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

Welcome to the AAON, Inc. First Quarter 2023 Earnings Conference Call. Our host for today's call is Joe Mondillo, Director of Investor Relations. [Operator Instructions]. I would now like to turn the call over to your host. Mr. Mondillo, you may begin, sir.

Thank you, operator, and good afternoon, everyone. The press release announcing our first quarter financial results was issued after market closed today, and can be found on our website, aaon.com. The call today is accompanied with a presentation that you can also find on our website as well as on the listen-only webcast. Please go to Slide 2 of the presentation. We begin with our customary forward-looking statement policy. During the call, any statement presented dealing with information that is not historical is considered forward-looking and made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995, the Securities Act of 1933 and the Securities and Exchange Act of 1934, each as amended. As such, it is subject to the occurrence of many events outside of AAON's control that could cause AAON's results to differ materially from those anticipated. You're also aware of the inherent difficulties, risks and uncertainties in making predictive statements. Our press release and Form 10-Q that we filed this afternoon detail some of the important risk factors that may cause our actual results to differ from those in our predictions. Please note that we do not have the duty to update our forward-looking statements. Joining me on today's call is Rebecca Thompson, CFO and Treasurer; and Gary Fields, President and CEO. Gary will provide some opening remarks Rebecca will then walk through the quarterly results, and we'll then finish with Gary for some commentary on the quarter and outlook. With that, I'll turn the call over to Gary.

Good afternoon, Overall, we're very pleased with our first quarter results. We reported record sales for a fifth straight quarter. Organic volume was up year-over-year 23.5%. That was against a quarter a year ago, where organic volume was up 21.3%. Our operations team is doing a great job managing the robust demand by increasing production capacity quickly while maintaining solid productivity. Backlog continued to grow. Quarter marked the seventh straight quarter of record backlog and a ninth straight quarter that backlog grew sequentially. Despite how successful we've been with adding production capacity, bookings continue to outpace production. The environment for us remains positive. Bookings trends are still on the rise, and our channel partners are very optimistic. Thus, we maintain a positive outlook for the year. I'll now hand over the call to Rebecca to go over the financial results.

Thank you, Gary. I'd like to begin by discussing the comparative results of the 3 months ended March 31, 2023, versus March 31, 2022. Please turn to Slide 4. Net sales increased 45.5% to $266 million from $182.8 million, the largest driving factor to the growth was organic volume, which contributed 23.5%. Volume growth reflected the company's strong backlog at the start of the quarter as well as a fourth straight quarter of record production, which reflects the company's success of attracting and retaining employees, along with continuously adapting to parts shortages. In addition to volume, pricing contributed 22%. Moving to Slide 5. Gross profit increased 67.5% to $77.2 million from $46.1 million. As a percentage of sales, gross profit was 29% compared to 25.2% in the first quarter of 2022. The increase in gross profit was primarily due to realization of price increases, counteracting the increasing cost of materials and labor. Within the quarter, we incurred some onetime expenses related to the improvement of employee benefits. This explains the majority of the contraction in gross profit margin compared to the fourth quarter of 2022. Please turn to Slide 6. Selling, general and administrative expenses increased 42.9% to $32.9 million from $23.1 million in the first quarter of 2022. As a percentage of sales, SG&A decreased to 12.4% from 12.6% in the first quarter of 2022. The increase in dollars is primarily attributable to salaries and benefits and profit sharing, which have increased as a result of our growing head count, employee pay increases and benefit improvements discussed above. Please turn to Slide 7. Income from operations increased 92.1% to $44.2 million from $23 million in the year ago quarter. As a percent of sales, operating margin expanded to 16.6% from 12.6% in the first quarter of 2022. Moving to Slide 8. Diluted earnings per share increased 103% and to $0.67 per share from $0.33 per share. In the quarter, we benefited from a large excess tax benefit of $3.8 million associated with depreciation of AAON stock, including discrete events, we continue to anticipate a tax rate of 24.3% through the rest of the year. Turning to Slide 9. Our balance sheet remains strong. Unrestricted cash totaled $2.5 million on March 31, 2023, and debt at the end of the quarter totaled $83.7 million. Within the quarter, we borrowed $12.7 million on our line of credit. Our leverage ratio of 0.47 was essentially in line with what it was a year ago and at the end of the prior quarter. The increase in debt was primarily related to investments in working capital. We had a working capital balance of $246.3 million at March 31, 2023, versus $203.5 million at December 31, 2022, and $169.5 million at March 31, 2022. The investment in working capital was made to help facilitate the robust volume growth while also helping mitigate supply chain issues. We anticipate working capital will become a source of cash in the second half of the year. Along with improved earnings, cash flow from operations will improve significantly throughout the year, helping pay down debt and finance projects. Capital expenditures for the first 3 months of the year were $28.9 million, up 106.2% from a year ago. We continue to expect capital expenditures for the year to be approximately $135 million, which equates to more than 150% year-over-year growth. We monitor our growth trajectory and capacity utilization regularly and we'll continue to invest in long-term growth. With that, I'll now turn the call back over to Gary.

Please turn to Slide 10. As I said in my opening remarks, we're very pleased with the first quarter. Our operations continued to perform well in Q1, and I continue to commend the team for their performance. Every quarter in the recent past, the company is pushing more volume through our 3 plants than we've ever seen before. Organic volume growth was up 23.5%, and on a 2-year stack, it was up 44.8%. We have made great strides in increasing our production capacity to allow for this growth. Total headcount was up 27.3% from a year ago and up 10.4% from the end of 2022. We continue to do a great job at onboarding new employees. More importantly, we are efficiently integrating them into our operations so as not to disrupt productivity and profitability. We are also investing in new equipment. Sheet metal production is running at high utilization rates. We're investing in new Salvagnini machines, both to replace old machines that will enable us to increase productivity as well as to add incremental sheet metal production. Supply chain issues continue to be a challenge. They seem to be slowly improving, but they still very much exist. This continues to weigh on productivity and output. Without them, volumes most likely would be stronger and productivity certainly would be better. That said, our productivity associated with dealing with these issues continues to improve. Lastly, volume growth was also a reflection of our premier sales channel and the backlog our rep partners have been able to generate for us. AAON has never been more aligned with its sales channel partners and has never supported them as much as we are now. Last month, we had the grand opening of our Exploration Center located at our headquarters in Tulsa. This is the latest example of how we are supporting our partners. This is a first of its kind in the industry. The building is a 27,000 square foot showroom that showcases our equipment side-by-side other market alternatives. Nowhere to this scale can customers go to see and compare AAON product next to market alternatives. Sales reps will use this to help customers better understand the value proposition that AAON equipment provides. Our sales channel has never been as strong as it is right now, and we're giving them more tools to help them to be even more successful. Now please turn to Slide 11. I want to discuss our gross margin performance and outlook. The 29% we posted in the quarter was in line with our internal expectations. As we stated on our fourth quarter call, and as Rebecca stated today, there were some onetime expenses that weighed on the margin. We anticipated the fourth -- the first quarter to be a low watermark, and continue to expect improvement throughout the year. In addition to certain expenses in the first quarter not recurring, we have more price coming. Meanwhile, input cost inflation is moderating. Productivity is also expected to improve throughout the year. Most head count additions will occur in the first half of the year. As that new head count is integrated, trained and fully up to speed, we expect productivity will improve, which we expect will occur in the second half of the year. All in all, we maintain the view that 2023 gross margin will be better than the fourth quarter of 2022. Now moving to Slide 12. Overall demand remains very strong. Bookings in the first quarter were the strongest of any quarter since the first quarter of last year. And if not for a large price increase we had on March 30 of last year, which resulted in a big pull forward of orders, this past quarter would have likely been a company record. Despite the robust growth in volumes and significant increase in production capacity, bookings continued to outpace sales. Total backlog was up 30% from a year ago and up 9.5% from the end of the fourth quarter. Many factors are contributing to the robust demand, including favorable lead times, a narrowing price premium between our equipment and market alternatives, the attractive value proposition that AAON equipment has to offer, the strengthening of our sales channel, robust growth at BasX and favorable secular market trends related to decarbonization, electrification, energy efficiency and new governmental regulations. Please turn to Slide 13. Our lead times have continued to extend. We still maintained industry best lead times, but the gap has begun to narrow. We're doing our best at reversing this with the investments we're making in production capacity. CapEx is expected to be up 150% this year, of which a vast majority is related to increasing production, and we're increasing head count. Considering that, I'm optimistic that lead times have peaked. Please turn to Slide 14. Demand continues to be fairly broad-based as far as end markets. Data centers and semiconductor markets are very strong. BasX had a very good quarter as far as bookings. The K-12 education vertical is solid. Health care and manufacturing are also still very good. We continue to see robust demand in the grow facility market. And while new construction warehouse is slowing, the end market remains good for us due to retrofit work. Overall, demand for us is solid across most of the board. Sentiment among our channel partners remains positive. Compared to a year ago, it may not be quite as strong, but overall sentiment is still very positive. Macro data is also still solid. Construction spending is now well beyond pre-pandemic levels and construction starts are at the strongest levels in years. The ABI and the Dodge Momentum Index, which track the pipeline of nonresidential projects early in the planning stages, have recently peaked, but they still imply the pipeline is still at historically high levels. Please move to Slide 15. Parts sales grew 38.5% in the quarter. And on a 2-year stack, they were up 88.6%. The business declined to 5.3% of total sales, but that was due to the robust growth of equipment sales. We remain optimistic through the rest of the year. Despite the positive outlook, parts continue to feel effects from the supply chain issues. As those issues dissipate, we expect parts sales accelerate. Long term, we continue to anticipate this business will become a larger part of the company, both on a sales and profitability basis. Now please turn to Slide 16. Before finishing up and handing off the call for Q&A, I want to provide some information on our outlook for the rest of the year. Based on the size and improving margin profile of the backlog, increasing production capacity and productivity, and strong order trends, we anticipate sales and earnings will improve sequentially through at least Q3. We continue to anticipate pricing will be a low double-digit contributor to sales growth for the year. For gross profit margin, we anticipate gross margin will improve throughout the year. For SG&A, we're making several investments that will help position the company better for long-term growth. This will limit the operating leverage you usually tend to see with SG&A. We continue to think SG&A as a percent of sales will be slightly higher than what we realized in 2022. Finally, CapEx will be approximately $135 million. In closing, I want to finish by thanking all of our employees, our sales channel partners and our customers. I also want to remind everyone we will be hosting an Investor Day on May 17 and 18 at our headquarters in Tulsa. You can find more details on this event in the Investor Relations section of our website. We will also be attending Wells Fargo's Industrials Conference on June 13. I hope to see some of you at these events. Thank you, and I will now open up the call for question and answers.

[Operator Instructions] And our first question comes from Brent Thielman of D.A. Davidson.

Gary, just -- I mean, it looks like still -- real robust orders and backlog here. I didn't see a breakdown of core AAON product [ versus ] BasX. Maybe if you could just talk to what you're seeing in terms of underlying demand on both sides there in either business line, Gary. And then also what are the sort of the strongest end market drivers for the company today, considering this huge book of business you're building?

Well, the pace at BasX is a little more brisk than the pace at legacy, but there's good, strong bookings at both. When I look back historically -- going back, say, 5 quarters, if I take out the effect of a price increase having pull forward, then bookings overall were at the highest level related to bill that they had been in all those quarters, and legacy stayed just about pace with that. We're still not able to produce as much as we're able to book. So the backlog continues to just accumulate a little bit at a time. I will say that it's coming more in parity for 2 reasons. While one particular reason is the increase in output volume. I mean that's really the key thing. The bookings have not really bent over anything at all. So we're just continuing to increase production. We've got more things in place now. Our head count is up. It continues to accumulate. And we're layering in people at the same pace that we're able to get more parts. So as there's been a lot of talk in a lot of business publications recently about the supply chain issues easing, if not, being a nonissue. I don't want to call them a nonissue. I'll just say that the big sticking points are behind us. Now we just fight with some kind of small things from time to time, but they are still a bit disruptive.

Okay. And Gary, one of the questions -- I think this dovetails nicely into the next one. But one of the questions we seem to get is when eventually industry lead times normalize, whenever that is, can AAON sustain the market share gains that you've ultimately seen? I'd just love to get your response and perspective on that.

Yes. We've had sales meetings. We had a eastern half of the United States sales meeting in March. We had a western half about last week or week before. So we had all the sales channel partners together. In between those 2 sales meetings, we had a meeting with the principals introducing them to the grand opening of the new marketing center. All of them assure us that while we did gain some business because of lead time, that those customers now appreciate the value even more since they've got this equipment on their buildings and being able to sustain those customers long term, is very probable. So I don't think that as lead times come together that it's going to be as impactful. It won't be impactful in a negative way. But we did gain because of the lead time initially. Now the next thing is that with the regulations that took effect January 1, 2023, all of our competitors had to raise the energy efficiency of their equipment considerably to get over that threshold. AAON had been over that threshold for a long time and had been priced according to that. In order to meet these 2023 regulations, there's more cost content in the units to do it. So a lot of the price premium had been associated with the difference in energy efficiency. And now they're much closer to us, so that's narrowed the price premium. So then the other value items that are enate to the AAON equipment become more visible stand-alone on themselves. So there's fewer things that you have to evaluate. There's less premium difference. And so for all these reasons, I think that our trajectory is sustainable.

That's great. Just the last one, understanding the investments [ in ] facilities, people you've had to make to support the growth and future growth for that matter. But as you move into 2024, do you anticipate being sort of improved SG&A leverage from what you're talking about doing this year?

Yes. It's probable that we'll get some leverage on that. But with the growth trajectory we're on, we're going to have to stay very aggressive at CapEx. What we're putting in place this year solves a lot of problems. But if we continue to grow at this rate for the reason that it takes about 3 years to plan and then get into production a new facility, we'll have to continue to invest there. So some of that hits SG&A and some of the planning processes and so forth. But the other thing to bear in mind is that we utilize a profit-sharing plan for our employees, everyone below the senior leadership team level is eligible for profit sharing, and that's 10% of our pretax profits. So as we become more profitable, there's more attributed to SG&A because of that one event right there. So we will get some leverage eventually, but I don't look for it to be significant or right away.

Our next question comes from Jonathan Braatz from Oppenheimer.

Gary, can you talk a little bit about your pricing for the remainder of the year. I think you've been increasing prices 1% per month. What do you see for the remainder of the year?

We increased prices 1% per month through April. When May 1 occurred, we did not. We hit the pause button. Our FP&A team has done a real good job of projecting where our financial performance will be and they've gone back and calibrated that against actuals so that we know that their algorithms are very accurate or as accurate as possible in a projection theme. And with that, we're certain that we have achieved the financial performance that we've always set as our goals. And with the price increases that are in place now, we believe that the gross margin will continue to increase quarter-over-quarter throughout the year so that when we end the year, it will end at the highest gross margin as a total year that we've had. We also believe that the total year will end up in parity or slightly north of what it was in Q4 of '22.

Yes. Okay. What are you seeing on the competitive front in terms of pricing? Are your competitors continuing to raise price?

Only seen 1 recently that announced another price increase. I haven't seen anything else. But people put price increases in -- late in the fall or earlier in first quarter, coming into effect about now. But those were more or less in line with the accumulation of our 1% price increases per month.

Okay. Okay. And then lastly, in the quarter, revenues from BasX was about $30 million. And I think that was down from $39 million in the fourth quarter. Is that just a reflection of seasonality? Or is there anything else?

No, that was supply chain, it was a timing issue because everything that we revenue from them is on a WIP schedule, and we had equipment that we couldn't quite finish because we had little bits and pieces that had not arrived in time. So it's a little bit of a kind of a stair-stepping process. You've got a big unit that's waiting on a few parts in order to get to that complete stage. I look for their revenue to be increasing throughout the year.

Okay. Okay. And is there anything you can say about their backlog versus last year?