Aaon Inc

NASDAQ:AAON

Earnings Call Transcript 2017-Q4

[Operator]

Good afternoon, ladies and gentlemen. Welcome to the AAON, Inc. Fourth Quarter and Full Year 2017 Sales and Earnings Call. There will be a question-and-answer period after management's brief presentation. This call will last approximately 45 minutes to an hour.

I would like to turn the meeting over to Mr. Gary Fields. Please go ahead, Mr. Fields.

[Gary Fields, President]

Good afternoon. Thank you for joining us. Today is February 27th we’re going to be doing annual and fourth quarter coverage. So, I want to start with reading a forward-looking disclaimer.

To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated. Please see the risk factors contained in our most recent SEC filings, including the annual report on Form 10-K and the quarterly report on Form 10-Q.

So, now I would like to introduce Scott Asbjornson, CFO to go over fourth quarter numbers.

[Scott Asbjornson, CFO]

Thank you, Gary. Welcome to our conference call. I'd like to begin by discussing the comparative results of the three months ended December 31, 2017 to December 31, 2016.

Net sales were up 13.6% to $104.2 million from $91.7 million. The increase in net sales was a result of increases in our production slightly offset by changes in our product mix. Gross profit increased 17.2% to $31.1 million from $26.5 million. As a percentage of sales, gross profit was 29.8% in the quarter just ended compared to 28.9% in 2016.

Selling, general and administrative expenses increased 58.9% to $13.7 million from $8.6 million in 2015. As a percentage of sales, SG&A was 13.2% of total sales in the quarter just ended compared to 9.4% in 2016. The increase in SG&A was due to increases in our warranty costs along with smaller increases in our salaries and benefits compared to the same period in 2016.

Income from operations decreased 2.9% to $17.4 million or 16.7% of sales from $17.9 million or 19.5% of sales. Our effective tax rate decreased to 9.6% from 36.3%. The Tax Cuts and Job Act enacted on December 22, 2017, lowered the corporate income tax rate from 35% to 21% in 2018. Due to this change, the Company re-measured its deferred tax assets and liabilities on the enactment date, which resulted in a $4.4 million benefit to our income tax provision.

Net income increased 38.1% to $15.8 million or 15.1% of sales from $11.4 million or 12.5% of sales. Diluted earnings per share increased by 39.4% to $0.30 per share from $0.21 per share. Diluted earnings per share were based on 52,932,000 shares versus 53,420,000 shares in the same quarter a year ago.

The results of the year ended December 31, 2017 versus December 31, 2016. Net sales were up 5.5% to $405.2 million from $384 million. The increase in net sales was primarily due to increased volume as compared to the prior year offset by changes in product mix.

Gross profit increased $5.3 million to $123.4 million from $118.1 million. As a percentage of sales, gross profit was 30.5% in the year just ended compared to 30.8% in 2016. Selling, general and administrative expenses increased 27.9% to $49.2 million from $38.5 million in 2016. As a percentage of sales, SG&A increased to 12.2% of total sales in the year just ended from 10.0% in 2016. The increase in SG&A is primarily due to increases in warranty expenses.

Income from operations decreased 6.9% to $74.1 million or 18.3% of sales from $79.6 million or 20.7% of sales. Our effective tax rate decreased to 26.8% from 33.3%. As already mentioned, this decrease was a result of the changes from the tax cuts and job act. Net income increased 2.1% to $54.5 million or 13.4% of sales from $53.4 million or 13.9% of sales. Diluted earnings per share increased by 3% to $1.03 per share from $1 per share. Diluted earnings per share were based on 53,079,000 shares versus 53,450,000 in the same period a year ago.

At this time, I will turn it over to our Treasurer and Chief Accounting Officer, Rebecca Thomson.

[Rebecca Thomson, Treasurer and Chief Accounting Officer]

Thank you, Scott. Looking at the balance sheet, you'll see that we had working capital balance of $103.7 million versus $101.9 million at December 31, 2016. Cash and investments totaled $30.4 million at December 31, 2017. The investments have maturities ranging from less than one month to five months. Our current ratio is approximately 3.1:1.

Our capital expenditures for the year were $41.7 million.

We expect capital expenditures for 2018 to be approximately $53.2 million. The increase in capital expenditures is primarily due to construction projects related to our new research and development lab, water-source heat pump production line as well as other internal developmental projects.

Shareholders' equity per diluted share is $4.47 at December 31, 2017, compared to $3.85 at December 31, 2016.

I would now like to turn the call back over to Gary Fields, our President

[Gary Fields, President]

Good afternoon. So, let's talk about the upcoming year 2018. So, in 2017, we had the retirement of significant management of manufacturing and the plant, and it took pretty much the third quarter thing started, accelerating for those young folks that took over fourth quarter you obviously see the results that are published today and you see that they got on firm footing and they got some profitability headed their direction. They did quite a lot with getting the production back in line.

One of the key things is that we got a handle on our warranty expenses, and this was due to, we cleared that in the first part of the year, we cleared out some old things that for whatever reason haven't come to the surface and then we also had a couple of issues with vendors and a process that through the middle part of the year. We've cleaned that it all up and our warranty is now trending back closer to historic values.

So, I think in the upcoming quarters, you are going to see where we have made the statement that we believe SG&A will get back on reasonable footing towards historic values, warranty being the biggest adversary to that having happened last year. So, we have definitely got that taking care of trending in the right direction.

The next thing is we went into 2018 with a very bloated backlog, it was $81.2 million. That backlog was caused by a couple of things. One was we had a price increase on November 15th, while those people didn't want delivery until 2018 and by our standard lead times that was in line. So the huge swell a fair amount of that was because people got the orders in really a little earlier than they wanted to have me in.

So you will see in the first quarter that we will be building that backlog out and getting back in line with a reasonable backlog number. The only reason that I have any concern about backlog is that if it's too high that tells me that we are not delivering in accordance with our customers' request. And so right now, the vast majority of what we are delivering is on time. We continue to have one of our manufacturing lines that runs a bit later than what they're requesting, but I have got a little more story to tell on that here in a minute.

Alright, so water-source heat pumps we have discussed water-source heat pumps extensively for the last nearly two years now. The water-source heat pumps that we are talking about are the models WH and WV. That is the new product that we began building. In 2017, we built about -- well not about, we built exactly 2,128 units that we shipped, we built another roughly 1,800, 2,000 units that we put in our inventory, but we shipped 2,128 units.

The first quarter of 2018 we expect to ship almost the exact same number of units. In other words, the first quarter of 2018 we are going to ship as many heat pumps as we have shipped in total since the inception of the WH and WV. So it is accelerating in the direction that we expected it to. It came a little later than we expected as we have discussed in previous calls, but it is arriving now, it is going in the right direction and I think 2018 is going to meet our expectations on that.

The other products that have done quite well tend to be our larger sized units, midsized and larger. And some of those were up as much as 22%, over any historical peak in the past. That is one of the reasons that our very largest units continue to run anywhere between two and four weeks behind when customers are requesting them. We are working diligently to resolve that and we've made a lot of headway with it. We believe that around the first part of April, we will have that on track to delivering exactly when they have asked for.

The better update on water-source heat pump is the first manufacturing line we put in put together, we called line 6A like Alpha, and it really comprised about one third of what our ultimate manufacturing footprint was point to look like. While 6B, Bravo, is nearing completion that will allow us to build up to 30 ton horizontal and vertical water-source heat pumps. Our current ability is to build to 5 ton on line 6A.

So, 6B enables us to build larger units and also to do some special prototyping and some rework on any units that didn’t pass first try on the in line test. 6C like Charlie is a high volume, high production line. It very much looks like 6A only quite a lot more manufacturing capability as far as production volume and it’s really arranged or the orders that and we’ve been getting some of these orders where you get a multitude of units that are identical. We’ve had orders with as many as 380 identical units on it. 6C will run that at a much more efficient rate and that is due to come on line August possibly September.

So the water-source heat pumps like I say, we’ve got everything going in our direction. Now, the orders are coming in on a pretty steady basis and we are able to produce the units to meet everyone’s expectations. The warranty incidents on these water-source heat pumps that we started making on this line 6 has been nil. We have had just very, very little trouble at all so that’s been a great thing. It was planned that way and the plans can be gathered.

In 2017, we had a couple of more rep agencies that were not performing to our expectations or weren’t aligned for good long-term partnership and we replaced them. These new reps usually take between probably the most aggressive 18 months and it’s probably averages more like 30 to 36 months before they began to make any significant strides in a positive territory; however, the most recent one that we replaced was only December 1st and is already making an impact far beyond with the people are that we replaced. So I’ve got coke for him that he will break out that mold and show me how to do this quicker than even 18 months.

We worked on redesigning some of our products particularly two ends of our primary units, the RN series units, the smallest units that we make in RN series were in a significant redesign on them now in order to make a benchmark setting unit with regards to energy efficiency and capabilities. The concept is complete. The prototype is being configured right now and we’re due to have all of that redesign completed in the third quarter of '18.

Also, our largest of our RN series unit, we’ve been concentrating on them for two regards. We had more warrantee incident with that series of units than we thought was tolerable, and so we resolved those issues. But why we were resolving them, we found a way to be even more efficient in the process. And so, we’ve got two steps that we’re taking, one immediately and one towards the end of third quarter to make that unit even more robust and make it more efficient than it currently is.

The replacements market and the new construction market still maintain about 50-50 equilibrium for us. We have seen some indication that the architectural billing index, ABI, the latest publication of it was a very, very high number. Do you remember the number exactly, Scott? 57, I think. I believe it was 57 which any mark above 50 is positive ground in that. So in 2017, I believe there might have been two months that were at or below 50.

But it's by and large been above 54 consecutively for quite a while. That tells us that nine to twelve months out is when -- when they publish that for instance January, you wouldn’t look for that activity to hit our order logs until nine to twelve months from then there. So, that gives us a very strong feeling about 2018, remaining very strong. So, we've had growth in certain of our products that has been disproportionate to the orders.

You see what the overall growth of the Company was and you can see how the backlog as seen, we're going to continue to grow. But our larger products have grown percentage wise 2017 over 2016 more so than our smaller products group. The other thing that grew significantly and I'll talk more about that in a minute, but it is air handling units. These are traditionally indoor installations, not compressorized. They have grown very nicely with a very limited offering that we have.

So with that, I’ll go on to the market segments. There has been really no change in our distribution, commercial and retail, office building, medical, healthcare, education, manufacturing, lodging and municipalities, all remain in the same shares that they've been historically for the last twelve months. But what we have seen is that there’s an opportunity for air handling units, indoor air handling units primarily.

We built some outdoor air handling units and we'll continue to do that, but we look to how we exploit this growth and how we are planning for that growth. So that being the case of water-source heat pumps coming up to production nicely. The R&D lab, the first environmental sales will come online on May 1st, and then we'll be bringing on more environmental sales each month all the way through and on October 1st is our date that we slated for a grand opening with all sales operational.

This is going to allow us to develop some additional products in a parallel format. Right now, we were constrained by the environmental chambers that we have operational. From a standpoint of the gross profit, we're going to do our very best to maintain that gross profit. We believe that we have arrested the warranty incidents. We don't think we have any unusual occurrences. So, 2018 looks to be pretty solid.

The one thing I will point out though is that the water-source heat pump will continue to be a little bit of a pressure on the gross profits because we're still in a start-up mode where we're going to have some volume in the water-source heat pump this year, but I don't look forward to contribute much to the gross profit lines yet.

So that the CapEx, Scott or Rebecca mentioned earlier, we've slated that at $53.2 million for this year and that that includes finishing out the lab. There was quite a lot of the lab expenditures that ended up getting over to 2018. That’s renovation, some equipment or replacement of some equipment and line 6B and line 6C for the water-source heat pump. Those are the primary drivers. We do have a very small sum of money in our CapEx set aside for exploring and developing a new air handling unit, a manufacturing facility.

We're currently involved in a site selection. We've narrowed this down to four sites, two, in Texas, two, in Oklahoma. We'll be making a decision in the next 30 days to 45 days on what the site is and we'll explain more about that at the time. But what I wanted to say about that is as we're currently – we have about $22 million to $24 million that we're doing on an indoor air handling units right now and it's been accelerating for the last few years.

We've got a lot of strategic initiatives that will enhance our ability to expand that business at a rate much faster than the majority of all of our other products. So in addition to the water-source heat pump that's going to ramp up at a rate that won't be in line with the other equipment percentage wise, the air handlers won't be too far behind that on what we have planned for that.

So with that, I believe we are open to questions.

[Operator]

[Operator Instructions] And your first question comes from John Brats.

[Unidentified Analyst]

Gary, you've characterized early on the backlog number being somewhat bloated, and it reflects the price increase in November. Does it all -- do you sense any increase in the backlog because of general market conditions you see any evidence that there's some momentum building in the market in general?

[Gary Fields, President]

I do. The backlog right now is at 21% over its historic numbers. That's about 10 million, and so it looks like that's going to be our new normal because like I said we have pretty much got everything back in the line of delivering on customers' expectations so the backlog is somewhat normalized at this moment.

[Unidentified Analyst]

And I guess, I guess probably doesn't take a genius to figure out that the backlog at year end implies a pretty healthy first quarter sales number?

[Gary Fields, President]

I like the way we you terminate -- termed that, yes.

[Unidentified Analyst]

Turning to the water-source heat pump, you have not received accreditation yet, I believe and…

[Gary Fields, President]

That is correct.

[Unidentified Analyst]

And when might you expect that? And do you think that's having any negative consequences on your sales and marketing efforts?

[Gary Fields, President]

So, all right, first off, the AHRI certification it's called, and listing, they began to have -- we've sent units to them on August 27th of '17. Their testing schedule is quite full, and they began testing, but they had not been able to complete. They pulled seven pieces of equipment to test. They have completed four of those. There's -- the fifth one is in right now, so looking at their schedule that's not really expeditious the way I see it, but it's looking eminent that we should have all that testing completed very soon.

As far as its impact on sales, I think it'd be naïve to say otherwise, it has had an impact because I spent entirely too much energy talking about the certification, which means that people have some reservation about moving forward until that occurs. There's always customers that will move forward because they know and trust AAON.

And the fact that all of our other products are certified and the fact -- this is kind of like the equivalent of patent pending, the certification, we have submitted the index that they other being tested. And so the vast majority of really understand it but when there's an entity such as an energy provider that's providing rebates, well you are not getting any rebates with that certification. So those projects that are driven by rebates are definitely out of our reach, in general at this point.

[Unidentified Analyst]

And just sort of a moving target but what is sort of your expectations now for the water-source heat pump in 2018? I'll have to go back and look out, I know it's -- and you thought it would grab this much market in the first year and second year. Can you sort of update us a little bit on your expectations?

[Gary Fields, President]

Our goals are to reach 5% market share this year and then each year that goes after this to add an additional 5% market share.

[Unidentified Analyst]

The market is about 500 million, correct?

[Gary Fields, President]

It was in 2017 and that's why I am more willing to term it in percent of market share because if the market goes up then I hope to get more. And if the market goes down then I'll get a little less. But our goals have been stated to be 5% market share 10, 15, 20, 25.

[Operator]

And your next question comes from of Brent Thielman.

[Brent Thielman, D.A. Davidson]

Scott, just want to be clear on the warranty expense, caught us off guard again last quarter a bit. So that should started normalized here in the first quarter, is that the way to think about this?

[Scott Asbjornson, CFO]

Sure, we currently believe we’re on trend at the moment with first quarter of '17. Hopefully, as the quarter progresses it will come down even beyond that, we don’t know of any major problems that are outstanding that are needing to be resolved. So, our expectation is that over the course of the year we should see that improved significantly over the last year.

[Brent Thielman, D.A. Davidson]

Got it. Okay. And then I guess just another question on the pump line. Did you guys offer the sales dollar impact for the fourth quarter?

[Scott Asbjornson, CFO]

No, we did not.

[Brent Thielman, D.A. Davidson]

Okay.

[Gary Fields, President]

It’s not real hard to figure out it was 2128 units may average little over $1200 units, so it was run $2.6 million, $2.7 million was totaled 2017 impact of the WH, WV. We recognized another fact. We make heat pumps, water-source heat pumps and all of our other will call them legacy products, the rift out products and those have been run an around 16 million, 17 million a year, but we’re not talking about those in conjunction with this conversation. All the conversations about the water-source heat pumps that we’ve had have all been about the new product which is model WH and WV those are the small indoor units.

[Brent Thielman, D.A. Davidson]

And then Gary I just want to dig a little bit more on the indoor annoying unit I think you said sort of the $22 million to $24 million business per year.

[Gary Fields, President]

Yes.

[Brent Thielman, D.A. Davidson]

Can you just explain on what you guys are exactly evaluating and where you think that business go over the next few years the too related numbers around that?

[Gary Fields, President]

Well, I’m not ready to put numbers around it per se because we’re in the planning stages right now. We’re planning what the product line would look like. We’re planning what the manufacturing pro tests would be. We’re utilizing a lot of what we learned on the small water-source heat pump to cross that over into this air handling unit business. There is a lot of things in that regard that we’re just now in the infancy of building that plan out. The fact is tomorrow is my first substantial committee meeting with the various stakeholders in the business that have influence on how that will occur.

So the bottom line is just that last time I looked air handlers were about $2.2 billion annual market and we believe that there is room for us to grow and expand into more of that market because currently like I say we’re about $22 million to $24 million in that. There are manufacturers that have been bought by consolidators and there is various things that their sales channel partners are nervous about.

So a lot of our sales channel already participates in this market. One of the driving factors for getting into the water-source heat pump was our sales channel was already selling around $75 million, $80 million of that type product and the manufacturers that we’re supplying them were leading room for improvement. And so they encouraged us to get into this business and said that when we got them at the way that they envision that they would be on board with us.

While we know that our same sales channel partners are extraordinarily involved in the air handling unit business way beyond the $75 million, $78 million fact is my former company Texas Air Systems as around close to $40 million and their handlers just themselves in the state of Texas. So it’s a significant opportunity for us. It’s one that I had in excess of 30 years of experience with in sales channel side and I very much understand that market and it very much placed to the strengths of what we do here day on.

What we learned on the water-source heat pumps as far as how to automate several of the manufacturing processes how to automate going from the user interface all the way through to product control for scheduling that software that we develop, all of that will be utilized in this new expanded air handling unit business. So, yes, I'm very excited about the possibilities there, but it's very early to be talking about any kind of numbers. What we can say is that it's a business we have extensive experience with we're already established in it and this is an expansion of how we do what we did.

[Operator]

And we have a follow-up from John Brett.

[Unidentified Analyst]

Gary in your own commentary, you'd mentioned that you expect the -- you hope the water-source heat pump. You’re talking about gross margins and gross profit. To make a contribution to the gross profit, are you referring to maybe -- contribute to a gross margin increase, I mean, it's contributing the gross profit, am I correct?

[Gary Fields, President]

Yes, we’re not selling them, lacking some profit, but it's not as profitable as we expected to be, it’s not as profitable as the benchmark for the whole company.

[Unidentified Analyst]

Right, okay. Okay, fine. Okay. And the other thing on the warranty, last year 2017, we had a big warranty expenses. Is there something new or different at the company or you have a couple people that are retired? Is that something -- is there something at the company that and the way you're doing, handling things that may have contributed to the warranty expenses because we really haven't had issues like this in the past, but is there something new and different that might be adding to the -- might have added to the warranty expenses in 2017?

[Gary Fields, President]

We had -- in our sales department we had leadership in there that was making little situations where somebody would make a warranty claim. He wouldn't weight it out real well and maybe would give them a discount on a project in order to make them happy, more like a sales concession. So it really wasn't officially a warranty item, but it kind of had a little look to that. So some of that was discovered when we replaced that person.

And so, we cleaned up a little of that that was a little of it, but more often than not what it was is we had mainly our sales channel partners that would go out there and fix problems and in some instances, they didn't even turn the bills into us for an extended period of time. And basically, I set my foot down and said look, you've got to get these bills in here and get this cleaned up, you can't just leave it sitting out there dangling forever.

We've got to address this directly and clean it up. So, it was just some people that had a little bit of a lackadaisical towards resolving the issues, and they were making decent money on the sale of the product and they just kind of went along happy go lucky, if you will. And then what would eventually get around clean in it up. So I can’t put a timeline on, I mean, it’s anything that's 90 days old or older I'm not going to consider, so you better get it cleaned up. So that was a good part of what was happening.

Then at the same time when these young guys came in, they wanted to make an impact, not only in product as far as production rate, but they believe that the other guys weren't staying out with being as diligent as they wanted to be, with getting some of these issues, identified and cleaned up. And so the first half of the year was a lot of really hard work. Then like I’ve said before, we had a couple of vendors that supplied equipment to us, components that either we have to understand how to apply them as well as we needed to or they didn't -- they weren't as robust as we had hoped for.

It was different scenarios with each one of them, but we’ve got all of that vetted out and resolved too. So the first half of the year was probably as much effort on his many people's party as he can to make sure that we cleaned everything up and we had a clean slate to go forward with. And that was both in the equipment that we produced being the best quality we knew how to produce with the best vendor partners on these purchase components and it was also an adjustment in policy.

So, it took a little longer to that energy, that energy went into the flywheel and then it took a little longer to get it totally exhausted, and through the flywheel. But one other things to keep in mind is that while there was a period of time when there was claims in actual -- actual payments was going up, well then that causes accrual to go up, and so a lot of what we are seeing, was the accrual increase as well and then once the trend starts back the other way then some of that accrual will come back to us.

[Unidentified Analyst]

One last question, when line 6B begins or starts up in September, August, September, it seems like 6A took a long time to fine tune and get running smoothly. Do you think it would take line 6B to that type of time like the time to move into full production?

[Gary Fields, President]

No, so let me clarify this, 6B is actually going to come online in the next 30 to 45 days.

[Unidentified Analyst]

Okay I am sorry yes. Okay.

[Gary Fields, President]

Yes, 6C, Charlie, won't come online until about September. The 6B, 6bravo will be coming online in next 30, 45 days and that is to build some larger product up to 30 tons horizontal and vertical, we are developing that product but some of that we have to get the line finished in order to be able to build the product, we don't have anywhere to build that larger book, water-source heat pump, so yes it's going to take some time in 2018 to develop the product, we have the engineering completed on some of these additional larger sizes but until we build and prototype and run them through there then we can't really test them out and perfect them.

So, it won't take as long as 6A, because we have established procedures on a lot of the construction methods already. For instance we don't have to learn how to use the induction brazing equipment, we already know how to use that and we just extended down to this line. A lot of the other functions that occurred in the learning process of 6A, we don't have to relearn them, we only have to extend them. And one of the most key things, Norm talked about this extensively throughout the year was the development of the software.

So we had to take multiple manufactures with their own unique software language and integrate them into one common software language that we could operate as a system and have that all integrated and it has to be very well sequenced because when you punch the button to start a product through there, then everything has to happen at vey choreographed exact sequence otherwise you will end up add a point on the line, where you don't have the parts that you need, because they -- this is the true definition of just in time manufacturing.

When we start the product on the manufacturing line, there's nothing from the fabrication standpoint prebuilt like we do in the rest of the plant. The rest of the plant we have sheet metal and assemblies and about a three day inventory on average, this we have zero when you start it. So, we have streamlined that software a whole lot, every now and then we get a little hiccup in it, but it's -- it's, and every now and then, I mean mostly this line runs very smooth now and so we will able to take that same concept and just extend it on down to 6B, so that learning curve has been accomplished and won't be a problem going forward.

[Operator]

And we have no more questions in queue.

[Gary Fields, President]

Well thank you very much, we appreciate it. And we will speak to you again in May for our first quarter results. Have a nice day.

[Operator]

This does conclude today's conference call, you may now disconnect.