our fourth quarter and early 2022 outlook compared to the third quarter, we anticipate fourth quarter sales to be slightly down while expecting gross margins to modestly improve. I want to note that the major sales meeting we held this quarter, which incurred approximately $1 million in SG&A burden, will not recur in '22 as we only conduct major sales meetings every year or so. As we progress through the first half of the year, we expect production rates to accelerate. Our headcount is increasing, and we believe most of our supply chain issues are being resolved. While unpredictability still exists, we have a strong outlook. Given the rising production rates and ongoing price increases, including another announcement effective January 1, gross margins are anticipated to expand with improvements expected in the fourth quarter. Long term, we've never been more optimistic. With all the initiatives we've undertaken regarding our product portfolio and strengthening our sales channel, we are transitioning from a niche player to a mainstream player in the market. We are confident in our strategy, though we've faced struggles common to the industry in the third quarter, which may have burdened us more than expected. However, if we look back at our performance in 2019, you'll see that our 2021 Q3 performance was 22% better than it was in '19. While it wasn't significantly better than '20, it shows growth. When comparing the industry, if you analyze Q3 '21 against Q3 '19, you will find most companies only saw an 11% or 12% difference, or maybe 14%, but not 22%. With that, I'm going to open the call up to questions.

First question from the line of Julio Romero. Your line is open.

So just to start on the labor front. At Tulsa last quarter, I think you mentioned you were down 30 to 40 employees year-over-year. Where do you stand today in terms of year-over-year headcount at Tulsa?

Exactly flat in Tulsa. So we've gained those 30 or 40, and we're up 12% in Longview.

Okay. Great. Great. And on the price increases, I think year-to-date, you had an increase in January, June, and September 1. Did you have another increase post September 1 take effect?

No. You're correct. They were January 11, June 1, September 1, taking effect. We announced one in late September that takes effect January 1 of '22.

Got it. Understood. And I guess it looks like your lead times extended somewhat, but on a relative basis, it looks like the delta between your lead times and your competitors has widened since last quarter. Is that a fair characterization?

Absolutely fair. So a couple of things to bear in mind. If you look at the production rate and the absolute backlog right now, our lead times would reflect a little longer than what we're actually doing. The reason for that is some of the projects can't receive the equipment in accordance with our lead time. We're quicker than the projects. There's a lot of trouble out there in the world right now getting projects to a point where they can accept the units. So we do our best to accommodate that. So it spreads our backlog out a little more than you just can't take the backlog, divide it by the production number, and come up with the actual lead time. But we are running 10 weeks on a lot of units, 12 weeks on some more units. I'd say probably 12 weeks categorize as the majority of our production for rooftop units. We're probably closer to 10, maybe eight to 10 weeks on our Longview products. This compares to some of our competitors, all of whom are well into the 20s and 30s, and we've even heard 50 weeks from some.

Got it. That's good color there. And I guess just last one for me here is the orders have continued to be strong, and that's kind of in line with last quarter's commentary that you expected orders to trend steady. And it sounds like the outlook isn't really unchanged. So I guess how long do you think you can continue this growth trend of strong orders?

Well, during our sales meeting, as I spoke about earlier, we had 500 sales channel partners attend, and the consensus among them is that it's never been better. Their pipeline is absolutely robust. The fact that we have products that are now attractive for the cold climate that are decarbonized and 100% electric is a motivating factor. This new water-source heat pump addressing the replacement market is another factor. The support and marketing tools we provide them are also key motivators. They expressed their robust pipeline and expect a high percentage of closure rates on that pipeline. Given this, we're forecasting strong sustained performance, with total bookings year-over-year up about 66%.

Next question from the line of Brent Thielman. Your line is open.

Gary, I guess just following up on that. Given I'm trying to think about this in a sense given the sort of shorter-term challenges that you're dealing with and everybody else is dealing with. I guess when does this cause you to pull the reins in at all, at least temporarily in terms of orders? Or is it just the fact that the lead times in the industry are so far out you can still capture market share and continue taking orders at the pace you are? I just wanted some more color there.

I don't have any tendency to pull back on the reins. My inclination is to figure out how to, using the horse analogy, lay the spurs to the production facility and get it to catch up. We've made a lot of strides in that regard. One critical thing was back in '18 and into '19 when similar issues led to a large backlog and underperforming production due to infrastructure problems. We've spent a lot of time correcting that. You saw that in Q4 of '19, where we rebounded and came through '20 very well. Our infrastructure still has surplus capacity beyond our backlog with ideal lead times. We have manufacturing capacity, and we have made changes in our recruiting processes and HR leadership. We're making progress on that front. Yes, we were down 30 to 40 people but now we're back to where we were last year. I assure you there are friends in the industry who would love to be back to where they were a year or two ago. We're confident we will maintain adequate headcount. The concerns that impacted Q3 and slightly Q4 were supply chain issues and sudden notifications from suppliers, but we've resolved these with the dedication of our purchasing and engineering departments to qualify new vendors. New vendors are beginning to spool up, and we've had small shipments arrive, but we expect an acceleration in Q4. So while Q4 may be close to Q3 in terms of revenue, we believe the margin will improve due to higher-priced backlog items. By Q1, we are optimistic and expect to meet our margin targets and return to increasing revenue. We're generally bullish on our outlook.

Well, that was my next question. So you got that one. I guess just so I understand it, I mean I think you talked about steel in one component of this. What are some of the big ticket items that have been challenging from a supply chain standpoint?

Well, copper tubing has been a significant challenge. We manufacture our own coils in Longview, and our copper supplier faced issues. We used a different copper supplier for our Tulsa facility. When we offered the opportunity for our Tulsa supplier to also supply our Longview facility, they agreed. We've also found additional suppliers to ensure we have backup options since one was lagging on delivery. We would have appreciated some notice instead of being informed on the day it was supposed to arrive.

Okay. What about trucking and freight?

I'm not hearing anything problematic. The vast majority of our shipments are conducted via contracted freight, and we add it to the invoice of the products we ship. We ship nearly everything truckload, with only a small percentage being less than truckload. We have a long-standing relationship, over 20 years, with our primary freight company, and they have performed excellently. While I can't comment on how they treat their other customers, they are a high-integrity company. They informed us, however, that we have to pay more for truck drivers now than we did, which dates back to early 2020. I believe the increase in driver wages was approximately 25%, which was passed onto us, but we haven't encountered any significant issues.

Yes. Okay. Maybe the last one. I know you've got the new introduction on the water-source heat pump side, which is pretty exciting. Any qualitative or quantitative thoughts and targets for '22 for the business? How you're thinking about that?

It's too early to discuss specifics regarding that impact. Now that we have it available, I'd like to observe for a quarter how its market reception develops. It was crucial to have it ready for immediate deployment. After we measure this for a while, I believe we can better discuss its impact. Currently, our backlog has increased by 30% year-over-year on water-source heat pumps, indicating positive momentum. However, I prefer to hold off on precise forecasting until we have clearer market responses.

Understood. Thanks for taking the questions. I appreciate it.

I want to thank all of you for joining us on the call. We'll talk to you again in February with our fourth-quarter results. Have a great day. Bye-bye.

That concludes today’s conference. Thank you, everyone, for participating. You may now all disconnect.