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, 2021. 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, 2021. 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, market, and sell premium air conditioning and heating equipment consisting of standard, semi-custom, and custom rooftop units, data center cooling solutions, cleanroom systems, 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, data centers, medical and pharmaceutical, and other commercial industries. We market our products to all 50 states in the United States and certain provinces in Canada. Foreign sales were approximately $6.0 million of our total net sales for the three months ended March 31, 2022 and $2.0 million of our sales during the same period of 2021. 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 in recent years. However, the recent rise in architectural billings and nonresidential building construction starts signal a 2022 recovery in nonresidential building construction after experiencing a downturn in 2021. Furthermore, general economic growth combined with pent-up demand from customers that delayed replacing old equipment is driving accelerated replacement demand. However, both the new construction and replacement markets are cyclical. If the domestic economy were to slow or enter a recession, this 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. Sales in the replacement markets are driven by various factors, including general economic growth, the Company’s new product introductions, fluctuations in the average age of existing equipment in the market, government regulations and stimulus, changes in market demand between more customized higher performing HVAC equipment and lower priced standard equipment, as well as many other factors. When new construction is down, we emphasize the replacement market. 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. We sell our products to property owners and contractors mainly through a network of independent manufacturers’ representatives. This go-to-market strategy is unique compared to most of our larger competitors in that most control their sales channel. We value the independent sales channel as we think it is a more effective way of increasing market share. Although we concede full control of the sales process with this strategy, the entrepreneurial aspect of the independent sales channel attracts the most talent and provides greater financial incentives for its salespeople. Furthermore, the independent sales channel sells different types of equipment from various manufacturers, allowing it to operate with more of a solutions-based mindset, as opposed to an internal sales department of a manufacturing company that is incentivized to only sell its equipment regardless if it is the best solution for the end customer. We also have a small internal sales force that supports the relationships between the Company and our sales channel partners. - 28 - 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. 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. At March 31, 2022, the price (twelve month trailing average) for copper, galvanized steel, stainless steel and aluminum increased 41.2%, 67.8%, 61.8%, and 1.6%, respectively, as compared to the price (twelve month trailing average) at March 31, 2021. 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. We occasionally increase the price of our equipment to help offset any inflationary headwinds. In 2021, we implemented three price increases; and on January 1, 2022, we implemented a fourth price increase. Recent Developments On December 10, 2021, we closed on the acquisition of all of the issued and outstanding equity ownership of BasX, LLC, doing business as BasX Solutions ("BasX") (Note 3). We began including the results of BasX’s operations in our consolidated financial statements beginning December 11, 2021. On December 29, 2021, BasX, LLC converted to a C-Corporation, BasX, Inc., and is subject to income tax. Backlog The following table shows our historical backlog levels: March 31, 2022 December 31, 2021 March 31, 2021 (in thousands) $ 461,400 $ 260,164 $ 96,733 The Company has increased our backlog both through the acquisition of BasX and organic growth. Excluding BasX's backlog at March 31, 2022, organic backlog increased 305.0% compared to March 31, 2021, due in part to the completion of the Longview, Texas expansion in early 2021, price increases implemented throughout 2021 and our favorable lead times. Results of Operations Three months ended March 31, 2022 March 31, 2021 (in thousands) Net Sales $ 182,771 $ 115,788 Cost of Sales 136,707 82,631 Gross Profit 46,064 33,157 Selling, general and administrative expenses 23,056 14,696 Gain on disposal of assets (2) — Income from operations $ 23,010 $ 18,461 The following are recent highlights and items that impacted our results of operations, cash flows and financial condition: • Our backlog is at a record level due primarily to strong end-market demand along with our ability to produce and meet customer lead times. - 29 - • Organic bookings increased 150% in the first quarter of 2022 compared to 2021 indicating a strong demand for our products. • Sales in 2022 grew 57.8% to $182.8 million due to organic volume growth of $24.6 million, addition of BasX revenue of $21.0 million, and price increases of $16.5 million. • Gross profit as a percentage of sales decreased in 2022 to 25.2% from 28.6% in 2021 due to the offset of increased sales by increased material costs and the adverse effect of supply chain issues on operations. • Our warranty expense decreased 21.1% in the first quarter of 2022 compared to 2021 as a result of the quality control efforts the Company has put in place in the past few years. • We continue to invest in the future growth of the Company evidenced by our $14.0 million in capital expenditures. We report our financial results based on three reportable segments: AAON Oklahoma, AAON Coil Products, and BasX, which are further described in "Segments" (Note 20) within our notes to the consolidated financial statements. The Company's chief decision maker ("CODM"), our CEO, allocates resources and assesses the performance of each operating segment using information about the operating segment's net sales and income from operations. The CODM does not evaluate operating segments using asset or liability information. Segment Operating Results for Three Months Ended March 31, 2022 and Three Months Ended March 31, 2021 Three Months Ended March 31, 2022 Percent of Sales 2 March 31, 2021 Percent of Sales 2 $ Change % Change (in thousands) Net Sales 3 AAON Oklahoma $ 139,867 76.5 % $ 99,976 86.3 % $ 39,891 39.9 % AAON Coil Products 21,935 12.0 % 15,812 13.7 % 6,123 38.7 % BasX 1 20,969 11.5 % — — 20,969 — Net sales $ 182,771 $ 115,788 $ 66,983 57.8 % Cost of Sales 3 AAON Oklahoma $ 106,031 75.8 % 70,204 70.2 % $ 35,827 51.0 % AAON Coil Products 14,629 66.7 % 12,427 78.6 % 2,202 17.7 % BasX 1 16,047 76.5 % — — 16,047 — Cost of sales $ 136,707 74.8 % $ 82,631 71.4 % $ 54,076 65.4 % Gross Profit 3 AAON Oklahoma $ 33,836 24.2 % $ 29,772 29.8 % $ 4,064 13.7 % AAON Coil Products 7,306 33.3 % 3,385 21.4 % 3,921 115.8 % BasX 1 4,922 23.5 % — — 4,922 — Gross profit $ 46,064 25.2 % $ 33,157 28.6 % $ 12,907 38.9 % 1 BasX was acquired on December 10, 2021. We have included the results of BasX's operations in our consolidated financial statements for the three months ended March 31, 2022. 2 Cost of sales and gross profit for each segment are calculated as a percentage of the respective segment's net sales. Total cost of sales and total gross profit are calculated as a percentage of total net sales. 3 Presented after intercompany eliminations. Total net sales increased $67.0 million or 57.8%, due in part to increased organic volumes of $24.6 million. The quarter also benefited from $16.5 million of price increases put in place throughout 2021 that only now were realized. The acquisition of BasX in December 2021 added $21.0 million to net sales for the three months ended March 31, 2021. AAON Coil Products saw a 40.0% increase in units sold, or approximately $3.2 million, due to the increase in capacity with the completion of the new manufacturing building at our Longview, Texas facility in early 2021. - 30 - During the three months ended March 31, 2021, several production days were lost due to planned maintenance and due to impacts of bad weather at both AAON Oklahoma and AAON Coil Products, resulting in lower volumes. Additionally, the expansion at our Longview facility was completed and production began during the first quarter of 2021. As shown in the table below, we've experienced increases in the cost of our raw materials. We implemented multiple price increases during 2021 and 2022 to counteract the increased cost of material. Additionally, in order to attract new employees, we increased starting wages for our production workforce by 7.0% in July 2021; and to retain our existing employees, we also put a cost of living increase of 3.5% in place in October 2021 for all employees below the Director level. In March 2022, we awarded annual merit raises for an overall 3.0% increase to wages. Additionally, during the first quarter of 2022, a review of the Company’s useful lives for certain sheet metal manufacturing equipment at AAON Coil Products resulted in a change in estimate (Note 1) that increased the useful lives from between ten and twelve years to fifteen years. The change was made prospectively and resulted in a decrease to depreciation expense within cost of sales on our consolidated statements of income of $1.8 million during the three months ended March 31, 2022. Raw Material Costs Twelve-month average raw material cost per pound as of March 31: 2022 2021 % Change Copper $ 5.28 $ 3.74 41.2 % Galvanized steel $ 0.99 $ 0.59 67.8 % Stainless steel $ 2.33 $ 1.44 61.8 % Aluminum $ 1.96 $ 1.93 1.6 % Selling, General and Administrative Expenses Three Months Ended Percent of Sales March 31, 2022 March 31, 2021 2022 2021 (in thousands) Warranty $ 1,157 $ 1,467 0.6 % 1.3 % Profit sharing 2,669 2,132 1.5 % 1.8 % Salaries & benefits 9,392 5,034 5.1 % 4.3 % Stock compensation 1,669 1,291 0.9 % 1.1 % Advertising 341 206 0.2 % 0.2 % Depreciation & amortization 1,691 699 0.9 % 0.6 % Insurance 709 731 0.4 % 0.6 % Professional fees 1,482 725 0.8 % 0.6 % Donations 189 (47) 0.1 % — % Bad debt expense 288 (13) 0.2 % — % Other 3,469 2,471 1.9 % 2.1 % Total SG&A $ 23,056 $ 14,696 12.6 % 12.7 % Excluding salaries and benefits at BasX of $2.7 million, salaries and benefits increased $1.6 million due to pay increases that went into effect during the second and third quarters of 2021. Additionally, profit sharing increased due to higher pre-tax income for the three months ended March 31, 2022. Depreciation and amortization expense at BasX was $1.0 million, accounting for the majority of the change from period to period. Professional fees increased mostly due to continued transaction costs and audit fees. - 31 - Income Taxes Three Months Ended Effective Tax Rate March 31, 2022 March 31, 2021 2022 2021 (in thousands) Income tax provision $ 4,782 $ 2,105 20.9 % 11.4 % The Company’s estimated annual 2022 effective tax rate, excluding discrete events, is expected to be approximately 25%. During the three months ended March 31, 2022, the Company recorded an excess tax benefit of $0.5 million as compared to $2.9 million during the same period in 2021, a decrease of 82.1%. 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 use of the revolving bank line of credit based on our current liquidity at the time. Working Capital - Our unrestricted cash increased $2.8 million from December 31, 2021 to March 31, 2022 and totaled $5.6 million at March 31, 2022. Revolving Line of Credit - Our revolving credit facility ("Revolver"), as amended and restated, provides for maximum borrowings of $100.0 million. As of March 31, 2022 and December 31, 2021, we had $65.0 million and $40.0 million, respectively, outstanding under the Revolver. We had one standby letter of credit totaling $0.8 million as of March 31, 2022. At March 31, 2022, we have $34.2 million of borrowings available under the Revolver. The Revolver expires November 24, 2026. Any outstanding loans under the Revolver bear interest at the daily compounded secured overnight financing rate ("SOFR") plus the applicable margin. Applicable margin, ranging from 1.25% - 1.75%, is determined quarterly based on the Company's leverage ratio. The Company is also subject to letter of credit fees, ranging from 1.25% - 1.75%, and a commitment fee, ranging from 0.10% - 0.20%. The applicable fee percentage is determined quarterly based on the Company's leverage ratio. At March 31, 2022, the weighted average interest rate of the Revolver was 1.3%. Fees associated with the unused portion of the committed amount are included in interest expense on our consolidated statements of income and were not material for the three months ended March 31, 2022. If SOFR cannot be determined pursuant to the definition, as defined by the Revolver agreement, any outstanding effected loans will be deemed to have been converted into alternative base rate ("ABR") loans. ABR loans would bear interest at a rate per annum equal to the highest of (a) the Prime Rate in effect on such day, (b) the Federal Funds Rate in effect on such day plus 0.50%, or (c) daily simple SOFR for a one-month tenor in effect on such day plus 1.00%. At March 31, 2022, we were in compliance with our financial covenants, as defined by the Revolver. These covenants require that we meet certain parameters related to our leverage ratio. At March 31, 2022, our leverage ratio was 0.63 to 1.0, which meets the requirement of not being above 3 to 1. As of May 5, 2022, we had $75.0 million of outstanding borrowings under our Revolver. 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. - 32 - 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. Our repurchase activity is as follows: Three Months Ended March 31, 2022 March 31, 2021 (in thousands, except share and per share data) Program Shares Total $ $ per share Shares Total $ $ per share Open market — $ — $ — — $ — $ — 401(k) 54,305 3,278 60.36 70,350 5,185 73.70 Directors and employees 13,358 804 60.19 16,972 1,217 71.71 Total 67,663 $ 4,082 $ 60.33 87,322 $ 6,402 $ 73.31 Our repurchase activity since Company inception, including our current authorized stock repurchase programs, are as follows: Inception to March 31, 2022 (in thousands, except share and per share data) Program Shares Total $ $ per share Open market 4,205,255 $ 74,793 $ 17.79 401(k) 8,258,737 169,154 20.48 Directors and employees 2,041,085 23,145 11.34 Total 14,505,077 $ 267,092 $ 18.41 - 33 - 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 17, 2021 June 3, 2021 July 1, 2021 $0.19 November 9, 2021 November 26, 2021 December 17, 2021 $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 2022 and the foreseeable future. Statement of Cash Flows The following table reflects the major categories of cash flows for the three months ended March 31, 2022 and 2021. For additional details, see the consolidated financial statements. Three Months Ended March 31, 2022 March 31, 2021 (in thousands) Operating Activities Net Income $ 18,059 $ 16,376 Income statement adjustments, net 11,730 14,606 Changes in assets and liabilities: Accounts receivable (43,244) (5,179) Income taxes 3,631 (2,766) Inventories (16,041) (1,627) Contract assets (4,252) — Prepaid expenses and other (3,588) 108 Accounts payable 6,325 4,904 Contract liabilities 17,998 — Deferred revenue 68 2,358 Accrued liabilities & donations 2,511 58 Net cash (used in) provided by operating activities (6,803) 28,838 Investing Activities Capital expenditures (14,031) (16,404) Cash paid in business combination, net of cash acquired (249) — Other 16 14 Net cash used in investing activities (14,264) (16,390) Financing Activities Borrowings under revolving credit facility. 25,000 — Stock options exercised 2,890 9,438 Repurchase of stock (3,278) (5,185) Employee taxes paid by withholding shares (804) (1,217) Net cash provided by financing activities $ 23,808 $ 3,036 - 34 - Cash Flows Provided by Operating Activities The Company currently manages cash needs through working capital as well as 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 decrease in cash flows from receivables was a result of increased sales, both as a result of 2021 price increases realized during the period and volumes, in the three months ended March 31, 2022 that have not been collected. The Company has also increased the purchase of inventory to take advantage of favorable pricing opportunities and also to mitigate the impact of future supply chain disruptions on our operations. Cash Flows Used in Investing Activities The capital expenditures for the three months ended March 31, 2022 relate to our continued investment in our production capabilities. The capital expenditures for the three months ended March 31, 2021 related to the completion of the expansion at our Longview, Texas facility, which became operational during early 2021. The capital expenditure program for 2022 is estimated to be approximately $100.4 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 Cash flows from financing activities is historically affected by the timing of stock options exercised by our employees and repurchases of the Company's stock. However, the increase in cash from financing activities is primarily related to borrowings under our revolving credit facility to manage our working capital needs, especially strategic purchases of inventory to avoid future supply chain delays, after our available cash on hand was used to fund the BasX acquisition. Stock options exercised decreased due to the decrease in the number of employee options exercised and decrease in our average stock price during the three months ended March 31, 2022 compared to the three months ended March 31, 2021. 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, 2022. Critical Accounting Policies There have been no material changes in the Company’s critical accounting policies during the three months ended March 31, 2022. Recent Accounting Pronouncements See Note 1 of the Notes to the Consolidated Financial Statements for a discussion of recent accounting pronouncements. - 35 - 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.