AAON: Share Price Defying Gravity - Time To Don Parachutes

Summary

• I previously opined that I liked the AAON business, but not the share price.
• Other contributors before me offered similar sentiments - we have mud on our faces - the share price, and accordingly the multiple, have continued to grow.
• Lower future EPS growth rates and a stratospheric P/E multiple seldom go hand in hand. Markets do correct eventually - this will likely come to an abrupt end.
• Looking for more investing ideas like this one? Get them exclusively at Dividend Growth Income+ Club. Get started today »

AAON: Investment Thesis

Based on SA Premium analysts' estimates, AAON, Inc. (NASDAQ:AAON) is projected to grow EPS by an average of 14.59% per year for the three years 2019 to 2022 (I start with 2019 to eliminate COVID-19 distortions). The 14.59% forward estimate compares to a 2.70% average yearly EPS growth rate for the three years ended 2019. Table 1 below shows EPS grew only slightly from $1.03 for 2017 to $1.05 for 2019, contributing to the low historical growth rate through the end of 2019, and the higher growth rate reflected in analysts' forward estimates. A better measure of AAON's longer-term EPS growth is the actual and projected average yearly EPS growth rate of 8.1%, based on EPS of $0.97 for 2016, and analysts' consensus estimate of $1.58 EPS for 2022. That's quite a good EPS growth rate, but it has to be questioned if it justifies a P/E ratio in the mid-forties and higher. Current P/E ratio is 50.11 - the future EPS growth rate already is more than fully reflected in the current share price. If multiples sink back to the historical average of 44.14 (see Table 3 below), negative returns are indicated from buying and holding AAON shares through the end of 2022. The indicated negative returns quickly get into double digits for P/E ratios below the 44.24 historical average. The company, as a business, appears to be performing well, the dividend is safe, and the balance sheet strong with no debt. But there appears to be a real danger to the share price from potential multiple contraction, leading to negative returns. It might not happen tomorrow, or next quarter, but market prices have a way of correcting over time, and often quite abruptly. A detailed analysis follows.

Looking for share market mispricing of stocks

What I'm primarily looking for here are instances of share market mispricing of stocks due to distortions to many of the usual statistics used for screening stocks for buy/hold/sell decisions. The usual metrics do not work when the "E" in P/E is distorted by the impact of COVID-19. And if the P/E ratio is suspect, so too, then, is the PEG ratio similarly affected. I believe the answer is to start with data at the end of 2019, early 2020, pre-COVID-19 and compare to projections out to the end of 2022 or later, when hopefully the impacts of COVID-19 will have largely dissipated. Summarized in Tables 1, 2, and 3 below are the results of compiling and analyzing the data on this basis.

Table 1 - Detailed Financial History And Projections

Table 1 documents historical data from 2016 to 2019, including share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates. The table also includes estimates out to 2022 for share prices, P/E ratios, EPS and DPS, and EPS and DPS growth rates (note - while estimates are shown for analysts' EPS estimates out to 2023, 2024 and 2025 where available, estimates do tend to become less reliable, the further out the estimates go. These estimates are only considered sufficiently reliable if there are at least three analysts' contributing estimates for the year in question). Table 1 allows modeling for target total rates of return. In the case shown above, the target set for total rate of return is 7.5% per year through the end of 2022 (see line 12), based on buying at the March 3, 2021, closing share price level. As noted above, estimates become less reliable in the later years. I have input a target return based on the 2022 year, although, unfortunately, it only has EPS estimates from two analysts. The table shows to achieve the 7.5% return, the required average yearly share price growth rate from Mar 3, 2021, through Dec. 31, 2022, is 6.83% (line 49). Dividends account for the balance of the target 7.5% total return. Table 2 below summarizes relevant data flowing from the assumption of a target 7.5% total return through the end of 2022.

Targeting a 7.5% Return

Table 2 - Targeting a 7.5% return

Table 2 provides comparative data for AAON, assuming share price grows at rates sufficient to provide total rate of return of 7.5%, from buying at closing share price on Mar. 3, 2021, and holding through the end of 2022. All EPS estimates are based on analysts' consensus estimates per SA Premium.

Comments on Table 2 are as follows

Part 1 - Consensus EPS (Case 1.1) (lines 1 to 12)

Part 1 shows the amounts the share price would need to increase to achieve a 7.5% rate of return through the end of 2022. The share price would need to increase by $9.55 from the present $74.16 to $83.71 at end of 2022, for the 7.5% rate of return to be achieved.

Part 2 - Required change in P/E ratio to achieve target 7.5% return (lines 21 to 23)

Part 2 shows the amount the P/E ratio would need to increase or decrease by, from buy date to end of 2022, to achieve the share price level at the end of 2022 necessary to achieve the targeted 7.5% return. For AAON, the P/E ratio at buy date needs to increase by 5.7% from the present 50.11, to 52.98 at the end of 2022 and the 7.5% return would still be achieved. Requiring an increase in the P/E ratio to achieve a targeted return would normally be regarded as a negative. However, due to the distortions of earnings and sentiment owing to the COVID-19 pandemic, it's difficult to judge whether the change in P/E ratio is a negative or the result of a distorted starting point. To overcome this difficulty, in Part 3, I review the necessary change in P/E ratio from a different, pre-COVID-19 starting point.

Part 3 - Projected change in P/E ratios from 2019 to 2022 (lines 31 to 46)

In Part 3, I start with the share price on Dec. 31, 2019, before the impact of the COVID-19 pandemic on earnings and market sentiment. The endpoint is projected to share price at the end of 2022, when it's assumed the market and earnings are no longer materially impacted by the pandemic, and EPS growth has brought the P/E ratio back closer to historical levels. For AAON, the share price needs to increase by $28.70 from $55.01 on Dec. 31, 2019, to $83.71 at end of 2022, and as detailed in Part 1, at $83.71, the targeted 7.5% rate of return would be achieved. For AAON, there are a number of givens in our assumptions. Using these givens, the change in the share price from Dec. 31, 2019, to end of 2022, can be expressed as mathematical formulae as follows:

(A) Change in share price, due to effect of EPS growth rate, equals share price at beginning multiplied by (1 plus average yearly Consensus EPS growth rate) to the power of number of years invested.

= $55.01*(1+14.6%)^3 = $82.77 (that would be the result if the share price grew in line with EPS growth, and the P/E multiple remained constant)

(B) Change in share price due to change in P/E ratio equals share price adjusted for EPS growth rate multiplied by (1 plus/minus percentage change in P/E ratio).

= $82.77*(1+1.1%) = $83.71 (price required at end of 2022 to provide 7.5% total return, buying at current share price)

The increase of $27.76 ($82.77 minus $55.01) due to the average yearly EPS growth rate is cumulative, and share price will continue to increase the longer the shares are held and the growth rate continues. The increase of $0.94 due to a change in the P/E ratio ($83.71 minus $82.77) has a one-off effect. A continuing high or low P/E ratio has no impact on future share price growth, only a change in P/E ratio affects share price, not the level of P/E ratio.

Next, rather than targeting a specific rate of return, I look at historical P/E ratios to see the potential impact on returns of a reversion to these levels of P/E ratio. First of all, I should explain a little about the Dividend Growth Income+ Club approach to financial analysis of stocks.

Understanding The Dividend Growth Income+ Club Approach

Dividend Growth Income+ Club logo Copyright: Robert Honeywill 2020

Total Return, Dividends, Share Price

The only way an investor can achieve a positive return on an investment in shares is through receipt of dividends and/or an increase in the share price above the buy price. It follows what really matters in share value assessment is the expected price at which a buyer will be able to exit shares, and expected cash flow from dividends.

Changes in Share Price

Changes in share price are driven by increases or decreases in EPS and changes in P/E ratio. Changes in P/E ratio are driven by investor sentiment toward the stock. Investor sentiment can be influenced by many factors, not necessarily stock specific.

"Equity Bucket"

Earnings are tipped into the "Equity Bucket" for the benefit of shareholders. It's prudent to check whether distributions out of and other reductions in the "Equity Bucket" balance are benefiting shareholders.

AAON's Projected Returns Based On Selected Historical P/E Ratios Through The End Of 2022

Table 3 below provides additional scenarios projecting potential returns based on selected historical P/E ratios and analysts' consensus, low, and high EPS estimates per Seeking Alpha Premium through the end of 2022.

Table 3 - Summary of relevant projections AAON

Table 3 provides comparative data for buying at closing share price on March 3, 2021 and holding through the end of 2022 (or longer if sufficient analysts' estimates are available). There's a total of nine valuation scenarios for each year, comprised of three EPS estimates (SA Premium analysts' consensus, low and high) across three different P/E ratio estimates, based on historical data, and alternative Cases A and B (see below). AAON's P/E ratio is presently 50.11. This is considered distorted by the impact of COVID-19, and it's assumed in due course the P/E ratio will revert to historical levels, or lower, per Table 3 above. This analysis, from hereon, assumes an investor buying AAON shares today would be prepared to hold through 2022, if necessary, to achieve their return objectives. Comments on contents of Table 3, for the period to 2022 follow.

Consensus, low and high EPS estimates

All EPS estimates are based on analysts' consensus, low and high estimates per SA Premium. This is designed to provide a range of valuation estimates ranging from low to most likely, to high based on analysts' assessments. I could generate my own estimates, but these would likely fall within the same range and would not add to the value of the exercise. This is particularly so in respect of well-established businesses such as AAON. I believe the "low" estimates should be considered important. It's prudent to manage risk by knowing the potential worst-case scenarios from whatever cause.

Alternative P/E ratios utilized in scenarios

1. The actual P/E ratios at share buy date based on actual non-GAAP EPS for FY-2020.
2. A modified average P/E ratio based on 18 quarter-end P/E ratios from Q4 2016 to Q4 2020 plus current P/E ratio in Q1 2021. The average of these P/E ratios has been modified to exclude the three highest and three lowest P/E ratios to remove outliers that might otherwise distort the result.
3. I would normally use a median P/E ratio here, calculated using the same data set used for calculating the modified average P/E ratio. Of course, the median is the same whether or not the three highest and lowest P/E ratios are excluded. In AAON's case, I am concerned historical P/E ratios are overly high. I have swapped out the historical median P/E ratio of 44.61 with a lower Case A estimate of 30.0.
4. The actual P/E ratio at Feb. 21, 2020, share price, based on 2019 non-GAAP EPS. The logic here is the market peaked around Feb. 21, 2020, before any significant impact from COVID-19 became apparent. This makes the P/E ratios at Feb. 21, 2020, reflective of most recent data before distortion of P/E ratios by the impact of the coronavirus pandemic. As for the median P/E ratio, I have swapped out the Feb. 21, 2020 P/E ratio of 52.61 with a lower Case B estimate of 25.0.

Reliability of EPS estimates (line 17)

Line 17 shows the range between high and low EPS estimates. The wider the range, the greater disagreement there is between the most optimistic and the most pessimistic analysts, which tends to suggest greater uncertainty in the estimates. There are two analysts covering AAON through the end of 2022. In my experience, a range of 11.6 percentage points difference in EPS growth estimates among analysts is extremely high, suggesting considerable uncertainty, and thus lesser reliability.

Projected Returns (lines 18 to 39)

Lines 25, 32 and 39 show, at the range of historical P/E ratio levels adopted, AAON is conservatively indicated to return between negative (32.3)% and negative (21.3)% average per year through the end of 2022. The negative (32.3)% return is based on analysts' low EPS estimates and the negative (21.3)% on their high EPS estimates, with a negative 26.6% return based on consensus estimates. Those are the lowest of the returns under the consensus, low and high EPS scenarios, based on Case B P/E ratio of 25.0. A P/E ratio of 25.0 is well below historical levels for AAON, but acknowledges the potential for multiple contraction. At the high end of the projected returns for AAON, the indicative returns range from negative (10.3)% to positive 4.4%, with consensus negative (2.7)%. But those higher returns require 2016 to 2020 historical P/E ratio of 44.14 to be maintained through the end of 2022. That is a very high P/E ratio, even for a company with a projected EPS growth rate of 14.6% (line 24 Table 1). Also, consider the projected EPS growth rate of 10.8% is well above 2016 to 2020 historical EPS growth rate of 2.70% (line 24 Table 1).

Review Of Historical Performance For AAON

AAON: Historical Shareholder Returns

In Table 4 below, I provide details of actual rates of return for AAON.

Table 4

For many stocks where I create a table similar to Table 4 above, I find a wide range of returns indicating a degree of volatility and risk. Table 4 above shows the results for AAON were over 20% returns, ranging from 20.4% to 42.8%, for all of eight different investors, each investing $3,000 over the last six years and holding to the present. These rates of return are not just hypothetical results. They are very real results for anyone who purchased shares on the various dates and held through to March 3, 2020. In the above examples, the assumed share sale price is the same for all investors, illustrating the impact on returns of the price at which an investor buys shares. There's a saying "success breeds success," and while it may not be the best fit here, there's certainly an element of it in what has been happening to the AAON share price, and the consequent success of investors in the company. Table 4 shows the share price at end of 2016 was $33.65, and Table 1 shows EPS for 2016 was $0.97, with a P/E ratio of 34.69. By end of 2019, the share price had increased by 63.5% to $55.01. But EPS had increased by just 7.6% to $1.05, resulting in the P/E ratio increasing from 34.69 to 52.39. Much of the share price increase came on the back of strong earnings growth in 2019. FY-2019 EPS came in at 29.6% above FY-2018, but this is misleading as it came on the back of a 21.4% decrease in EPS for 2018. It seems then that investors became excited at the prospects of COVID-19 driving increases in air conditioning sales to improve air quality. That has resulted in the share price increasing by another 34.8% from $55.01 at the end of 2019 to the current $74.16, and a P/E ratio of 50.11. A 50.11 P/E ratio might be justified where future high EPS growth rates are expected. But SA analysts' high EPS estimate for 2022 is $1.82, which reflects a 7.1% average yearly EPS growth rate from the end of 2019 through the end of 2022. The consensus EPS growth estimate is just 2.2%, over the same period. The high investor returns in Table 4 are obviously a result of investor over-exuberance and are unrelated to company performance, past, present, or future. The market can misprice stocks for a very long time, but eventually, there comes a day of reckoning.

Checking AAON's "Equity Bucket"

Table 5.1 AAON Balance Sheet - Summary Format

Table 5.1 shows an increase of $145 million in shareholders' equity, which was used to fund an increase of $110 million in net operating assets, and an increase of $35 million in cash, over the four years Dec. 31, 2016, to Dec. 31, 2020. The company has no debt. Outstanding shares decreased by 0.5 million from 52.7 million to 52.2 million, over the period, due to share repurchases offset by shares issued for stock compensation. The $145 million increase in shareholders' equity over the four years is analyzed in Table 5.2 below.

Table 5.2 AAON Balance Sheet - Equity Section

I often find companies report earnings that should flow into and increase shareholders' equity. But often the increase in shareholders' equity does not materialize. Also, there can be distributions out of equity that does not benefit shareholders. Hence, the term "leaky equity bucket." I find this happening to some extent with AAON.

Explanatory comments on Table 5.2 for the period Dec. 30, 2016, to Dec. 31, 2020:

• Reported net income (non-GAAP) over the 4-year period totals $231 million, equivalent to diluted net income per share of $4.37.
• Net income growth was flat between Dec.2017 and Dec.2019, but improved significantly in 2020 .
• Over the four-year period, the non-GAAP net income excludes $2 million (EPS effect $0.05) of items regarded as unusual or of a non-recurring nature in order to better show the underlying profitability of AAON.
• Other comprehensive income includes such things as foreign exchange translation adjustments in respect to buildings, plant, and other facilities located overseas and changes in valuation of assets in the pension fund - these are not passed through net income as they fluctuate without affecting operations and can easily reverse in a following period. Nevertheless, they do impact the value of shareholders' equity at any point in time. For AAON, these items were $2 million (EPS income effect $0.05) over the four-year period.
• There were share issues to employees, and these were a significant expense item. The amounts recorded in the income statement and in shareholders' equity, for equity awards to staff, totaled $79 million ($1.48 EPS effect) over the four-year period. The market value of these shares is estimated to be $92 million ($1.74 EPS effect). The understatement of expense by $13 million is material in the context of non-GAAP earnings total of $231 million over the 4-year period, and of some concern from a "leaky equity bucket" aspect.
• By the time we take the above mentioned items into account, we find, over the four-year period, the reported non-GAAP EPS of $4.37 ($231 million) has decreased to $4.12 ($218million), added to funds from operations available for distribution to shareholders.
• Dividends of $67 million, and share repurchases of $98 million were adequately covered by the $218 million generated from operations, leaving a balance of $53 million added to equity. Shares to the staff at the market value of $92 million further increased this $53 million to $145 million added to shareholders' equity per Table 5.1 above.

AAON: Summary and Conclusions

I can only repeat, the company, as a business, appears to be performing well, the dividend is safe, and the balance sheet strong with no debt. But there appears to be a real danger to the share price from potential multiple contraction, leading to negative returns.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. I do not recommend that anyone act upon any investment information without first consulting an investment advisor and/or a tax advisor as to the suitability of such investments for their specific situation. Neither information nor any opinion expressed in this article constitutes a solicitation, an offer, or a recommendation to buy, sell, or dispose of any investment, or to provide any investment advice or service. An opinion in this article can change at any time without notice.