What changed in this filing

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Item 7. Management’s Discussion and Analysis

2021-02-25 compared with 2020-02-27 · 62 added, 72 removed, 257 unchanged (34% of the section changed)

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The following discussion should be read in conjunction with the other sections of this Annual Report on Form 10-K, including the consolidated financial statements and related notes contained in Item 8, Financial Statements and Supplementary Data .

Correction of an Error

We have corrected our previously issued consolidated financial statements contained in this Annual Report on Form 10-K.

Refer to the Explanatory Note preceding Item 1, Business , for background on the correction, the fiscal periods impacted, control considerations, and other information.

In addition, we have changed certain previously reported financial information at December 31, 2018 and for the years ended December 31, 2018 and December 31, 2017 in this Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations , including but not limited to information within the Results of Operation s section.

See Note 2, Error Correction , in Item 8, Financial Statements and Supplementary Data , for additional information related to the correction of an error.

Description of the Company

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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.

We sell our products to property owners and contractors through a network of independent manufacturers’ representatives and our internal sales force.

The demand for our products is influenced by national and regional economic and demographic factors.

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economy and global economy.

For the year ended December 31, 2019, the prices for copper, galvanized steel, stainless steel and aluminum decreased approximately 3.2%, 5.8%, 2.3% and 1.6%, respectively, from 2018.

For the year ended December 31, 2018, the prices for copper, galvanized steel and stainless steel increased approximately 4.7%, 18.2%, 11.8% and 6.4%, respectively, from 2017.

For the year ended December 31, 2020, the prices for copper, galvanized steel, stainless steel and aluminum increased approximately 0.6%, 12.2%, 8.5%, and 12.8%, respectively, from 2019.

For the year ended December 31, 2019, the prices for copper, galvanized steel and stainless steel decreased approximately 3.2%, 5.8%, 2.3%, and 1.6%, respectively, from 2018.

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.

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The following are highlights of our results of operations, cash flows, and financial condition:

• We started to realize the price increases put in place in 2018 and early 2019.

• We saw improvement in our gross margin despite sheet metal fabrication downtime and changes in personnel.

• Overall units sold increased approximately 4.6% for the year ended 2019, as compared to the same period last year.

• We continue to see growth and improvement in our water-source heat pump line that increased revenues by $10.8 million.

• Our warranty expense has stabilized and we expect to see continued improvement.

• We spent $37.2 million in capital expenditures in 2019, continuing our work on such projects as our new research and development lab, water-source heat pump production line and additional Salvagnini machines that will increase our sheet metal capacity.

• Our order intake level continued to support our high backlog.

• In 2020, we fully realized the price increases put in place during 2019.

• We continued to become more efficient.

Our gross profit percentage improved from 25.4% during the year ended in 2019 to 30.3% in 2020 despite employee absenteeism, mostly in June, related to COVID-19.

• Our warranty expense has continued to improve from 2018 through 2020.

• We honored our founder and Executive Chairman, Norman Asbjornson, with a donation to Winifred Public Schools of $1.25 million.

• With a record year, were able to reward our employees with increased profit sharing and bonuses.

• We spent $67.8 million in capital expenditures in 2020, over half of which was for our new building in Longview, Texas.

• We recognized a gain of $6.4 million from the receipt of insurance proceeds related to our roof on our Tulsa facility that sustained hail damage in the spring.

• Total cash, cash equivalents and restricted cash was $82.3 million at December 31, 2020.

Results of Operations

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Total units 26,231 26,307 (76) (0.3) %

Most of the increase in revenues is due to our price increases in 2018 which were realized during 2019.

Additionally, our parts sales and water-source heat pumps sales continue to grow with increases of $7.0 million and $10.8 million, respectively.

Our sales increased 9.6%, or $45.2 million mostly due to the increase in rooftop sales which increased by $51.5 million (increase of 15%).

The increase in rooftop units sales was due in part to our increased sheet metal production from the additional Salvagnini machines that were placed into operation allowing increased production (1,265 units or 9% unit increase over 2019) and from price increases put in place over the last year.

Cost of Sales

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The principal high volume raw materials used in our manufacturing processes are steel, copper, and aluminum.

As shown below, our average raw material prices decreased during the year, a trend we expect to continue into 2020.

The Company also maintained a steady level of workforce throughout 2019.

The Company continues to improve its labor and overhead efficiencies and expects improvements to continue as new sheet metal machines were placed into service in the last quarter of 2019 and early 2020.

As shown below, our average raw material prices increased during the year.

However, the Company had increased its inventory levels in 2019 and early 2020 at lower prices and was able to benefit from these lower priced raw materials as the stock was consumed in 2020.

The Company continues to closely monitor its raw materials prices to try and purchase quantities when there are dips in the market.

The Company improved its labor and overhead efficiencies with our new sheet metal machines that were placed into service in the last quarter of 2019 and early 2020, eliminating any bottlenecks in our sheet metal production.

The Company's headcount was also down compared to 2019, resulting in a higher production output per employee.

Twelve month average raw material cost per pound as of December 31:

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Our profit sharing expenses are up due to higher earnings.

Depreciation has increased due to our continued expansion of our facilities.

The Company makes company wide equity grants each year that cause our increases in stock compensation.

We raised our minimum wage twice during 2019 and work to keep our salaries consistent with market rates to help retain employees.

Salaries & benefits increased due to additional bonuses and employee incentives.

Stock compensation was 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.

Years Ended December 31, Effective Tax Rate

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Additionally in 2019, the Company determined it could take advantage of an additional 1% tax credit in Oklahoma 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 $1.2 million.

The additional Oklahoma Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law, resulted in a benefit of $1.2 million.

Year Ended December 31, 2019 vs.

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Total units 26,307 25,152 1,155 4.6 %

Most of the increase in revenues is due to our price increase from November 2017.

Additionally, our parts sales and water-source heat pumps sales continued to grow with increases of $6.4 million and $4.7 million, respectively.

Most of the increase in revenues was due to our price increases in 2018 which were realized during 2019.

Additionally, our parts sales and water-source heat pumps sales grew with increases of $7.0 million and $10.8 million, respectively.

Cost of Sales

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The principal high volume raw materials used in our manufacturing processes are steel, copper, and aluminum.

As shown below, our raw material prices increased during the year.

Additionally, in January 2018, the Company paid all employees a one-time bonus of $1,000 per employee as a result of the Tax Cuts and Jobs Act (the “Act”) which lowered the federal corporate tax rate from 35% to 21%.

This bonus increased cost of sales by $1.9 million, excluding taxes and benefits.

The Company maintained a higher level of workforce through the end of 2017 and beginning of 2018 in anticipation of our growing business.

The growth in order intake during the beginning of 2018 did not occur as quickly as anticipated.

As shown below, our average raw material prices decreased from 2018 to 2019.

The Company also maintained a steady level of workforce throughout 2019.

Twelve month average raw material cost per pound as of December 31:

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The Company experienced a decrease in warranty claims paid of 13.4% in 2019.

Additionally, the Company had a change in estimate in how it calculates its estimated failure rate that is applied to sales to estimate our potential future liability for warranty claims.

This change in estimate reduced our accrual, and thus our expense, by $0.9 million.

Our profit sharing expenses are also down due to lower earnings.

Our advertising expense decreased due to cost savings on our annual sales show.

Professional fees have increased related to additional services and work

performed for the Wattmaster acquisition.

These fees are not expected to be recurring.

Our other expenses have increased due to sales concessions granted to our customers.

Our profit sharing expenses increased due to higher earnings.

Depreciation increased due to the continued expansion of our facilities.

The Company makes company wide equity grants each year that caused our increase in stock compensation.

We raised our minimum wage twice during 2019 to keep our salaries consistent with market rates to help retain employees.

Years Ended December 31, Effective Tax Rate

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Income tax provision $ 13,320 $ 13,171 19.9 % 23.7 %

The Tax Cuts and Jobs Act was enacted on December 22, 2017.

The overall effective tax rate decreased from 27.9% to 23.7% due to the reduced corporate rate of 35% to 21% in 2018.

At the end of 2017, we recorded a $3.7 million reduction in expense due to the remeasuring of our deferred taxes due to the Act.

Upon completion of the Company's 2018 tax return in 2019, the Company recorded additional benefit due to higher than expected research and development credit of $0.6 million.

Additionally in 2019, the Company determined it could take advantage of an additional 1% tax credit in Oklahoma for years in which the Company's location was deemed to be within an enterprise zone.

The additional Oklahoma Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law, resulted in a benefit of $1.2 million.

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 cash, cash equivalents and restricted cash increased $42.4 million from December 31, 2018 to December 31, 2019.

As of December 31, 2019, we had $44.4 million in cash, cash equivalents and restricted cash.

Working Capital - Our unrestricted cash and cash equivalents and increased $52.2 million from December 31, 2019 to December 31, 2020.

As of December 31, 2020, we had $82.3 million in cash and cash equivalents and restricted cash.

Revolving Line of Credit - On July 26, 2018 we renewed our $30.0 million line of credit (“BOK Revolver”) with BOKF, NA dba Bank of Oklahoma (“Bank of Oklahoma”).

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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.

On October 24, 2019 we amended the BOK Revolver to allow for the occurrence of transactions associated with the New Markets Tax Credit transaction (Note 19).

This amendment also removed section 8.1.4 which required our Chief Executive Officer, Norman Asbjornson, to maintain ownership of 25% of the Company.

Norman Asbjornson does not currently, and has not for several years maintained this level of ownership, a limited waiver of default was also added to the amendment.

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”).

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Agreement Execution Date Authorized Repurchase $ Expiration Date

June 2, 2016 $25 million April 15, 2017

May 16, 2018 $15 million March 1, 2019

March 5, 2019 $20 million March 4, 2020

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.

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Capital expenditures (67,802) (37,166) (37,268)

Insurance proceeds 6,417 — —

Cash paid for business combination — — (6,377)

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Financing Activities

(Payments) borrowings under revolving credit facility, net — — —

Proceeds from financing obligation, net of issuance costs — 6,614 —

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Employee taxes paid by withholding shares (1,169) (1,207) (1,097)

(1,207) (1,097) (1,614)

Cash dividends paid to stockholders (19,815) (16,645) (16,728)

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Cash Flows from Operating Activities

Cash flows from operating activities increased in 2019 mainly as a result of our continuing operations results which included the full year of price increases enacted during 2018, combined with an overall decrease in the average cost of inventory raw materials in 2019.

In 2018, the Company's cash flows were tighter due to our capital expenditures and business combination that was completed during the year.

Cash flows from operating activities increased in 2020 mainly as a result of our continuing operations which capitalized on our reduced lead times and second full year of benefiting from price increases enacted during 2018 and 2019, combined with an overall decrease in the average cost of inventory raw materials purchased in 2019.

For 2019, the Company saw an increase in customer prepayments and lower warranty claims that decreased our liability payments.

Our increased federal and state tax credits created additional cash inflows.

The positive warranty downward trend continued in 2020.

In 2018, the Company's cash flows were tighter due to our capital expenditures and business combination that was completed during the year.

Cash Flows from Investing Activities

Cash flows from investing activities increased marginally in 2019 as compared to 2018.

Cash flows from investing activities are primarily affected by the timing of our capital expenditures and purchase/maturity of investments with available cash.

Cash flows from investing activities increased in 2020 as compared to 2019 and 2018.

Cash flows from investing activities are primarily affected by the timing of our capital expenditures.

In November 2020, we received approximately $6.4 million from insurance proceeds which will be utilized to extend the useful life of our facility's roof in Tulsa, Oklahoma.

Additionally, we paid approximately $6.4 million in 2018 related to our February 2018 business combination.

The capital expenditures for 2019 relate to the completion of our R&D lab and water-source heat pump lines, along with expansion of our Longview facility.

The capital expenditures for 2020 relate to the completion of our Longview facility expansion as well as the addition to and replacement of sheet metal manufacturing equipment.

The capital expenditures for 2019 relate to the completion of our R&D lab and water-source heat pump lines, along with the expansion of our Longview facility.

Our capital expenditure program for 2021 is estimated to be approximately $70.7 million.

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Additionally, we received approximately $6.6 million in net proceeds in 2019 related to the New Markets Tax Credit transaction (Note 18).

We also increased our dividend per share in 2020 from $0.16 to $0.19.

Off-Balance Sheet Arrangements

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Commitments and Contractual Agreements

We had no material contractual purchase agreements as of December 31, 2019, except for one contractual purchase obligation for approximately $2.5 million that expires in December 2020.

We had no material contractual purchase agreements as of December 31, 2020.

Contingencies

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We believe the following critical accounting policies affect our more significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements.

Inventory Reserves – We establish a reserve for inventories based on the change in inventory requirements due to product line changes, the feasibility of using obsolete parts for upgraded part substitutions, the required parts needed for part supply sales, replacement parts and for estimated shrinkage.

Warranty – A provision is made for estimated warranty costs at the time the product is shipped and revenue is recognized.

Our product warranty policy is:

the earlier of one year from the date of first use or 18 months from date of shipment for parts only;

Our product warranty policy is the earlier of one year from the date of first use or 18 months from date of shipment for parts only;

an additional four years for compressors (if applicable);

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25 years on stainless steel heat exchangers (if applicable);

and ten years on gas-fired heat exchangers in RL products (if applicable).

and ten years on gas-fired heat exchangers in our historical RL products (if applicable).

Our warranty policy for the RQ series covers parts for two years from date of unit shipment.

Our warranty policy for the WH and WV Series geothermal/water-source heat pumps covers parts for five years from the date of manufacture.

Our warranty policy for the WH and WV Series geothermal/water-source heat pumps covers parts for five years from the date of installation.

Warranty expense is estimated based on the warranty period, historical warranty trends and associated costs, and any known identifiable warranty issue.

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Should actual claim rates differ from our estimates, revisions to the estimated product warranty liability would be required.

Stock Compensation – We measure and recognize compensation expense for all share-based payment awards made to our employees and directors, including stock options and restricted stock awards, based on their fair values at the time of grant.

Share-Based Compensation – We measure and recognize compensation expense for all share-based payment awards made to our employees and directors, including stock options and restricted stock awards, based on their fair values at the time of grant.

Compensation expense is recognized on a straight-line basis over the service period of the related share-based compensation award.

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In December 2019, the FASB issued ASU 2019-12, Income Taxes:

Simplifying the Accounting for Income Taxes.

Simplifying the Accounting for Income Taxes (Topic 740) .

The ASU includes simplification of accounting for income taxes for franchise taxes, step up in tax basis for goodwill as part of a business combination and interim reporting of enacted changes in tax laws.

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We do not expect ASU 2019-12 will have a material effect on our consolidated financial statements and notes thereto.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurements:

Changes to the Disclosure Requirement for Fair Value Measurements.

The ASU includes additional disclosure requirements for unrealized gains and losses for Level 3 fair value measurement and significant observable inputs used to develop Level 3 fair value

measurements.

The ASU is effective for the Company beginning after December 15, 2019.

We do not expect ASU 2018-13 will have a material effect on our consolidated financial statements and notes thereto.

Quantitative and Qualitative Disclosures About Market Risk.

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis