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Executives

Norman H. Asbjornson - Chairman, Chief Executive Officer, President, President of AAON Canada Inc, President of AAON Properties Inc and President of AAON Coil Products Inc

Scott M. Asbjornson - Chief Financial Officer and Vice President of Finance

Analysts

Jonathan P. Braatz - Kansas City Capital Associates

Joseph Mondillo - Sidoti & Company, LLC

AAON (AAON) Q2 2013 Earnings Call August 8, 2013 4:15 PM ET

Operator

Good day, ladies and gentlemen. Welcome to the AAON Second Quarter Sales and Earnings Conference Call. This call is being recorded. I would now like to turn the meeting over to Mr. Norman Asbjornson. Please go ahead, sir.

Norman H. Asbjornson

Well, thank you, and thanks to all of you listening in to our second quarter report. Prior to embarking on it, I want to read the forward-looking disclaimer. To 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 of 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 10-Q.

Thank you. I would like now to turn the mic over to the financial department. I want you to be aware, we have Rebecca Thompson, our Chief Accounting Officer; and Scott Asbjornson, our Chief Financial Officer, here. At the present time, I'll turn it over to Scott.

Scott M. Asbjornson

Welcome to our conference call. I'd like to begin by discussing the comparative results of the 3 months ended June 30, 2013 to June 30, 2012.

Revenues were up 9.5% to $91.2 million from $83.3 million. Revenues increased due to gains in market share in the new commercial, industrial, construction and replacement markets and the result of price increases introduced in May 2012 and April 2013.

Gross profit increased 31.1% to $27.7 million from $21.1 million. As a percentage of sales, gross profit was 30.3% in the quarter just ended compared to 25.3% in Q2 2012. The improvement in gross margins can be attributed to decreases in raw material costs and increased product prices.

Selling, general and administrative expenses increased 31.7% to $9.1 million from $6.9 million in 2012. As a percentage of sales, SG&A was 10.0% of total sales in the second quarter of 2013 and 8.3% in 2012. The increase in SG&A from the quarter ended June 30, 2012 was primarily due to higher profit sharing expense, warranty, sales taxes and employee compensation.

Income from operations increased 31.4% to $18.6 million or 20.4% of sales from $14.2 million or 17% of sales. Our effective tax rate increased to 36.12% from 34.2% in the second quarter of 2012. We expect the rate for the balance of the year to be approximately 34.5%.

Net income increased 30.4% to $12.1 million or 13.3% of sales from $9.3 million or 11.2% of sales. Diluted earnings per share was $0.33 per share versus $0.25 per share. Diluted earnings per share were based on 37,150,000 shares versus 37,092,000 shares in the same quarter a year ago.

The results of the 6 months ended June 30. Revenues were up 6.6% to $158.1 million from $148.3 million. Gross profit increased 24.2% to $43 million from $34.6 million. Gross profit as a percent of sales was 72% -- sorry, 27.2% for the 6 months of 2013 compared to 23.3% in 2012.

Selling, general and administrative expenses increased 24.7% to $16.1 million or 10.2% of sales during 2013 from $12.9 million or 8.7% of sales, primarily due to increases in profit sharing, warranty, stock-based compensation, employee benefits, professional fees, advertising and sales taxes.

Income from operations increased 24.0% to $27 million or 17.1% of sales from $21.8 million or 14.7% of sales.

Our effective tax rate was 29.5% compared with 36.2% in the second quarter of 2012 due to discrete benefits related to the research and development credit and the Indian employment credit. These federal credits were retroactively reinstated on January 2, 2013. No research and development credit or Indian employment credit benefits were recorded in the 6 months ended June 30, 2012.

Net income increased 38.9% to $19.3 million or 12.2% of sales from $13.9 million or 9.3% of sales.

Diluted earnings per share was $0.52 per share versus $0.37 per share. Diluted earnings per share were based on 37,056,000 shares versus 37,125,000 shares in the same period a year ago.

Moving to the balance sheet. We see that we have a working capital balance of $67.8 million. Our current asset ratio was approximately 2.3:1. Our capital expenditures were approximately $1.9 million. Shareholder equity per diluted share is $4.11 at June 30, 2013 versus $3.73 at December 31, 2012. We paid cash dividends of $3.7 million on July 2, 2013.

I'd now like to turn the call back over to Norm, who will discuss our results in further detail, along with the new products and the outlook for the remainder of the year.

Norman H. Asbjornson

Sales was up 9.5% for the quarter and 6.6% for the 6 months. Sales increased due to our ability to gain market share, price increases, all due to redesigned products.

The replacement market was strong, but not overwhelmingly so. The new construction market continued to be weak compared to last year. We need to recognize that the -- and long-term indicator on new construction, which is the Architect's Billing Index has turned around in the fall of last year and, according to historical data, precludes or predetermines what's going to happen 9 to 12 months later. So we're just entering the time when we should get a boost in new construction compared to last year. But for the first part of this year, it was not positive, it was negative.

Along that line, to give you a feeling of it, I'm going to inject some numbers for the various parts of our market. We basically compete in 7 different parts of the market: Lodging, office, commercial, health care, educational, religious and manufacturing. Of all those markets, the only 1 in June that had an upside to it is lodging. And lodging, to give you a feel, is roughly $40 million in the month of June compared to approximately $260 million for the total of the markets we compete in. So that small amount was the only one that was positive. All the rest of them were negative.

The negative was approximately 5% in total for the month of June in comparing 2013 to 2012 for the month of June. So we haven't yet seen an increase in our market share. So why are we doing well and are up with 9.5%, as mentioned, and 6.6%? As we said, it's market share gained by the company, it is not the market itself that gave us the boost.

Other markets that we're in, as far as basic -- that's got a kind of a good sound to it, has been the geothermal market and that was fairly stable and we are continuing to do reasonably well on it. In new products that we are gaining market share gradually would be chillers and air-handlings. These products fall across the entire spectrum of the markets that we're covering and we're slowly gaining market share on that end of the market. Take-off of the air handler is a split system market and that also has been growing for us.

In the high-rise building market, which has been kind of flat and slow, basically, this is in the 30 to -- or I should say 10 storeys to the 100-storey building. There's a market product called a 4x4 unit that we entered a few years ago, and that is growing for us even though the market is fairly flat.

We've also begun a more serious endeavor in parts sales. It isn't yet relating to any great improvement in dollar sales, but you should be aware of it, because as years go on, we're going to talk more about our parts business because we're seriously entering into the parts business and we have it off and running now and we're starting to build on it.

There's no particular market that worked particularly well. As discussed in general, a lot of the new market, and we'll go back to talk briefly on the replacement market, it was healthy for the first 6 months. Might have been up a slight amount from 2012, but not appreciable. It was more flat than it was up. And as we've spoken before, new construction is down slightly from a year ago.

The tone of the various markets we've discussed, as far as where we've been and what's going on. And so, I'd now like now to look at the backlog.

Our backlog on 6/30/13 was $66.2 million versus $62.2 million a year ago.

We did have a downturn from the end of the first quarter when we had over $70 million, so we have eaten up some of our backlog. The incoming order rate has slowed. As I had mentioned in our news release, it's looking softer. Now does that say it's going to be softer than 2013 -- or 2013 is going to be softer than 2012? No, I don't believe it is. I think that it's going to start growth -- slight growth, but for it to do very much and have us actually ship it, not very much of that is going to happen. However, on new orders that worked because of taking market share, we will continue to get growth on a year-to-year basis. It's just that it won't be in the magnitude that the first half of the year was because the market isn't supporting it at this point in time on new order input.

Gross profit as a percent of sales. We believe it was the most outstanding profit as percent of sales of any company in our industry. And to get there, our gross profit in the month or in the quarter was 30.3% compared to 25.3% in 2012. Our year-to-date gross profit was likewise quite high at 27.2% compared to 23.3% in 2012. As was discussed earlier, SG&A expenses have increased to 10% for the quarter versus 8.3% in the quarter of 2012. And to 10.2% for the 6 months versus 8.7% in 2012. It would appear to us that we have, for a whole lot of reasons, increased our SG&A expenses slightly and you should look for a 9% to 10% as the new norm for that.

The net income, up to 30.4% and up 38.9% for the 6 months, was an outstanding achievement, I believe, and was due to virtually everything working well that we tried to make work well. That doesn't often happen and it's not too likely to be done again. However, again, not to be too cautionary, we are going to whip last year's results. The question is, how well can we do it? We have pretty high ambitions but, from your standpoint of guessing what we should do, that's up to you to try and decide as to what you believe we're capable of doing.

The balance sheet, we've increased our liquidity considerably. The outlook for the remainder of 2013, we've been discussing. The capital expenditures for 2013, we had originally told you, would be in the $8 million to $10 million area. That would be on the high side of what our expectations are presently. We basically, as has been discussed previously, expended most of our capital needs and we're filling in gaps now, some of them we haven't gotten filled as quickly as we should. One of the ones which we were anticipating doing a little sooner and hasn't moved forward quite as fast is a small building program, which we have embarked upon now, but all of it will not happen in this coming 6 months. So we're going to be down below our expectations, I believe, of $8 million to $10 million.

The outlook for next year. We are continuing to bring out new products. We are, this month, going to introduce some new chillers and some new condensing units that will be a great improvement to our old ones. We're introducing some new coils, which gives us a better product and a little cost reduction. So the march forward continues on and we're pretty optimistic that if the marketplace will just hold steady, we will do well. And if the marketplace will gain a little bit, we will do wonderfully well.

I don't have anything else at this point, so I want to thank you for your attention. I look forward to talking to you in November for our second quarter results. And now, I'll turn it over to question and answers.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes in from Jon Braatz from Kansas City Capital.

Jonathan P. Braatz - Kansas City Capital Associates

You start off by talking a little bit about the AI Billings Index and how it's last year at this time. It might be a precursor to some better numbers as we look down the road. Do you get any indication ahead of time in terms of maybe some order flow that, in terms of your products, that would suggest that we're actually going to see a pickup in construction? What kind of lead time is there involved, maybe?

Norman H. Asbjornson

Well, I think their 9 to 12 months, which ABI talks about, is a realistic number. And so we're just entering -- it turned in the fall of last year, when it turned positive. And it's remained positive, not big-time positive, but in the low 50s ever since, with 1 exception, I think, or so. So we know that design work has increased that's out there. We hear from it because our representatives are calling on consulting engineers to get our product laid out, and so they're telling us that they're fairly active at the engineering level. The only cautionary thing I would say is that too often, more than we normally have expected, they talk about jobs that had been bid, but haven't yet signed and they don't know when they're going to move forward. So there's a good deal of concern on the part of people who want to build the buildings. They obviously have invested money in the architectural work and the engineering work, but the actual signing of the contact to move it forward, they seem to get a little hesitant. So we see a positive sign because there is a lot of activity out there relative to -- I shouldn't say a lot. There's more activity now than there has been. And so we think it's going to turn into -- but I would caution you that we are hearing this rarely -- they won't sign the contracting so the job hasn't moved any yet.

Jonathan P. Braatz - Kansas City Capital Associates

Okay. Okay. The other thing is, one of the reasons you gave for a higher SG&A expense ratio was the warranty cost. Depending on your mix, is your warranty a little bit different in terms of a percentage? From one product have a higher warranty expense than others?

Norman H. Asbjornson

No. It is, to some degree, yes. For instance, our products that we built out of our Longview facility that we call a split systems, which is a condensing unit and an air handler and it's similar on a bigger scale to what you have in your home. That's dependent upon the tradesman who install it to do the piping between the 2, and that makes you subject to a little bit more likelihood you're not going to get a good job and have problems. So that's probably the biggest -- consistent one that we have. Other than that, the bigger problem is, when we introduce a new product, unfortunately, we aren't immune to making mistakes. And sometimes, when we put a new product out there, we have to go out and correct some mistakes that we made. And so, as we move forward with new products, we do enhance our likelihood that we're going to have a warranty issue that we might not have on a more -- well, more familiar product.

Operator

[Operator Instructions] And our next question comes Joe Mondello from Sidoti & Company.

Joseph Mondillo - Sidoti & Company, LLC

So first question. I just wanted to address the gross margin, which was pretty much almost, if not record level. Just wondering, sort of what you're feeling on -- I mean, you mentioned you sort of had everything go right for you in this quarter. Just wondering, sort of how sustainable or -- what you're looking for going forward? And if you could talk about how much of a driver was product mix? Did you have a very favorable product mix?

Norman H. Asbjornson

I don't know that product mix had too much to do with it. It was more of a normal product mix, so I wouldn't say it particularly did. We got price reductions and we got effective price increases that happened with good regularity and gave us a lot of margin. Plus we managed to do some fairly significant amount of additional efficiency gain on the amount of products that we got out the door with the manpower we had and the people, all the way from salaried personnel to hourly personnel, have worked well for the month. And we just didn't make a lot of mistakes that we sometimes make. And so, that's what I was referring to. We didn't have a lot of cleanup works to do on anything. The warranty issue is a combination of 2 things: One, it is a forward-looking thing because there is a methodology that we use in accordance with what the accounting profession wants us to do to put a reserve away for warranty expenses, and it's based upon historics, as well as historical cost per unit, as well as the increase in dollars we put out there. So when we put out more dollars into the marketplace, we have to up our dollars commensurate with it. But that doesn't change the ratio so much, it's just that it does increase the dollars. And we did do a lot of reevaluation of reserves and everything in our balance sheet. We did a lot -- I'd say the financial team did a good job scrubbing our financials this year. And we got some negatives and some positives out of that. And so, the one thing that we came to awareness was, we were not maybe covering ourselves as adequately we should on warranty. So we upped the amount that we put out there for that purpose.

Joseph Mondillo - Sidoti & Company, LLC

So in terms of the gross margin, I mean, you're talking about how still demand is not extremely strong. How do you feel about that 30% going forward? And where do you think sort of peak gross margins are once we, maybe, start entering a much stronger time period?

Norman H. Asbjornson

Well, I've reviewed your most recent financial statement and I'm not going to tell you the top line is a cakewalk, it's not going to be. Your bottom line is neither, but the bottom line is a more secure number for me than is the top line. So I feel comfortable in what you've got out there right now on your numbers and I think it represents what the forward look is that we've got.

Joseph Mondillo - Sidoti & Company, LLC

Okay. On the sales growth, I'm guessing you got maybe 2%, 3% on pricing? So that leaves maybe 6%, 7%-ish around there on volume. Just wondering if you have any idea of that 6%, 7%, what new construction was like versus replacement? The construction environment has been pretty much year-over-year negative slightly in the second quarter. So did you see any sort of contraction? And was it all made up of replacement? Or how did that sort of 6%, 7% volume play out between those 2 markets?

Norman H. Asbjornson

Well, I think that we probably got about roughly 4% or 5% due to -- what additional market share we took. And the balance of it was probably due to more stable replacement market, which means it grew slightly compared to the new construction market. So if we had 6% there, 4% or 5% was due to market share and the other 1% to 1.5% or whatever, was the fact that the replacement market improved, whereas the other market, as near as I can see, was down, 4% or 5%.

Joseph Mondillo - Sidoti & Company, LLC

Sure. Just in terms of market share gains. Could you just give a bigger -- just a big picture of -- I mean, we've been talking about market share gains for several years now. Just a big picture on why the product line and the company is making such strides on market share? What is the big picture of why AAON is doing such a good job of taking market share from their competitors?

Norman H. Asbjornson

Well, it goes back to the original formulation of AAON 25 years ago. Well, at that point in time, the market consisted of a purely standardized product group of companies and customized group of companies and they were very different in capabilities, very different in price, very different in all aspects and we went down between them. Now the way you go down between them, is you have to adopt a different methodology for manufacturing products than what they were doing 25 years ago. And because they're tied into that methodology, those companies still are in those market realms. They haven't really been able to close the gap between the customer and the production line manufacturers of 25 years ago, which is where we are precisely. We are running down the middle of that and it's been a very popular part of the market for a whole host of reasons because the customers can get more what they want and not have to pay the price of a custom unit than they can get it in a production line product. And it's been our driving force for 25 years and continues to be. And that is an extraordinarily difficult change for anybody, whether it would be the custom people or the production line people to try and get into the market we're in, because it's a total different way of organizing your company. And we organized 25 years ago. And all we've done is perfect ourselves since that point. So if they try and come after us, they've got a big hurdle. Not only do they have to do what we did 25 years ago, but they have to overcome the improvements we've made in the past 25 years as well. So it works very well for us there. The market is slowing where we're going.

Joseph Mondillo - Sidoti & Company, LLC

So your products are generally priced higher than most of the market, but generally, the quality and the sort of the options within the products are much better than the competitors. So if I'm looking at a line of all your products versus your competitors', is it generally -- it's generally fair to say, cost per quality is just above and beyond most of your competitors?

Norman H. Asbjornson

That's a correct statement to say. I would like to say though, the -- and the people who are in the production end of it, the company is doing an extremely good job of delivering a good product -- less capable, less quality a little bit in some aspects, than what we do. But they do a very good job and the people in the custom world do a very good job. Their problem is, they're not in our world. And our world is in between the 2 of them and we are delivering more quality because that's part of what we're -- we're not a price-driven company, we're a value-driven company. And that's a different way to approach a market, approaching it with the total value of energy efficiency, longevity, maintainability, as well as first cost, as opposed to being primarily a first cost and the other thing things trailing along somewhere behind.

Operator

Thank you. There are no more questions at this time.

Norman H. Asbjornson

Okay. Thank you for attending our second quarter discussion. I look forward to talking with you again in November and hope to be able to give you some very good news at that point in time. Thanks to all of you who are in attendance. Bye.

Operator

Ladies and gentlemen, this does conclude your conference call for today. We thank you for your participation. You may now disconnect your lines and have a have a great day.

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