AAON, INC. 10-K

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview 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 . Description of the Company We engineer, manufacture, market, and sell 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 pump, 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 certain provinces in Canada. 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 recent 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. 17 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. 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. When new construction is down, we emphasize the replacement market. The new construction market in 2020 continued to be unpredictable and uneven. Thus, throughout the year, we emphasized promotion of the benefits of AAON equipment to property owners in the replacement market. The principal components of cost of sales are labor, raw materials, component costs, factory overhead, freight out, and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper, and aluminum. We also purchase from other manufacturers certain components, including compressors, motors, and electrical controls. The price levels of our raw materials fluctuate given that the market continues to be volatile and unpredictable as a result of the uncertainty related to the U.S. economy and global economy. 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. We expect to receive delivery of raw materials from our fixed price contracts for use in our manufacturing operations. The following are highlights of our results of operations, cash flows, and financial condition: • 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 Units sold for years ended December 31: 2020 2019 2018 Rooftop Units 15,713 14,448 15,273 Condensing Units 1,920 1,738 2,007 Air Handlers 2,073 2,372 2,500 Outdoor Mechanical Rooms 33 33 38 Water-Source Heat Pumps 6,492 7,716 5,334 Total Units 26,231 26,307 25,152 18 Year Ended December 31, 2020 vs. Year Ended December 31, 2019 Net Sales Years Ended December 31, 2020 2019 $ Change % Change (in thousands, except unit data) Net sales $ 514,551 $ 469,333 $ 45,218 9.6 % Total units 26,231 26,307 (76) (0.3) % 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 Years Ended December 31, Percent of Sales 2020 2019 2020 2019 (in thousands) Cost of sales $ 358,702 $ 349,908 69.7 % 74.6 % Gross Profit $ 155,849 $ 119,425 30.3 % 25.4 % The principal components of cost of sales are labor, raw materials, component costs, factory overhead, freight out, and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper, and aluminum. 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: 2020 2019 % Change Copper $ 3.65 $ 3.63 0.6 % Galvanized Steel $ 0.55 $ 0.49 12.2 % Stainless Steel $ 1.41 $ 1.30 8.5 % Aluminum $ 2.02 $ 1.79 12.8 % 19 Selling, General and Administrative Expenses Years Ended December 31, Percent of Sales 2020 2019 2020 2019 (in thousands) Warranty $ 6,621 $ 8,047 1.3 % 1.7 % Profit Sharing 11,593 7,448 2.3 % 1.6 % Salaries & Benefits 20,159 13,394 3.9 % 2.9 % Stock Compensation 5,341 6,690 1.0 % 1.4 % Advertising 823 818 0.2 % 0.2 % Depreciation 1,999 1,524 0.4 % 0.3 % Insurance 1,066 805 0.2 % 0.2 % Professional Fees 2,514 2,738 0.5 % 0.6 % Donations 2,115 1,137 0.4 % 0.2 % Bad Debt Expense 153 91 — % — % Other 8,107 9,385 1.6 % 2.0 % Total SG&A $ 60,491 $ 52,077 11.8 % 11.1 % The Company experienced a decrease in warranty claims paid of 15.6% in 2020. Our profit sharing expenses are up due to higher earnings. 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. Income Taxes Years Ended December 31, Effective Tax Rate 2020 2019 2020 2019 (in thousands) Income tax provision $ 22,966 $ 13,320 22.5 % 19.9 % 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. 20 Year Ended December 31, 2019 vs. Year Ended December 31, 2018 Net Sales Years Ended December 31, 2019 2018 $ Change % Change (in thousands, except unit data) Net sales $ 469,333 $ 433,947 $ 35,386 8.2 % Total units 26,307 25,152 1,155 4.6 % 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 Years Ended December 31, Percent of Sales 2019 2018 2019 2018 (in thousands) Cost of sales $ 349,908 $ 330,414 74.6 % 76.1 % Gross Profit $ 119,425 $ 103,533 25.4 % 23.9 % The principal components of cost of sales are labor, raw materials, component costs, factory overhead, freight out, and engineering expense. 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 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: 2019 2018 % Change Copper $ 3.63 $ 3.75 (3.2) % Galvanized Steel $ 0.49 $ 0.52 (5.8) % Stainless Steel $ 1.30 $ 1.33 (2.3) % Aluminum $ 1.79 $ 1.82 (1.6) % 21 Selling, General and Administrative Expenses Years Ended December 31, Percent of Sales 2019 2018 2019 2018 (in thousands) Warranty $ 8,047 $ 8,807 1.7 % 2.0 % Profit Sharing 7,448 6,165 1.6 % 1.4 % Salaries & Benefits 13,394 12,638 2.9 % 2.9 % Stock Compensation 6,690 4,733 1.4 % 1.1 % Advertising 818 762 0.2 % 0.2 % Depreciation 1,524 950 0.3 % 0.2 % Insurance 805 1,235 0.2 % 0.3 % Professional Fees 2,738 2,441 0.6 % 0.6 % Donations 1,137 933 0.2 % 0.2 % Bad Debt Expense 91 174 — % — % Other 9,385 9,356 2.0 % 2.2 % Total SG&A $ 52,077 $ 48,194 11.1 % 11.1 % The Company experienced a decrease in warranty claims paid of 13.4% in 2019. 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. Income Taxes Years Ended December 31, Effective Tax Rate 2019 2018 2019 2018 (in thousands) Income tax provision $ 13,320 $ 13,171 19.9 % 23.7 % 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 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”). Under the line of credit, there was one standby letter of credit of $1.8 million as of December 31, 2020. At December 31, 2020 we have $28.2 million of borrowings available under the revolving credit facility. No fees are associated with the unused portion of the committed amount. 22 As of December 31, 2020 and 2019, there were no outstanding balances under the revolving credit facility. Interest on borrowings is payable monthly at LIBOR plus 2.0%. The weighted average interest rate was 2.6% and 4.3% for the years ended December 31, 2020 and 2019, respectively. At December 31, 2020, we were in compliance with all of the covenants under the BOK Revolver. We are obligated to comply with certain financial covenants under the BOK Revolver. These covenants require that we meet certain parameters related to our tangible net worth and total liabilities to tangible net worth ratio. At December 31, 2020, our tangible net worth was $350.9 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 Repurchase - 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. 23 Our repurchase activity is as follows: 2020 2019 2018 (in thousands, except share and per share data) Program Shares Total $ $ per share Shares Total $ $ per share Shares Total $ $ per share Open market 103,689 $ 4,987 $ 48.10 5,799 $ 200 $ 34.46 252,272 $ 8,374 $ 33.19 401(k) 438,921 25,073 57.12 419,963 19,386 46.16 497,753 18,472 37.11 Directors and employees 23,272 1,169 50.23 28,668 1,207 42.11 33,751 1,097 32.49 Total 565,882 $ 31,229 $ 55.19 454,430 $ 20,793 $ 45.76 783,776 $ 27,943 $ 35.65 Inception to Date (in thousands, except share and per share data) Program Shares Total $ $ per share Open market 4,205,255 $ 74,793 $ 17.79 401(k) 7,906,660 145,000 18.34 Directors and employees 2,005,201 20,751 10.35 Total 14,117,116 $ 240,544 $ 17.04 Dividends - At the discretion of the Board of Directors, 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 18, 2018 June 8, 2018 July 6, 2018 $0.16 November 8, 2018 November 29, 2018 December 20, 2018 $0.16 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 November 10, 2020 November 27, 2020 December 18, 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 2021 and the foreseeable future. 24 Statement of Cash Flows The table below reflects a summary of our net cash flows provided by operating activities, net cash flows used in investing activities, and net cash flows used in financing activities for the years indicated. 2020 2019 2018 (in thousands) Operating Activities Net Income $ 79,009 $ 53,711 $ 42,329 Income statement adjustments, net 44,793 42,440 28,513 Changes in assets and liabilities: Accounts receivable 19,859 (13,412) (2,832) Income tax receivable (3,815) 5,129 (4,448) Inventories (9,726) 2,557 (5,598) Prepaid expenses and other (2,364) (329) (528) Accounts payable (2,155) 280 (1,176) Deferred revenue 1,010 425 412 Accrued liabilities 2,203 7,124 (1,816) Net cash provided by operating activities 128,814 97,925 54,856 Investing Activities Capital expenditures (67,802) (37,166) (37,268) Insurance proceeds 6,417 — — Cash paid for business combination — — (6,377) Purchases of investments — (6,000) (16,201) Maturities of investments and proceeds from called investments — 6,000 25,145 Other 112 120 66 Net cash used in investing activities (61,273) (37,046) (34,635) Financing Activities Proceeds from financing obligation, net of issuance costs — 6,614 — Payment related to financing costs — (301) — Stock options exercised 21,418 12,625 4,987 Repurchase of stock (30,060) (19,586) (26,846) Employee taxes paid by withholding shares (1,169) (1,207) (1,097) Cash dividends paid to stockholders (19,815) (16,645) (16,728) Net cash used in financing activities $ (29,626) $ (18,500) $ (39,684) Cash Flows from Operating Activities 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. 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 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. 25 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. Many of these projects are subject to review and cancellation at the discretion of our CEO and Board of Directors without incurring substantial charges. Cash Flows from Financing Activities Cash flows from financing activities is primarily affected by the timing of stock options exercised by our employees. Cash flows from stock options exercised increased to the increase in our publically traded stock price. 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 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. Commitments and Contractual Agreements We had no material contractual purchase agreements as of December 31, 2020. Contingencies We are subject to various claims and legal actions that arise in the ordinary course of business. We closely monitor these claims and legal actions and frequently consult with our legal counsel to determine whether they may, when resolved, have a material adverse effect on our financial position, results of operations or cash flows and we accrue and/or disclose loss contingencies as appropriate. We have concluded that the likelihood is remote that the ultimate resolution of any pending litigation or claims will be material or have a material adverse effect on the Company’s business, financial position, results of operations, or cash flows. Critical Accounting Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“US GAAP”) requires management to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue, and expenses in our consolidated financial statements and related notes. We base our estimates, assumptions, and judgments on historical experience, current trends and other factors believed to be relevant at the time our consolidated financial statements are prepared. However, because future events and their effects cannot be determined with certainty, actual results could differ from our estimates and assumptions, and such differences could be material. 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 and 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; an additional four years for compressors (if applicable); 15 years on aluminized steel gas-fired heat exchangers (if applicable); 25 years on stainless steel heat exchangers (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 installation. Warranty expense is estimated based on the warranty period, historical warranty trends and associated costs, and any known identifiable warranty issue. 26 Due to the absence of warranty history on new products, an additional provision may be made for such products. Our estimated future warranty cost is subject to adjustment from time to time depending on changes in actual warranty trends and cost experience. Should actual claim rates differ from our estimates, revisions to the estimated product warranty liability would be required. 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. Forfeitures are accounted for as they occur. The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model. The use of the Black-Scholes-Merton option valuation model requires the input of subjective assumptions such as: the expected volatility, the expected term of the options granted, expected dividend yield and the risk-free rate. The fair value of restricted stock awards is based on the fair market value of AAON common stock on the respective grant dates, reduced for the present value of dividends. New Accounting Pronouncements Changes to U.S. GAAP are established by the Financial Accounting Standards Board (“FASB”) in the form of accounting standards updates (“ASUs”) to the FASB’s Accounting Standards Codification. We consider the applicability and impact of all ASUs. ASUs not listed below were assessed and determined to be either not applicable or are expected to have minimal impact on our consolidated financial statements and notes thereto. In December 2019, the FASB issued ASU 2019-12, 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. The ASU is effective for the Company beginning after December 15, 2020. We do not expect ASU 2019-12 will have a material effect on our consolidated financial statements and notes thereto. Item 7A. 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, occasionally, we use fixed price cancellable and non-cancellable contracts with our major suppliers for periods of six to 18 months to manage this exposure. 27