AAON, INC. 10-Q

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto, which are included in this report, and our audited consolidated financial statements and the notes thereto, which are included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019. This discussion contains or incorporates by reference “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts, but rather are based on expectations, estimates, assumptions and projections about our industry, business and future financial results, based on information available at the time this report is filed with the SEC or, with respect to any document incorporated by reference, available at the time that such document was prepared. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those identified in the section entitled “Forward-Looking Statements” in this Item 2 of this Quarterly Report on Form 10-Q and in the section entitled “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019. We do not assume any obligation to update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, new information or circumstances or otherwise, except as required by law. Overview We engineer, manufacture and market air conditioning and heating equipment consisting of standard, semi-custom and custom rooftop units, chillers, packaged outdoor mechanical rooms, air handling units, makeup air units, energy recovery units, condensing units, geothermal/water-source heat pumps, coils and controls. These products are marketed and sold to retail, manufacturing, educational, lodging, supermarket, medical and other commercial industries. We market our products to all 50 states in the United States and all provinces in Canada. Foreign sales were approximately $8.4 million of our total net sales for the nine months just ended and $11.5 million of our sales during the same period of 2019. Our business can be affected by a number of economic factors, including the level of economic activity in the markets in which we operate. The uncertainty of the economy has negatively impacted the commercial and industrial new construction markets. A further decline in economic activity could result in a decrease in our sales volume and profitability. Sales in the commercial and industrial new construction markets correlate closely to the number of new homes and buildings that are built, which in turn is influenced by cyclical factors such as interest rates, inflation, consumer spending habits, employment rates and other macroeconomic factors over which we have no control. We sell our products to property owners and contractors through a network of manufacturers’ representatives and our internal sales force. The demand for our products is influenced by national and regional economic and demographic factors. The commercial and industrial new construction market is subject to cyclical fluctuations in that it is generally tied to housing starts, but has a lag factor of six to 18 months. Housing starts, in turn, are affected by such factors as interest rates, the state of the economy, population growth and the relative age of the population. Our sales strategy is currently balanced between new construction and replacement applications. The new construction market through the third quarter of 2020 is showing signs of uncertainty. We continue to emphasize the benefits of AAON equipment to property owners in the replacement market. Our manufacturing operations are considered a critical infrastructure industry, as defined by the U.S. Department of Homeland Security, as such, the decrees issued by national, state, and local governments in response to the COVID-19 pandemic have had minimal impact on our operations except for higher employee absenteeism in our manufacturing facilities. We maintained continuous operations during the nine months ended September 30, 2020. For the most part, our workers are able to socially distance themselves during the manufacturing process. Additional precautions have been taken to social distance workers that work in close environments. The Company utilizes sanitation stations, requires the use of a facial covering when unable to socially distance, performs daily temperature scanning, and performs additional cleaning and sanitation throughout the day and deep cleaning overnight. The Company did see significant employee absenteeism in the latter part of June 2020. These unexpected employee absences resulted in reduced shipments and longer lead times in the second quarter of 2020. During the third quarter 2020 employee attendance levels were stronger than previously anticipated. Additionally, our work force has adapted well to school and childcare related issues. - 25 - While the Company's operations are primarily in Oklahoma and Texas, our domestic sales to customers cover almost all 50 states. Only the state of Texas has more than 10% of our revenues. For the nine months ended September 30, 2020, we've experienced record sales. We have not seen a significant slow down or disruption in our customer jobs and have benefited from some of the new construction for temporary hospitals due to COVID-19. The outlook for 2021 continues to present a lot of uncertainty. The Architecture Billings Index has been down for several months, indicating a decline in construction, which may start to impact the new nonresidential construction market in late 2020. Although construction may decline, our equipment is uniquely positioned to address COVID challenges by providing heightened filtration and sanitation through the use of MERV 13 filters, UV lights and bi-polar ionization installed in the factory. With approximately 50% of our total sales already represented by the replacement market, we are confident of our ability to grow our market share in the replacement market while we continue to pursue opportunities in the new construction market. With our improved lead times, we have been able to continue our planned reduction of our backlog to a more manageable level and we believe this will also allow our order intake to stay consistent but do not see significant growth opportunities in the near term We had unrestricted cash and cash equivalents of $70.6 million as of September 30, 2020. Our capital expenditures during the nine months ended September 30, 2020 were $49.0 million, as compared to $30.8 million for the same period a year ago, and we anticipate our full-year 2020 capital expenditures will total approximately $73.2 million. Our expansion to our Longview, Texas facility is on schedule and expected to be operational by January 2021. The Company also has $28.3 million available under its line of credit. Should the Company experience an unexpected downturn due to COVID-19; spending on dividends and capital expenditures can be reduced and the line of credit can be utilized. The principal components of cost of goods sold are labor, raw materials, component costs, factory overhead, freight and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper and aluminum, and are obtained from domestic suppliers. We also purchase from domestic manufacturers certain components, including compressors, motors and electrical controls. We have experienced minimal disruption to our supply chain due to COVID-19. The price levels of most raw materials were stable in the past twelve months, but we are beginning to see increases in raw material costs. There is also a possibility prices could rise in the future depending on the impact COVID-19 has on our supply chain. At September 30, 2020, the price (twelve month trailing average) for copper, galvanized steel and aluminum decreased 4.1%, 2.0% and 2.2% (stainless steel increased 0.8%), respectively, as compared to the price (twelve month trailing average) at September 30, 2019. We attempt to limit the impact of price fluctuations on these materials by entering into cancellable and non-cancellable fixed price contracts with our major suppliers for periods of six to 18 months. We expect to receive delivery of raw materials from our fixed price contracts for use in our manufacturing operations. The following are recent highlights and items that impacted our results of operations, cash flows and financial condition: • We experienced significant employee absenteeism, mostly in June, related to COVID-19 during the nine months ended that impacted our production. • We continue to become more efficient. Our gross profit percentage improved from 23.9% during the nine months ended in 2019 to 30.6% in 2020. • We invested $49.0 million in capital expenditures, continuing our work on projects such as our Longview, TX expansion and the purchase of additional Salvagnini machines that will increase our sheet metal capacity. • Total cash, cash equivalents and restricted cash was $78.6 million at September 30, 2020. Backlog The following table shows our historical backlog levels: September 30, 2020 December 31, 2019 September 30, 2019 (in thousands) $ 84,885 $ 142,747 $ 165,325 During 2018 and most of 2019, the Company struggled to maintain adequate sheet-metal production capacity that resulted in long lead times and a high backlog. The Company started to increase its sheet-metal production at the end of 2019 with the - 26 - addition of new Salvagnini machines. This led in part to a record fourth quarter of 2019 that helped reduce our backlog. Since then, the Company has continued to increase its sheet-metal capacity, increase sales, improve lead times and reduce our backlog to a more manageable level. Results of Operations Three months ended September 30, 2020 vs. Three months ended September 30, 2019 Units Sold Three Months Ended September 30, 2020 September 30, 2019 Rooftop units 4,372 3,520 Condensing units 593 418 Air handlers 534 552 Outdoor mechanical rooms 6 7 Water source heat pumps 1,847 1,311 Total Units 7,352 5,808 Net Sales Three Months Ended September 30, 2020 September 30, 2019 Change % Change (in thousands, except unit data) Net sales $ 134,772 $ 113,500 $ 21,272 18.7 % Total units 7,352 5,808 1,544 26.6 % Our net sales increased by 18.7% due in part to our price increases in the past year and more so from increases in sheet metal production. Cost of Sales Three Months Ended Percent of Sales September 30, 2020 September 30, 2019 2020 2019 (in thousands) Cost of sales $ 93,924 $ 86,090 69.7 % 75.9 % Gross profit 40,848 27,410 30.3 % 24.1 % 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. Twelve-month average raw material cost per pound as of September 30: 2020 2019 % Change Copper $ 3.52 $ 3.67 (4.1) % Galvanized Steel $ 0.50 $ 0.51 (2.0) % Stainless Steel $ 1.32 $ 1.31 0.8 % Aluminum $ 1.76 $ 1.80 (2.2) % - 27 - Selling, General and Administrative Expenses Three Months Ended Percent of Sales September 30, 2020 September 30, 2019 2020 2019 (in thousands) Warranty $ 2,054 $ 2,707 1.5 % 2.4 % Profit sharing 3,000 1,684 2.2 % 1.5 % Salaries & benefits 4,725 3,437 3.5 % 3.0 % Stock compensation 1,330 767 1.0 % 0.7 % Advertising 229 146 0.2 % 0.1 % Depreciation 515 400 0.4 % 0.4 % Insurance 254 218 0.2 % 0.2 % Professional fees 542 693 0.4 % 0.6 % Donations 106 155 0.1 % 0.1 % Bad debt expense 117 (37) 0.1 % — % Other 1,844 2,204 1.4 % 1.9 % Total SG&A $ 14,716 $ 12,374 10.9 % 10.9 % Profit sharing expenses increased due to our increased earnings for the three months ended 2020 as compared to 2019. Salaries & benefits is up as well due in part to additional incentives for our employees as a result of the Company's strong performance. Income Taxes Three Months Ended Effective Tax Rate September 30, 2020 September 30, 2019 2020 2019 (in thousands) Income tax provision $ 5,696 $ 742 21.8 % 4.9 % The Company’s estimated annual 2020 effective tax rate, excluding discrete events, is expected to be approximately 24%. During the three months ended September 2019, upon completion of the Company's 2018 tax return, the Company recorded additional benefit due to higher than expected research and development credit of $0.6 million. Historically, the Company has taken advantage of the Oklahoma Investment New Jobs Credit ("OK Credit"). This OK Credit allows the Company to take a credit equal to 1% of eligible investments each year for five years, beginning with the year of investment. The Company determined it could take advantage of an additional 1% tax credit for years in which the Company's location was deemed to be within an enterprise zone. The additional OK Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law, resulted in a benefit of $0.3 million for 2018 and $0.9 million for our 2015, 2016 and 2017 amended returns, combined. - 28 - Results of Operations Nine Months Ended September 30, 2020 vs. Nine Months Ended September 30, 2019 Units Sold Nine Months Ended September 30, 2020 September 30, 2019 Rooftop units 12,179 11,079 Condensing units 1,447 1,291 Air handlers 1,545 1,669 Outdoor mechanical rooms 22 28 Water source heat pumps 5,109 5,977 Total Units 20,302 20,044 Net Sales Nine Months Ended September 30, 2020 September 30, 2019 Change % Change (in thousands, except unit data) Net sales $ 397,851 $ 346,759 $ 51,092 14.7 % Total units 20,302 20,044 258 1.3 % Our net sales increased by 14.7% due in part to our increased sheet metal production from the additional Salvagnini machines that were placed into operation allowing increased production in our rooftop units and in part from price increases put in place over the last year and a half. Cost of Sales Nine Months Ended Percent of Sales September 30, 2020 September 30, 2019 2020 2019 (in thousands) Cost of sales $ 275,925 $ 263,715 69.4 % 76.1 % Gross profit 121,926 83,044 30.6 % 23.9 % 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. Twelve-month average raw material cost per pound as of September 30: 2020 2019 % Change Copper $ 3.52 $ 3.67 (4.1) % Galvanized steel $ 0.50 $ 0.51 (2.0) % Stainless steel $ 1.32 $ 1.31 0.8 % Aluminum $ 1.76 $ 1.80 (2.2) % - 29 - Selling, General and Administrative Expenses Nine Months Ended Percent of Sales September 30, 2020 September 30, 2019 2020 2019 (in thousands) Warranty $ 5,356 $ 6,129 1.3 % 1.8 % Profit sharing 8,691 4,948 2.2 % 1.4 % Salaries & benefits 14,921 10,602 3.8 % 3.1 % Stock compensation 4,020 5,989 1.0 % 1.7 % Advertising 446 496 0.1 % 0.1 % Depreciation 1,470 1,092 0.4 % 0.3 % Insurance 733 594 0.2 % 0.2 % Professional fees 1,796 1,723 0.5 % 0.5 % Donations 1,892 1,019 0.5 % 0.3 % Bad debt expense 193 91 — % — % Other 6,351 6,280 1.6 % 1.8 % Total SG&A $ 45,869 $ 38,963 11.5 % 11.2 % Profit sharing expenses increased due to our increased earnings for the period. Salaries & benefits is up as well due in part to additional incentives for our employees as a result of the Company's strong performance. Stock compensation is lower because the valuation of the Company-wide equity grant awarded in March 2020 was less than the grant awarded in March 2019. Donations increased due to the contribution of approximately $1.3 million to Winifred, Montana Public Schools in recognition of Norman H. Asbjornson's transition from CEO to Executive Chairman. Income Taxes Nine Months Ended Effective Tax Rate September 30, 2020 September 30, 2019 2020 2019 (in thousands) Income tax provision $ 16,111 $ 7,380 21.1 % 16.8 % The Company’s estimated annual 2020 effective tax rate, excluding discrete events, is expected to be approximately 24%. During the three months ended September 2019, upon completion of the Company's 2018 tax return, the Company recorded additional benefit due to higher than expected research and development credit of $0.6 million. Historically, the Company has taken advantage of the Oklahoma Investment New Jobs Credit ("OK Credit"). This OK Credit allows the Company to take a credit equal to 1% of eligible investments each year for five years, beginning with the year of investment. The Company determined it could take advantage of an additional 1% tax credit for years in which the Company's location was deemed to be within an enterprise zone. The additional OK Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law, resulted in a benefit of $0.3 million for 2018 and $0.9 million for our 2015, 2016 and 2017 amended returns, combined. Liquidity and Capital Resources Our working capital and capital expenditure requirements are generally met through net cash provided by operations and the occasional use of the revolving bank line of credit based on our current liquidity at the time. Working Capital - Our unrestricted cash increased $43.8 million from December 31, 2019 to September 30, 2020 and totaled $70.6 million at September 30, 2020. Revolving Line of Credit - Under the line of credit with Bank of Oklahoma, there was one standby letter of credit of $1.7 million as of September 30, 2020. At September 30, 2020, we have $28.3 million of borrowings available under the revolving credit facility. No fees are associated with the unused portion of the committed amount. We had no outstanding balance under the revolving credit facility at September 30, 2020 and December 31, 2019. Interest on borrowings is payable monthly at LIBOR plus 2.0%. The termination date of the revolving credit facility is July 26, 2021. - 30 - At September 30, 2020, we were in compliance with all of the covenants under the revolving credit facility. We are obligated to comply with certain financial covenants under the revolving credit facility. These covenants require that we meet certain parameters related to our tangible net worth and total liabilities to tangible net worth ratio. At September 30, 2020, our tangible net worth was $344.9 million, which meets the requirement of being at or above $175.0 million. Our total liabilities to tangible net worth ratio was 0.3 to 1.0 which meets the requirement of not being above 2 to 1. New Market Tax Credit Obligation - On October 24, 2019, the Company entered into a transaction with a subsidiary of an unrelated third-party financial institution (the “Investor”) and a certified Community Development Entity under a qualified New Markets Tax Credit (“NMTC”) program pursuant to Section 45D of the Internal Revenue Code of 1986, as amended, related to an investment in plant and equipment to facilitate the expansion of our Longview, Texas manufacturing operations (the “Project”). In connection with the NMTC transaction, the Company received a $23.0 million NMTC allocation for the Project and secured low interest financing and the potential for future debt forgiveness related to the expansion of its Longview, Texas facilities. Upon closing of the NMTC transaction, the Company provided an aggregate of approximately $15.9 million to the Investor, in the form of a loan receivable, with a term of twenty-five years, bearing an interest rate of 1.0%. This $15.9 million in proceeds plus capital contributed from the Investor was used to make an aggregate $22.5 million loan to a subsidiary of the Company. This financing arrangement is secured by equipment at the Company's Longview, Texas facilities, and a guarantee from the Company, including an unconditional guarantee of NMTCs. Stock Repurchases - The Board has authorized three stock repurchase programs for the Company. The Company may purchase shares on the open market from time to time, up to a total of 5.7 million shares. The Board must authorize the timing and amount of these purchases and all repurchases are in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. Our open market repurchase programs are as follows: Agreement Execution Date Authorized Repurchase $ Expiration Date May 16, 2018 1 $15 million March 1, 2019 March 5, 2019 1 $20 million March 4, 2020 March 13, 2020 $20 million ** 2 1 The 2018 and 2019 purchase authorizations were executed under 10b5-1 programs. 2 Expiration Date is at Board's discretion. The Company is authorized to effectuate repurchases of the Company's common stock on terms and conditions approved in advance by the Board. The Company also has a stock repurchase arrangement by which employee-participants in our 401(k) savings and investment plan are entitled to have shares in AAON, Inc. stock in their accounts sold to the Company. The maximum number of shares to be repurchased is contingent upon the number of shares sold by employee-participants. Lastly, the Company repurchases shares of AAON, Inc. stock from certain of its directors and employees for payment of statutory tax withholdings on stock transactions. All other repurchases from directors or employees are contingent upon Board approval. All repurchases are done at current market prices. - 31 - Our repurchase activity is as follows: Nine Months Ended September 30, 2020 September 30, 2019 (in thousands, except share and per share data) Program Shares Total $ $ per share Shares Total $ $ per share Open market 103,689 $ 4,987 $ 48.10 5,799 $ 200 $ 34.46 401(k) 303,112 16,403 54.12 335,139 15,237 45.46 Directors and employees 22,655 1,130 49.88 24,948 1,023 41.00 Total 429,456 $ 22,520 $ 52.44 365,886 $ 16,460 $ 44.99 Our repurchase activity since Company inception, including our current authorized stock repurchase programs, are as follows: Inception to September 30, 2020 (in thousands, except share and per share data) Program Shares Total $ $ per share Open market 4,205,255 $ 74,793 $ 17.79 401(k) 7,770,851 136,330 17.54 Directors and employees 2,004,584 20,712 10.33 Total 13,980,690 $ 231,835 $ 16.58 Dividends - At the discretion of the Board, we pay semi-annual cash dividends. Board approval is required to determine the date of declaration and amount for each semi-annual dividend payment. Our recent dividends are as follows: Declaration Date Record Date Payment Date Dividend per Share May 20, 2019 June 3, 2019 July 1, 2019 $0.16 November 6, 2019 November 27, 2019 December 18, 2019 $0.16 May 15, 2020 June 3, 2020 July 1, 2020 $0.19 Based on historical performance and current expectations, we believe our cash and cash equivalents balance, the projected cash flows generated from our operations, our existing committed revolving credit facility (or comparable financing) and our expected ability to access capital markets will satisfy our working capital needs, capital expenditures and other liquidity requirements associated with our operations in 2020 and the foreseeable future. - 32 - Statement of Cash Flows The following table reflects the major categories of cash flows for the nine months ended September 30, 2020 and 2019. For additional details, see the consolidated financial statements. Nine Months Ended September 30, 2020 September 30, 2019 (in thousands) Operating Activities Net Income $ 60,117 $ 36,438 Income statement adjustments, net 37,131 32,449 Changes in assets and liabilities: Accounts receivable 5,011 (2,096) Income taxes (3,142) 2,283 Inventories (6,994) (4,014) Prepaid expenses and other (598) (513) Accounts payable 3,654 782 Deferred revenue 1,128 263 Accrued liabilities & donations 688 4,991 Net cash provided by operating activities 96,995 70,583 Investing Activities Capital expenditures (48,955) (30,831) Purchases of investments — (6,000) Maturities of investments and proceeds from called investments — 6,000 Other 99 107 Net cash used in investing activities (48,856) (30,724) Financing Activities Stock options exercised 18,519 11,283 Repurchase of stock (21,390) (15,437) Employee taxes paid by withholding shares (1,130) (1,023) Cash dividends paid to stockholders (9,910) (8,303) Net cash used in financing activities $ (13,911) $ (13,480) Cash Flows Provided by Operating Activities The Company manages cash needs through working capital rather than drawing on its line of credit. Collections and payments cycles are on a normal pattern and fluctuate due to timing of receipts and payments. The Company has been able to improve its collections of outstanding receivables due in part through prepayment of orders. The Company also has also increased the purchase of inventory to take advantage of current favorable pricing and also to prevent future supply chain disruptions. Cash Flows Used in Investing Activities The capital expenditure program for 2020 is estimated to be approximately $73.2 million. The capital expenditures for 2020 relate to the expansion of our Longview, Texas facility, purchase of additional Salvagnini sheet metal fabrication machines, completion of our R&D lab and other operational improvements. Many of these projects are subject to review and cancellation at the discretion of our CEO and Board of Directors without incurring substantial charges. - 33 - Cash Flows Used in Financing Activities Stock options exercised increased due to the increase in the number of employee options exercised and increases in our stock price. The Company also purchased approximately $5.0 million of our outstanding stock through the open market buyback program (Note 15 ) during the nine months ended September 30, 2020. Off-Balance Sheet Arrangements We are not party to any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations We had no material contractual purchase obligations as of September 30, 2020. Critical Accounting Policies There have been no material changes in the Company’s critical accounting policies during the nine months ended September 30, 2020. Recent Accounting Pronouncements See Note 1 of the Notes to the Consolidated Financial Statements for a discussion of recent accounting pronouncements. Forward-Looking Statements This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “will”, “should”, and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Important factors that could cause results to differ materially from those in the forward-looking statements include (1) the timing and extent of changes in raw material and component prices, (2) the effects of fluctuations in the commercial/industrial new construction market, (3) the timing and extent of changes in interest rates, as well as other competitive factors during the year, (4) general economic, market or business conditions, and (5) the impact of COVID-19 on the economy, demand for our products and our operations, including the measures taken by governmental authorities to address it, which may precipitate or exacerbate other risks and/or uncertainties. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Commodity Price Risk We are exposed to volatility in the prices of commodities used in some of our products and we may use fixed price cancellable and non-cancellable contracts with our major suppliers for periods of six to 18 months to manage this exposure. - 34 -