Hello, my name is Phillip and I'll be your conference operator today. At this time, I would like to welcome everyone to the AAON Inc. Third Quarter Sales and Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session [Operator Instructions]. Thank you. And now I would like to turn the call over to your host, Mr. Gary Fields. Sir, please go ahead.

Good afternoon. I'd like to read the forward-looking disclaimer. To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the Safe Harbor provisions of the Securities Litigation Reform Act of 1995. As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated. Please see the risk factors contained in our most recent SEC filings, including the Annual Report on Form 10-K and the quarterly report on Form 10-Q. So now, I would like to turn it over to Scott Asbjornson, CFO to discuss some of the financial details.

Welcome to our conference call. I’d like to begin by discussing the comparative results of the three months ended September 30, 2018 versus September 30, 2017. Net sales were down 0.6% to $112.9 million from $113.7 million. Net sales for the quarter are mainly due to decreases in rooftop unit sales. Our gross profit decreased 8.1% to $32.8 million from $35.7 million. As a percentage of sales, gross profit was 29% in the quarter just ended compared to 31.4% in 2017. The Company saw improvements in its gross profit in the third quarter compared to previous quarters in 2018. The Company continues to experience increases in raw material costs due to tariffs and trade restrictions. Selling, general and administrative expenses increased 1.2% to $13.2 million from $13 million in 2017. As a percentage of sales, SG&A increased to 11.7% of total sales in the quarter just ended from 11.5% in 2017. Income from operations decreased 13.5% to $19.6 million or 17.3% of sales from $22.6 million or 19.9% of sales. Our effective tax rate decreased to 28.2% from 35.3%. The Company's estimated annual 2018 effective tax rate, excluding discrete events, is expected to be approximately 26%. The decrease in our effective rate was due to the Tax Cuts and Jobs Act that was enacted on December 22, 2017, lowering the federal corporate tax rate to 21%. Net income decreased to $14.1 million or 12.5% of sales compared to $14.7 million or 12.9% of sales in 2017. Diluted earnings per share decreased by 3.6% to $0.27 per share from $0.28 per share. Diluted earnings per share were based on 52,628,000 shares versus 53,014,000 shares in the same quarter a year ago. The results of the nine months ended September 30, 2018 versus September 30, 2017; net sales were up 6.8% to…

Good afternoon. The net sales decreased 0.6% for the quarter. They are up 6.8% year-to-date. We've had price increases that have gone into effect and are becoming effective on the actual equipment shipped. The related impact to that is that we are regaining our margin percentages. At the same time, we have market pressures from increased deal costs due to the tariff increased aluminum cost and now component costs. The price increases that we've put into effect are beginning to offset all of those other price increases and we look for this to be somewhat accretive over the next quarter. Water source heat pump business is beginning to gain some momentum. We achieved our AHRI certification a few months ago. Orders coming in the door are increasing at a rate that's we expected. We have been redesigning some of our legacy products to gain efficiencies and to gain some other operational strategies. One of those operational strategies that we had not previously participated in is the grow business. As many of you know, medical marijuana and -- so forth has been legalized in many states, and this has prompted a demand for these facilities that have very specialized environment. AAON was very well equipped to make some small modifications to our products and gain a very substantial foothold in a new and emerging business. Our replacement market versus new construction remains fairly steady at about 50-50. We've had continued growth in our large tonnage products of gaining market share, as well as just an increasing overall production of those machines. The water source heat pump, as I have mentioned previously, is coming up to speed of beginning to get on track with our expectations, still lagging behind somewhat, but it's gaining. The various market segments remained fairly steady; commercial and…

[Operator Instructions] Your first question is from the line of Joe Mondillo.

I wanted to ask you guys about -- so lower productivity, I imagine, lower productivity caused sales to only increase from the second quarter by about 3%. So sequentially, you saw 3% revenue growth despite the strong backlog and that's because of lower productivity. On the other hand, you saw your margins sequentially improve by 400 basis points, and that because of productivity. So I am just wondering if you could distinguish why revenue was not very good because of productivity but margin was good because of productivity. If you could clear that up?

Well, there's two factors there. One of them is we had some price increase from back in November that finally found its way on to the plant floor. I believe that was 3% price increase across the board that went into effect to November. And just due to backlog and lead times, it took all the way to the third quarter to get that fully enabled. So that helped part of it. The other part of it is that we -- in the second quarter, we ramped up and added a considerable number of people to the plant staff. And these actually ended-up being disruptive, because the people, while they came in with little knowledge of how to do what we do, they distracted almost an equal number of people that were trying to train them. So throughout the third quarter as attrition took place for various reasons, we allowed that attrition the shrink our staff on the plant floor somewhat, so that helped us with that efficiency, because we weren’t paying those people for doing nothing. Yet, this smaller staff was able to build like you said it almost exactly the same amount of equipment that they did in previous quarter.

And then -- so with this improvement that we're making here. Should we anticipate daily sales to improve? At the same time, the productivity improvement is taking place, and then on top of that you get price increases that’s the June price increase that starts hitting. So, it seems like price increase and maybe productivity should boost the gross margins a good amount in the fourth quarter?

Joe, I agree with both of those. First off, we had a second price increase that went into effect on June 15th for orders coming in the door. Due to backlog and lead time we will get about 75% to 80% of everything we build in the fourth quarter, we'll be at that new price. So that was 5% price increase across the board in June. If we do the math and we call it 80% of what we build, that gets you a net gain of 4%. Now, there are other things to keep note of is, we had steel contracted for that got us all the way through third quarter without having any real impact from the tariff on steel, that ended. So in fourth quarter we'll be purchasing steel at the new price, the inflated price. Now, we have had pressures from aluminum all along. So now we will be able to offset that some more. We've had pressures from increased component prices. The most recent tariff went into effect, I would say, in the last 30 to 45 days, 60 days something like that. It was another 10% on small components like contactors and capacitors, and accessory items not big items. So in summary, we'll have about 4% usable of the price increase in the fourth quarter. And I think that the increased materials will take up about half of that. Then in December the 3rd we'll have some escalating wage rates. So the very last month of the quarter, we'll have some wage rate increases that salaries and wages, so those are absorb a bit more of that. But we are now on top of the curve with regards to our price increases versus our rising cost. So, I think it's a very valid statement that our margins will continue to improve. Now, on a daily basis -- in the month of October, we have seen on a daily basis, an increase in productivity, as far as dollars per day going out of the door it. It's not been drastic, but it's been improving. And so it tells us that a lot of the things that we did to correct these actions and get more production out the door are effective. We did that through multiple things. One of which was a revised and enhanced on-boarding process and training program for these plant workers. So, all of this being said, I'm very confident that fourth quarter we'll see some marginal improvement as well.

And then I wanted to ask I guess a product mix question, and its two parts. Roofs, I noticed rooftop units were down on year-over-year in the third quarter, and chillers and air handlers were actually up. Could you comment on product mix? And then also I know in the beginning of the year, you were talking about how large lower margin type units were somewhat of an issue and I think maybe the December or November price increase was going to try to combat that. So it’s a two-part product mix pricing kind of question.

So, let's address rooftop units first. We have a range of rooftop units that go from two tons to 210 tons. So our two ton threw approximately 210 units, have been very steady, very slight change but nothing material as far as number of units, what has increased has been the larger tonnage units. While those bring equal dollars, so the dollars didn't change much. We went from 113,000,668 down to 112,000,937. So there wasn't much dollar change. Yet, those units were down by 450, 480 units. So the units are larger, more expensive. And I am going to tell you in the 50 to 70 ton range, those units have increased in their market share and their number of units. But at the same time, the midsized units went down for the quarter. So that product mix changed. The units that -- the fifth -- well, really they go from about 40 tons to 70 tons those are a very nice margin units. The units that are above 70 tons are the ones that we've had the lower margin on. However, our price increases have been aggressive on those units. And while there's still lower than the benchmark margin, we've actually improved them a good bit. Now another thing with total number of units going up from 6,258 up to 6,547, you'll notice that we built almost twice as many heat pumps. That’s the new water source heat pumps that we've been talking about. So in 2017, in this same three month period, we built 614 units. In 2018, we built 1,161. And if you look at it on a year-to-date basis, its 3,780 compared to the same nine-month period last year 15. So we have more than doubled our production rate on water source heat pump. We’re seeing the orders coming in at a rate of expansion that supports that growth on a continued basis. Since our AHRI approval, we've seen what we expected that the order rates have increased substantially.

Lastly and I’ll allow someone else to have a shot, the warranty expense. Last year, I remember there's bouncing up to over $3 million a quarter. It seemed like it was going to be temporary and then it fell down in the first quarter to maybe $1.5 million in the first quarter. And it seemed like that was temporary in nature. But then in the second quarter, it bounced again above $3 million and it was above $3 million in the third quarter. Could you explain what's going on here and if you still do think that settles back down to closer to historical levels?

Yes, it is settling down. So the actual spend for the three months ending September 30th was $3.50 million versus 2017 was $3.277 million. So we have had a slight decrease in the spends in that quarter. Let me re-correct that. The spend was $2.355 million versus $2.281 million. So it was a very modest increase in actual spend. However, this has isolated like you say, it went down for a bit and then it came back up. Some of it was due to some seasonal repairs. We had actually began to accrue for some that we knew occur that we couldn’t actually spend the money to do the repairs until the weather got right. We identified two major areas that we had concern, one was paint and another one was a component supplier. And we have remedied both of those. So that's why we are confident that we will have a declining rate in one of the expense.

So when you say -- just a follow-up and clarify. When you say declining rates, do you anticipate as a percent of sales, it's going to decline or will it decline from -- I mean historically, your warranty expense was closer to $1 million a quarter, so will it decline closer to the historical levels? Or are you just saying as a percent of sales, it's going to remain elevated for whatever reason. But at a percent of sales, going to decline but absolutely it will remain elevated?

Well, I think first off as a percent of sales, I think it will decline because we're going to have increasing sales and I don't think will have an acceleration in the current. Now, the absolute dollar spent, to your point there, I also believe that that's going to begin to curtail here pretty quickly actually, because some of those items were resolved and paid for. And a primary one was that the paint issue, we had a paint process that failed on this that was in early to mid-2017. And then we had a slight reoccurrence in January, very slight -- we'll call it a whiplash. But we buy enlarge resolved the issue with paint in the fall last year. So, there was like I said, just a very small reoccurrence and it was actually a strange situation how it reoccurred. But we identified what that was and corrected that as well. So the paint issue was fairly substantial in actual dollars spent and that is absolutely resolved. We've had no reoccurrence since the one isolated incident that was back in January. Then we had a component manufacture that we had an issue with that really manifest itself early last year, two things occurred there. One was we issued a service bulletin of -- a procedure that could be done that would enable this component to have a more expected life expectancy. And so that service bulletin procedure we had to pay for those, and those trickled in as our field service reps were able to apply the cure, if you will. And so that's also largely completed. Now both of those things took longer to get completed than what I thought they would. The total dollar spend was what we thought it would be. It just took longer, because of the seasonality and the workforce out there to actually resolve the problems.

And going forward, whatever warrants you reserves that you're reserving related to that issue as well as the paint should subside, I guess?

Well, it will. But the warranty reserve -- there's an accrual method there and it's a little slower to respond in the actual accrual. So, it takes more historical data to support a change.

You've got a couple years for this. What has happened over the last 12 months is it's going to flow through the calculation, and it's going to take a little while for that to flush out. So, if you go back and you look at when does the units shipped versus when did you incur the warranty costs, and then you're making projection. So we've got a way for that same amount of time to go past in the future without having those problems before that we'll fall out of the calculation. So, as we keep certain products versus moving forward is it -- as if that's going to happen again when we really don't -- we anticipate we have resolved the problem and it's not going to reappear but through our profits we're saying on the off chance that it does and we've got a reserve for it.

And in terms of that anniversary or future time period. Is that something like 12 months or how does that view starts to decline?

I would say most of the units that we shipped out we found the problems within last 12 to 18 months.

Your next question is from the line of Brent Thielman.

Gary, how much of that $53 million increase in backlog. Could you parse it out for us how much of it traditional HVAC products versus heat pump products, I guess feel for where that growth is coming from?

In the backlog, I would say a preponderance of it's in legacy products. While the water source heat pump is accruing a backlog that’s beginning to register on the meter; it’s not the preponderance of that backlog.

And you talked about some of the newer market opportunities out there. What feedback -- I mean you get from the fields just in terms of commercial market overall. You feel like -- and actually there's a nice bump in backlog, looks like a lot of its reflective of the traditional business. Does it feel like your end markets are accelerating the pace?

It feels like that -- we’ve began to see an acceleration in May. Our sales channels actually started forecasting an acceleration clear back that was supposed to have occurred in January. There was factors that we’ve still not identified as to why January, February and March were all below their forecast. But if I take it in sum total the first nine months of the year, we’re at 97% of what they forecast for year-to-date. So their forecast was quite accurate within 3% of being perfect. That being said, what they had forecast was about 15%, 16% growth this year in orders coming in the door versus 2017. So, there has been strength there. Beginning in May, we began to see that here. Of course, June was a little artificial for us because of the price increase. Now, as all of this has occurred, we determine that about $35 million of the $156 million backlog at the end of the second quarter was pulled forward, because we looked at the forecast and then how it actually occurred throughout the third quarter and believed that that $35 million would have just occurred in the third quarter as far as orders coming in the door. Now, if I look at Architectural Billing Index, I find that other than the Northeast region, every region is recently reported above the benchmark of 50, which indicates growth. The overall, I don’t have the exact number in front of me, but it seems to me it was around 52 -- I believe the number right now is around 52 for this latest report. What we've had though is 11 months in a row that have been above 50. So that is a firm indicator for our style of business telling us what's going to occur for the next nine months. So each month that rolls on, I look nine months out and say it's going to be steady. Our sales channel partners were in here last month for a sales meeting, a National Sales Meeting. We had approximately 700 individuals that came in. And before they saw what we were doing at the sales meeting, they were all very excited about the market opportunities and what was going on. When they saw the new product additions and the new product enhancements we've done, along with our laboratory, the tenor of the group went to a high-pitch scream of excitement. So when you have got your sales channel partners, this involved, this excited, about what we’re doing I think that's going to support firm growth for us for a long time, somewhat irregardless of what the market does, because if we get more of their time then the other manufacturers that are on their line sheet get less of their time, and so more of their time results in more sales for us.

And we’ve talked before just about some of the challenges and labor constraints in the open market, and it looks like you’ve worked through those issues. I guess my question is with this growth in the business, do you foresee a need that go on another tranche of hiring here in the near term? Do you feel like you have what you need in place, the factors and support the growth that looks like it's coming? do you feel like you have what you need in place, factories to support the growth coming that it looks it coming?

Well, I think that we need to have some incremental growth in those personnel in mind at all times. What we did was because the forecast came up so short in the first quarter and it damaged our first quarter results as a result of that, I was a little bit hesitant to add people on incremental basis, because it seemed that I might be overstaffed. Well, then this huge swing in orders came in and we tried to staff-up somewhat to meet that swing in order. So that made an incremental percentage add that was just out of control. I don't know what the effect -- do we add over 20%?

Out of the peak, it was over 20%.

Yes, we added over 20% at one time. The task of on-boarding those people effectively, we weren’t up to the task. We just couldn't do it. So, what we've done has gone back to a more managed approach where we're on-boarding people at a more reasonable rate something that we can be effective with, and we proved that in the third quarter with the improved margins. And then further with what I'm looking at that just occurred in October, we've improved again. In October, we are down 230 individuals versus our peak, which is about roughly 10%, I guess. And we are producing more dollars per day than we've ever produced. So, that gave us clarity on the fact that yes, we need to add people but we have to do it in a more controlled rate in order to get the effectiveness out of them and not be so disruptive to the other existing workers.

And then maybe one more from me, with the pump orders coming in the certifications behind you, it seems like everything's in order here for all systems go. Are you comfortable, helping frame for us the target you're thinking about for pump revenue over the next 12 months.

I'm not yet comfortable declaring anything there, because two things. We went from 40 hours a week, which was 5 to 8 hour days and we just about three weeks ago, turned this onto a seven days a week and there is 3.5 days each shift 12-hours. When we did that, we spread some of the experienced personnel between the two shifts and we actually went backwards a little on the number of units per week that we were producing. So until I get a little more maturity on that workforce, I'm a little reluctant to give any firm production of schedule on the dollars. What I will tell you is that in October, our orders were up -- coming in the door were up 30% over September. So, we have got to get this resolved. I think that we're on track to get it resolved, but it remains a substantial challenge. I guess just to add the final color on that. We can get the orders. We got to prove we can build them and that's what we're working on.

Your next question is from the line of Brian Gustavson.

Just coming at a different way, can you just maybe talk about capacity utilization and where you were this quarter and where you think you can get to?

Well, from a facility standpoint, we've already determined that we can -- we have the facilities currently in place with no modifications to run $60 million a month. We have the ability to get orders in not quite at that rate yet, but we've got the ability to get the orders yet. What we don't have is the qualified trained personnel to get those orders built. So that the facilities here, the equipment -- the manufacturing equipments in place to do that as we get more maturity on these people. And then bear in mind were in a range of 3% unemployment rate. So when you add people, even when you get them trained, you're not talking about the cream of the craft people. So on a per head basis what we put out, we may have some new metrics to consider. And as time goes by, our training programs that we’re putting in place should help us to utilize these people to the best of their ability. But I don't see any constraints from a facility standpoint or from a manufacturing equipment standpoint it's all from a personnel standpoint. And I'm talking about personnel on the plant floor. From engineering -- manufacturing engineering, production control, all of these other aspects of business, we have a great staff right now that is capable of handling quite a lot more business than what we've actually been able to produce. So from the supervisory and management positions up, I think we’re in good shape. It's just the basic manufacturing workers themselves that we've got to get in better shape to increase this volume.

But it sounds like you’re improving that capacity utilization that you’re -- or becoming more efficient as from over the summer into this quarter?

Very much so. And like I said earlier, October has shown us some other key improvements that we have achieved. So a lot of the things that Scott and I have been working on together with his HR group and with our production control group are beginning to manifest themselves. So once you understand what these successful strategies are then you just begin to utilize them more broadly.

But just thinking -- what do you think the masked revenue per quarter is that you could do with this workforce situation you have now is that plus or minus…

You just saw pretty close to it with what I've got now. We might be able to improve that 5% or something like that through efficiencies but we’ve got to be able to onboard more people effectively in order to really get the rate moving in the right direction.

I think also what we want to say is it depends as well how effectively we onboard those people and then increase the total number of people that we have. So, it really is about getting them on our staff and trained and we can raise that number beyond that 5% higher than where we’re at. It’s just an issue of getting enough of these people in and stabilize.

[Operator Instructions] You have a follow-up from the line of Joe Mondillo.

Just wondering what you're hearing from your customers related to may be the delays in production and longer lead times, any cancellations or anything related to that, any thoughts.

Yes, we've had zero cancellations. And it was interesting. One of my board members asked me the other day if the weather had any impact on us, because there'd been heavy rain on the East Coast, heavy rain in Texas, there'd been a hurricane, so on and so forth. And I said thankfully, yes. What that did was, some of those people that were affected by that have called and said hi, can you postpone my order for a bit. So that allowed us to shuffle somebody else's order in front of them that was more critical that by chronology they would've been later. So we have spent an inordinate amount of effort managing the relationship with our customers and their expectations. We’re very aggressive at publishing what our lead times are. We update that frequently to make sure that they understand where we’re at with lead times. I don't want to tell you that we take this lightly at all, but I want to tell you that it's been more manageable than what I expected under the circumstances.

And in terms of publishing the higher lead times. Do you think any of the slowdown in order rates is related to that at all? I know some of it most definitely was a pull forward before the price increases. But you think there's any customers going anywhere else or waiting in future period of time to put in an order, anything like that related to that?

No Joe, I don't believe so, because I'm looking at October bookings orders that came in the door and they're 20% higher than September bookings.

You don’t happen to have the year-over-year improvement in October. Do you?

I can tell you that were within earshot right now of booking exactly what we've booked all of last year. So we've got like three months left to go for what we're going to increase on bookings. I can look it on…

So you're year-to-date bookings through October is about similar to last…

To all of 2017, really close. Hold on Norm just handed it to me here, it's pretty detailed. Let me look through it. Yes, so our year-to-date bookings are in the range of -- we're 9 million -- let me look at -- that was just, so let me pull together a long view here real quick because I think they're pretty steady. I don't think they've changed it all. Yes. So our total right now -- we're in range -- we're just a few million dollars short of what we booked the entire year 2017, that’s as of the report that came out first thing this morning. So we've got November and December yet to book and our forecasts for those are very strong, much stronger than we've ever had for November and December before.

So you're anticipating November and December to be up year-over-year from November and December 2017?

Absolutely. And so our backlog finishing out the year, it is going to be extraordinary comparatively.

Also, I wanted to just clarify the price increases in the future that you have in place. Is it just the December -- I think I want to say 10th price increases. Is that all you have in place, or is there anything else?

So we had a price increase, June 15th of 5% across the board due to lead time and backlog, about 80% of that price increase will actually be effective on product built in the fourth quarter. So it obviously would be a 100% in the first quarter, that 5%. The next price increase goes into effect on December 5th. Again, due to lead time and backlog, I would not expect any of the December 5th equipment to hit the plant floor sooner than about the middle of the second quarter. There might be a little tiny bit hitting the tail end of the first quarter, but the vast majority of it will hit in the second quarter predominantly the middle of the second quarter.

And that's across the board price increase or more selected?

It is. It was 4% across the board. I'll just -- the products that we build in Longview, we did not have an additional price increase. When we went back to June, we changed some multipliers and we effectively had 8.5% price increase on the Longview products in June, so that was cumulatively all we needed.

And then lastly, just two things, probably for Scott, the tax rate did you say you anticipate the go forward tax rate even, in the 2019, to be 26%. Did I hear that right?

That's what we estimated at this point, yes.

And then the CapEx was a little -- it seems to be a little lower than you were originally anticipating. Is anything being pushed into 2019 and what budget ballpark are you thinking for 2019 or is it too early to tell?

We're still putting together 2019 at this point. And really, we always overestimate what we're going to get done, and this year is really no different so certain numbers were maybe a little bit bigger at the beginning of the year. So we haven’t purposely pushed off anything of significance into next year. It's just been the management of the projects and trying to get everything completed.

And there’re no further questions at this time.

Okay. Well, we thank you for all your calls and questions. So we will speak to you again in February for our year end results. Good day.

That does conclude today's conference. Thank you for participating. You may now disconnect.