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, 2020. 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, 2020. 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 $2.0 million of our total net sales for the three months just ended and $2.8 million of our sales during the same period of 2020. 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 first quarter of 2021 is showing signs of improvement compared to 2020. 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 historical higher employee absenteeism, especially in June 2020, in our manufacturing facilities. We maintained continuous operations during the three months ended March 31, 2021 except for the shut-down for planned maintenance in January and weather related event described in Note 1. 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. - 21 - 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. The outlook for 2021 presents some uncertainty but looks positive as COVID-19 restrictions begin to lessen. The Architecture Billings Index ("ABI") was down for most of 2020, indicating a decline in construction, which started to impact the new nonresidential construction market in late 2020. This did slightly affect the Company with a slower order intake and caused us to slow down some of our production in the first quarter. At the end of March, the ABI published its monthly index making February 2021 the first month since February 2020 that the ABI exceeded 50, indicating an expansion in the market. Even if construction may decline, our equipment is uniquely positioned to address COVID-19 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. We had unrestricted cash and cash equivalents of $97.0 million as of March 31, 2021. Our capital expenditures during the three months ended March 31, 2021 were $16.4 million, as compared to $21.9 million for the same period a year ago, and we anticipate our full-year 2021 capital expenditures will total approximately $70.7 million. Our expansion of our Longview, Texas facility was completed and operational during the first quarter 2021. The Company also has $28.2 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 March 31, 2021, the price (twelve month trailing average) for copper, galvanized steel, stainless steel and aluminum increased 2.5%, 20.4%, 9.9%, and 8.4%, respectively, as compared to the price (twelve month trailing average) at March 31, 2020. 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: • Our first quarter results demonstrated a slowed demand as we started the quarter. Due to the slowed demand, we shut-down for several days in January and performed planned maintenance. Then, we encountered extreme weather conditions in February that resulted in additional days of plant shut-down. • Bookings increased 21% in the first quarter of 2021 compared to 2020 indicating an improved demand for our products. • We invested $16.4 million in capital expenditures, including completing our work on projects such as our Longview, TX expansion and the purchase of additional Salvagnini machines that will increase our sheet metal capacity. • The first quarter of 2021, had a lower tax rate compared to the first quarter of 2020, due to an increase in our excess tax benefit related to stock awards of $1.8 million. Backlog The following table shows our historical backlog levels: March 31, 2021 December 31, 2020 March 31, 2020 (in thousands) $ 96,733 $ 74,417 $ 119,642 The Company started 2020 with a high backlog from challenges in maintaining adequate sheet-metal production capacity in 2019. The Company started to increase its sheet-metal production at the end of 2019 and into 2020 with the addition of new - 22 - Salvagnini machines. This led in part to a all time record sales and earnings for the year-ended December 31, 2020 that helped reduce our backlog. Since then, the Company improved lead times and reduced our backlog to the current, more manageable level. Results of Operations Three Months Ended March 31, 2021 vs. Three Months Ended March 31, 2020 Units Sold Three Months Ended March 31, 2021 March 31, 2020 Rooftop units 2,959 4,061 Condensing units 518 408 Air handlers 493 510 Outdoor mechanical rooms 7 10 Water source heat pumps 1,624 1,617 Total Units 5,601 6,606 Net Sales Three Months Ended March 31, 2021 March 31, 2020 Change % Change (in thousands, except unit data) Net sales $ 115,788 $ 137,483 $ (21,695) (15.8) % Total units 5,601 6,606 (1,005) (15.2) % The first quarter of 2020, benefited from a high backlog that allowed the Company to run at full capacity and set all time record highs for revenues in the first quarter. The order intake began to slow in late 2020 and the Company intentionally slowed production to keep its backlog at a healthy level. Additionally, the Company lost production days in January for planned maintenance and in February due to impacts of bad weather. Cost of Sales Three Months Ended Percent of Sales March 31, 2021 March 31, 2020 2021 2020 (in thousands) Cost of sales $ 82,631 $ 94,536 71.4 % 68.8 % Gross profit 33,157 42,947 28.6 % 31.2 % 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, which are obtained from domestic suppliers. We continue to see overall raw material costs increase. The decrease in overall production, driven by slowing demand and order intake at the beginning of the period, resulted in unfavorable labor - 23 - and overhead inefficiencies, including the Company's ability to absorb certain fixed costs. This resulted in a overall decrease in gross margin during three months ended March 31, 2021 as compared to 2020. Twelve-month average raw material cost per pound as of March 31: 2021 2020 % Change Copper $ 3.74 $ 3.65 2.5 % Galvanized steel $ 0.59 $ 0.49 20.4 % Stainless steel $ 1.44 $ 1.31 9.9 % Aluminum $ 1.93 $ 1.78 8.4 % Selling, General and Administrative Expenses Three Months Ended Percent of Sales March 31, 2021 March 31, 2020 2021 2020 (in thousands) Warranty $ 1,467 $ 1,465 1.3 % 1.1 % Profit sharing 2,132 3,167 1.8 % 2.3 % Salaries & benefits 5,034 5,400 4.3 % 3.9 % Stock compensation 1,291 1,036 1.1 % 0.8 % Advertising 206 126 0.2 % 0.1 % Depreciation 699 462 0.6 % 0.3 % Insurance 731 239 0.6 % 0.2 % Professional fees 725 540 0.6 % 0.4 % Donations (47) 180 — % 0.1 % Bad debt expense (13) 294 — % 0.2 % Other 2,471 2,305 2.1 % 1.7 % Total SG&A $ 14,696 $ 15,214 12.7 % 11.1 % Profit sharing expenses decreased due to our decreased earnings for the period. Insurance increased due to an increase in overall premiums during the period. Income Taxes Three Months Ended Effective Tax Rate March 31, 2021 March 31, 2020 2021 2020 (in thousands) Income tax provision $ 2,105 $ 5,976 11.4 % 21.5 % The Company’s estimated annual 2021 effective tax rate, excluding discrete events, is expected to be approximately 27%. During the three months ended March 31, 2021, the Company recorded an excess tax benefit of $2.9 million as compared to $1.1 million during the same period in 2020, an increase of 173%. The increase was primarily due to timing of stock awards as a result of our high stock price during the three months ended March 31, 2021. 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. - 24 - Working Capital - Our unrestricted cash increased $18.0 million from December 31, 2020 to March 31, 2021 and totaled $97.0 million at March 31, 2021. Revolving Line of Credit - Under the line of credit, there was one standby letter of credit of $1.8 million as of March 31, 2021. At March 31, 2021, 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. We had no outstanding balance under the revolving credit facility at March 31, 2021 and December 31, 2020. Interest on borrowings is payable monthly at LIBOR plus 2.0%. The termination date of the revolving credit facility is July 26, 2021. At March 31, 2021, 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 March 31, 2021, our tangible net worth was $373.0 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: Effective 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. - 25 - Our repurchase activity is as follows: Three Months Ended March 31, 2021 March 31, 2020 (in thousands, except share and per share data) Program Shares Total $ $ per share Shares Total $ $ per share Open market — $ — $ — 103,689 $ 4,987 $ 48.10 401(k) 70,350 5,185 73.70 123,672 6,578 53.19 Directors and employees 16,972 1,217 71.71 19,099 953 49.90 Total 87,322 $ 6,402 $ 73.31 246,460 $ 12,518 $ 50.79 Our repurchase activity since Company inception, including our current authorized stock repurchase programs, are as follows: Inception to March 31, 2021 (in thousands, except share and per share data) Program Shares Total $ $ per share Open market 4,205,255 $ 74,793 $ 17.79 401(k) 7,977,010 150,185 18.83 Directors and employees 2,022,173 21,968 10.86 Total 14,204,438 $ 246,946 $ 17.39 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 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. - 26 - Statement of Cash Flows The following table reflects the major categories of cash flows for the three months ended March 31, 2021 and 2020. For additional details, see the consolidated financial statements. Three Months Ended March 31, 2021 March 31, 2020 (in thousands) Operating Activities Net Income $ 16,376 $ 21,853 Income statement adjustments, net 14,606 8,199 Changes in assets and liabilities: Accounts receivable (5,179) (2,789) Income taxes (2,766) 772 Inventories (1,627) 1,020 Prepaid expenses and other 108 (670) Accounts payable 4,904 2,742 Deferred revenue 2,358 229 Accrued liabilities & donations 58 6,241 Net cash provided by operating activities 28,838 37,597 Investing Activities Capital expenditures (16,404) (21,877) Other 14 73 Net cash used in investing activities (16,390) (21,804) Financing Activities Stock options exercised 9,438 4,497 Repurchase of stock (5,185) (11,565) Employee taxes paid by withholding shares (1,217) (953) Net cash provide by (used in) financing activities $ 3,036 $ (8,021) 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 decrease cash flows from receivables was due to the planned Company shut down during the last week of December 2020 which lowered overall accounts receivable at December 31, 2020. The Company has also increased the purchase of inventory to take advantage of favorable pricing and also to prevent future supply chain disruptions. Cash Flows Used in Investing Activities The capital expenditures for 2020 related to the expansion of our Longview, Texas facility, which was completed and became operational during early 2021. Additionally in 2020, we purchased Salvagnini sheet metal fabrication machines and completed our R&D lab as well as other operational improvements. The 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 Used in Financing Activities Stock options exercised increased due to the increase in the number of employee options exercised and increase in our stock price. The Company also purchased approximately $5.0 million of our outstanding stock through the open market buyback program (Note 13 ) during the three months ended March 31, 2020. - 27 - 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 March 31, 2021. Critical Accounting Policies There have been no material changes in the Company’s critical accounting policies during the three months ended March 31, 2021. 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. - 28 -