AAON, Inc. (AAON) Earnings Call Transcript & Summary

All right. Good morning, everyone. Thank you for joining us again at the 9th Annual Crédit Suisse Industrials Conference. My name is John Walsh. I am the multi-industrial analyst here. And we're very excited to have for the first time at our conference, HVAC company AAON. We have both Gary Fields, CEO; and Rebecca Thompson, AAON's CFO.

And with that, I'd like to kick it off with the first question here. And since it's your first time here at our conference, Gary, maybe you could just give us a little bit about the company and kind of where you see yourself positioned in the industry just as an introduction?

Certainly. Thank you. So AAON was born out of the John Zink Company in 1988, Norman Asbjornson founded the company, he had come to Tulsa to run John Zink, it was transaction happened. He ended up owning it, taking it public. John Zink at that time, AAON initially had 2 customers, Walmart and McDonald's. That was it. And it was a very niche player serving only those 2 customers. Norm had history from a previous company that had a large independent sales channel, of which I was part of that independent sales channel. He decided to expand AAON through hiring these sales channel partners to sell AAON equipment. This all began in about 1989, 1990. So that was my first involvement with AAON in the sales channel. Then they grew the company from only having up to like 20-ton capacity units to soon having 150 times and currently having 250-ton units. So we have a broad portfolio. We begin at 2 tons, and we go through 240 tons actually with package rooftop units, expanded further into indoor air handling units are primarily split system for custom applications. But the real heritage of the company was special applications and innovations. So a lot of the buzzword terms that you hear in the market today, we're actually invented at AAON. So one you'll hear is DOAS, that is a Dedicated Outside Air System. AAON began producing this style of unit maybe 25 years ago. And then it was monitored DOAS by the industry. The next one was single-zone VAV. That was another innovation of AAON. But what AAON has really done is tried to provide innovative solutions to more niche problems over the years. And while doing so, the product developed to have a lot of value content to it. It was actually appealing to a broader audience than just the special applications. So one of the things we did with the sales channel we started building out the knowledge of how to present that. And that's when we started gaining more market share, more broadly accepted application. And we continue to move further and further in that direction with the decarbonization effort that the world is under right now. We are on the leading edge of that with the packaged rooftop units, having air source and water source heat pumps and package rooftop units. The air source heat pump units that we have currently are very appealing in performance characteristics down to 0-degree ambient and we're working towards minus 25 ambient. We have that completed in a prototype stage. So we believe there's more value content in the unit. So the delta between us and some of the more standard manufacturers when you're using gas heat will diminish greatly. And so the fact that we are casing that we build to hold the unit is much more durable, much more expensive than what a lot of our ordinary competitors have, it becomes a less percentage cost of the overall package when you start having the value add of this air source heat pump. So we're already seeing great traction with several of our national account type customers, wanting this decarbonized effort for the heating side of the system. And we've already obtained numerous orders based on that fact track there. And they're telling us that in package roof top units, we're the only ones that have this kind of offering. Now you'll hear a lot about cold climate air source heat pumps from our competitors, but this is in a residential application and a split system. They are yet to incorporate those things. It's not that they don't know how. I don't know why their game plans the way it is. I'll leave it. But our game plan is that we're moving towards low ambient capable air source heat pumps with vigor.

Thank you for that. And maybe as a follow-on, and you touched on it a little bit. I was looking through your transcript and thought this is a very interesting comment you made, wanting to transform the business from a more of a niche player to a mainstream player. And curious how you -- What are the gates you have to go through for that to happen? And please correct me if I'm wrong, but it sounds like with decarb and the focus on energy efficiency, a lot of that will be driven almost just by the market now moving up to you, right, versus you moving down with a product into the market. I just want to make sure I understand that correctly.

That is a great way to categorize that. The market is moving up to us. That is absolutely correct. So when I look at our orders booked in 2021, of which we are significantly in orders booked in 2021. A vast majority of that is in a decarbonized or an indoor air quality enhanced product. So we're seeing a lot of traction in that. And so that it's very apparent that the demand for this style product is there. And the fact that you have more technology in that bottle, if you will, and it makes the whole bottle more affordable when you're looking at that sort of technology request. So the market is definitely moving up to us. It's a perfect way to categorize it.

Great. And then as you think about your channel to market, you touched on it earlier in your introduction about the company, this independent kind of network of salespeople. That contrasts with more, obviously, direct model that we see from some of the other OEMs. Can you talk about your -- why or your indirect channel to market and why you like that?

Yes, I'm very passionate about that. It's my heritage. My father began in that style of business in 1970, through the '70s and really up into the mid-90s Trane was the most significant. They set the bar for how business was done in HVAC as far as I'm concerned. And they did it with a franchise business model, which were independent operators. And this is when Trane had their most significant growth, and most significant penetration of market share, and they set the foundation for what they became. So knowing how all of that occurred and knowing that in order to be successful with the independent, you have to be appealing to them in a multitude of ways. You've got to have great products. You got to have great support. You got to have good lead time. You got to do what you say you're going to do. If you do these things, then they will pay attention to you. They will -- when they look at their line sheet, they'll spend their time on you. Now the difference is these larger OEMs that have converted from -- what at one time we are all independent and they've all gone to the -- we call them the factory office, the company-owned sales channel. This is for a multitude of reasons, but key amongst these is that they can control exactly what product that they ask people to sell and what price that they sell it for. They can sell it at a lower margin because their long game is to have service and parts. And so their initial sale is not the holy grail for their margin. Their holy grail for their margin is to get the long-term service contracts and to get the parts business. That's somewhat of an annuity for them. In AAON's case, we are looking to make an honest profit, a good margin on the sale of the equipment. Our independent channel owns parts businesses and service businesses, and that's their revenue stream we support those, but we do not participate in that profit stream.

Got you. Got you. And then you talked about a big emphasis in your orders books around decarb indoor air quality. Curious, are you seeing any of your customers pull forward replacement of any of their existing equipment before failure? I mean we typically think of HVAC as a replacement business, but would love to know if some of those big secular themes are actually changing that dynamic a little bit.

Yes, they are. Direct empirical evidence of that is some school districts that their long-term CapEx planning didn't have some of these replacements in them, two things motivating that. One is the desire to hasten replacement to improve indoor air quality so that they can get these kids in school and another safe. And the other one is that there's finally some federal money filtering down for these projects. So going back a bit over a year ago, we saw some federal subsidies that were out there for municipalities and school districts and so forth. And it was presumed at that time that we would start seeing it towards the end of '21, beginning of '22. Well, we're definitely seeing that. So I've talked to -- just again, as that empirical evidence, I've talked to multiple school districts that said we have this federal money. But even if we didn't put that, we were going to have to have a bond issue, we're going to have to do something. We had to pull forward. We needed to replace these units because we have got to provide best practices indoor air quality measures for HVAC system so we can get these kids back in school. So that is one particular sector that has clearly indicated that. Now I'm seeing similar activities, not quite as clear, but some of your national account type operations, rather they're quick-serve restaurants or rather they're convenience stores. We're seeing some of that there. It's not quite as clear, but it's definitely on people's minds that we have got to have better indoor air quality measures in our buildings. And I think there's some feeling that there could be capability if you didn't. If you had an outbreak in your building, are we going to see someone try and litigate on that? There is potential for that, I believe. And so that's at least on some people's minds. We've seen it in hospitality as well. What we're seeing them pull forward and replacing some units specifically with indoor air quality. Now when you can couple that with a decarb or a higher efficiency, if you can get into air quality decarb and higher efficiency, that's almost a trifecta. That makes the sale very, very clean, very appealing.

No, that's very interesting. Maybe just pivoting a little bit. You've obviously have been active on the M&A front. Can you talk a little bit about the most recent transaction it may brought you into the data center market, kind of what do you think is the opportunity there? And then maybe also what the expectations would be to continue to use free cash flow to be acquisitive?

It's a great question. So I'm actually sitting in Bend, Oregon right now. That's where we acquired the company. Rebecca and I came out here yesterday. We're between -- we signed the purchase agreement, and we're yet to close. We're anticipating closing in the next few days. And so we're out here going over a few of the last-minute check boxes to make sure everything is in order so we can get closed here in the next few days. This company is very, very intriguing. And through the negotiations that they reached out to us to offer the company for sale. And 2 of the people that were significant shareholders have been business friends of mine most of my career. And when they reached out to us, there was no [ bunding ] and report type conversation because we've known each other for years. They just said, we believe this would be a great strategic alignment with what you're doing. We believe there'd be a lot of synergies to it because a lot of that -- they're earlier in the growth curve on building some things out. And so we began to talk about it, well, so I'll go back, 21 years ago, I personally sold 12 data center projects for MCI WorldCom, AAON of equipment on those. I had 40 AAON units on each one. They were around North America. At the same time, the person that sold the data center units themselves looked for the data hall, he sold 88 units and his sale was about 10x the revenue my sale was, real close to 10x. So I was always intrigued by the fact that AAON was appealing for the support areas of the data center but not the core area. We didn't have the knowledge expertise and so forth to do that. So for over 20 years, I've been intrigued by that. Well, when I was in a sales channel, we represented a company that was a predecessor in some regards to the company we just bought. It was called Huntair. And so I sold some of that data center work that I knew what it was about and knew these people. So this group, they came from [ broad McLaren ] Pace many, many years ago, when that was bought by a venture capitalist and ultimately by York, they all moved on and started Huntair. That was a wonderful company. They started Cleanpak at the same time, another wonderful company. They sold that to Nortek, which is now Nortek Air Solutions owned by Madison Industries. For whatever reason, many years ago, 10, 12 years ago, they left that operation, and they decided to start one more and that was this company. So the model for what you do has been in place for a very long time. The people are just absolutely stellar. And now that we're out the open that we have signed a purchase agreement, we were able to meet with more and more employees. Initially, there some key employees that we were able to meet with that were part of the nondisclosure agreement. Well, yesterday, I was able to spend time a little deeper in the organization, 2, 3 layers deep, and it's just phenomenal. Two of these men that I met with yesterday have followed Dave Benson from Pace to Huntair to here. Now I don't know how you think about things that when a leader has people follow him, that tells me 2 things. One is, he's a very high quality, highly respected, highly regarded leader, it tells me that. The next thing it is, is these are also highly respected, highly regarded people or he wouldn't bring them with him. And so this has happened -- this company has just got a plethora of these really superstar quality people. So while the business itself is younger and smaller, that has no reflection on what the capabilities are. And that's what makes it so intriguing and exciting. Now we've already seen evidence that the announcement of AAON purchasing this company is having a substantial impact in a positive way in that some of these larger blue-chip customers while they had high regards for Basics, they had some reservations because of their financial foundation not being deep and broad. And so you're looking at very expensive consequences if you fail to perform. And if there's no real recourse available because there's no real foundation there, then they're going to have a little pause for reservations. So Basics was granted some smaller contracts in relative terms to what I believe they will be offered now. As I walked in the door yesterday, they told me that one of these clients, it's been a longtime client that's been metering smaller orders to them, I mean significant but smaller, just offered them a huge order. Now I think that confidence of them being part of AAON. Now they also have established track record of doing what they said they were doing. They've delivered these units very nicely to this customer. But I believe that, that had an immediate impact that this blue-chip customer says, okay, you've proven yourselves. And now you've got good foundation, good affiliation. Let's go ahead and open the valve wide open. And so they were just offered a huge deal yesterday.

Great. And I think on the announcement call, you had talked about changing or expanding your kind of total addressable market, which I thought was interesting on how big the total addressable market was for the data center piece alone relative to other industries. So maybe you could just -- there's always a little bit of a debate there on the correct size of this TAM. But could you just talk a little bit about how you see your total addressable market and the size of it?

Well, Joe pulled all of that together for me, and I believe he's got good credibility on what he's looking at there. What we bought with Basics for the data center, the clean room and the custom air handling units doubled AAON's total addressable market. Now the customer handling unit business, that's one that I participated in my entire career. Back when I represented the Nortek companies, that was one of the marquee products that I participated in. So I'm very, very familiar with that market. The data center, as I said, 20-something years ago when I sold the 12 data centers to MCI WorldCom, the data home, the core data center equipment was 10x of what I sold. So when Joe put these numbers together and presented them to me, they made sense to me with a historical perspective of the markets that I personally had participated in. Now the clean room business is a bit unique to me. I've had very little participation in that in my career. But I clearly see where they're at with it and what they have presented as the addressable market. Again, this is a wonderful opportunity for AAON because they were building the clean room enclosures and they didn't always have the best value equipment, HVAC conditioning equipment to go with that clean room and closure. And now you put them together. So this is an accretive sale for both companies. We had no ability to produce the clean room housing, the room housing, they had no ability to produce the equipment. So that's one of those synergistic type sales that we look forward to.

Great. And then just thinking about your EBITDA margins relative to the group, quite strong. Would love to get your perspective on price cost. And how you see that playing out and how it has been playing out for you as a company?

Well, we'll talk about how it has been playing out. And that is that I have great respect for our sales channel, I know their process, so I try and give them reasonable lead time on the announcement versus the effective date for a price increase. I try to minimize their exposure, while we have great forecasting tools for our cost inputs and they work wonderful about 98% of the time. In this pandemic time, there are some things that are not quite as predictable that have bit us just a little. Normally this time of the year, we're having conversations with our major suppliers as to what the upcoming year looks like for price increases. And there's just been a historic, well, we're going to do this for a cost of living kind of increase or something like that. Now you're seeing supply chain constraints that are generating more demand versus what's available. So there's some market pricing going on with certain materials, and that filters down. So in summary, we've been bit a little by the timing in that our normal forecast and our normal announcement with that buffer zone I gave works out stellar. Right now, we've got nicked up just a little by things happening much quicker than normal. But we've been able to get price increase in on a continuous basis, and it's been very sticky. We've not had any pushback whatsoever. So it's a matter of timing. So we might get nicked up for a month or 2, but not for quarters over quarters. Now interestingly enough, I gave them a little more notice than normal of a January 1, 2022 price increase effective date, and I announced it at 5%. Well, when I announced it, 5% looked like most of that was going to be accretive to margin that we were going to have some safety zone between our target margin and what was actual? Well, we saw that eroding on a much quicker basis than normal with announcements that people came between my announcement and this effective date. So we went back and looked at it and we were still able to give our sales channel 6 weeks of notice because we did this a couple of weeks ago. I changed that 5% to 8%. And I thought, okay, I'm going to get some kind of pushback on this. I'm going to hear something from someone. Well, the only thing I heard was from 2 of my sales channel partners saying, thank you for giving us the 6 weeks' notice. This is absolutely understandable. And we have great concern for your bottom line as well as ours because if you're making money and meeting your expectations, then you'll keep this thing growing beneficially to all of us. So I think we have a very good relationship with the sales channel. They understand why we have price increases that we're not doing them just so that we could do extravagant things. We're taking this money. We're very aggressive with our CapEx, building this business. The acquisition we -- this is going to benefit a lot of our sales channel partners. So they liked the way the investors seem to like the way we're spending our money and our sales channel does too. So they support us very thoroughly on these price increases. I've actually had messages when things weren't quite as good on our published bottom line as we wanted. I get messages from -- hey, you're probably not going to hear from a lot of people, but I want you to go up on the price. We want you to be whole. So that's the respect we have mutual respect with them.

Very interesting. And then can you maybe just remind us any kind of hedging processes you have in place for either steel or copper and just the delay is when you actually realize those?

Yes. We don't really have a hedging in place. But what we -- in the form of a hedge contract, we do -- when we think the opportunity is right and the price is right, we do buy more materials than we'll stack up our inventory. I think that steel, we've got some steel that's a little higher priced than what you might currently -- because we're on a first in, first out basis, FIFO. So we probably have some steel that's a little higher priced than what we can replace it with today, but it's not substantial. It's only a little bit. And so I'm very satisfied with the way we're managing that. But mostly, things have had a steady upward trend. So you've not seen a bend over in the price to where you say, oh, darn, I'm caught with several million dollars worth of this at this higher price. Steel is the only thing that I've seen rollover in price at all, and it's been very mild. So copper continues to go up substantially. Aluminum is relatively steady, but then component prices, same thing. One of our compressor suppliers of note, they'll only let me buy forward so far because they want to protect their price. I'd love to give them a contract for what -- I'd love to just write them a purchase order for what I'm going to use or think I'm going to use in 2022. We have the funds available to do that. But they'll only let me go out a few months.

Great. And then maybe just circling back to some of your earlier comments, it sounded like a lot of your products that we spoke about earlier might have already been existing to the portfolio. Curious what you're doing in terms of new product development as we think about decarb and energy efficiency and not only that, but refrigerant changes? I mean there seems to be a lot hitting the industry at once. So maybe you could talk a little bit about that new product development pipeline and the refrigerant changeover as well, if that's meaningful to your business?

Yes. Well, I'm going to give your second one, I'm going to give the answer first. We have determined that R454B is the refrigerant that we'll be using to replace 410A. There was much discussion as to which refrigerant was going to be the refrigerant chosen. So we have dedicated our efforts to 454B for replacing 410A. In doing so, we've already got equipment in there in our laboratory facilities being tested now. but on a very minimal basis because I think we only have one chamber that is equipped for the semi flammable or partially flammable refrigerant. So we -- one of the things we've got to do is we've got to get all of our chambers outfitted to handle this mildly flammable refrigerant. So we're in the midst of doing that. But where -- the reason I gave refrigerant first is because it ties into some of our new product development in this regard. In order to take an air source heat pump down to a colder climate capability, like a minus 25 Fahrenheit. There's a technology required in the compressor and some of the refrigerant components to do that. And because these are advanced technologies, they are things that we've proven how they work, but they're not yet in production quantities. Most of those manufacturers have decided that they're going to wait until they have this new alternative refrigerant determine what we're going to use, which many of us have chosen 454B. I know I'm not -- I'm probably the last one to announce that. Most of the other OEMs have already announced what they're going to do. And the majority of them have gone 454B. So now these component manufacturers are working fervently to develop this new technology component that will allow us to provide an air source heat pump with good efficiency, good capacity down to minus 25 Fahrenheit. And so that's where we're going. Now if you look at the packaged rooftop unit itself, you'd say, well, I don't see anything different because it's all the internals that are different. So where this development is, is, first off, our air source heat pump that we've made for many years was really only capable of about 25 degrees above 0 Fahrenheit until recently, and that's when we were able to move that bar down to 0. Now we've actually tested these units in colder conditions in that. And some of them -- we wanted to have a safety margin because at those temperatures, you don't need anything failing. So they're actually proven to operate several degrees colder than that. And our laboratory, we're capable of going to a little over minus 20 degrees Fahrenheit. And so we've taken these units to failure. But the bottom line is our development is towards air source heat pumps and water source heat pumps knowing that the decarbonization effort is so substantial. We have other products that we're developing for high-rise office buildings that we're expanding on an existing product like we make a self-contained water cooled vertical unit that usually has placed floor by floor in high-rise buildings. And due to some repositioning in the market, we're going to be expanding the size of those units that we offer. We currently offer only up to a 35-ton single module and we intend to go in excess of 110 tons single module.

All right. I'm just looking at the time here, certainly, a lot of exciting things happening. We really appreciate the AAON team being here. We look forward to continuing the dialogue, and we hope that everyone stays well. And once again, thank you to the team for being with us.

Thank you as well.

All right. Take care, everyone.