Ladies and gentlemen, thank you for standing by, and welcome to the AAON, Inc. Second Quarter Sales and Earnings Call. [Operator Instructions] I would now like to hand the conference over to your first presenter, Mr. Gary Fields. The floor is yours, you may begin.

Good afternoon. I'd like to begin by reading a 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'd like to begin with telling you a little bit about our experience with coronavirus and how it's affected our business. First of all, and of utmost importance, is to thank our employees. We've been able to maintain continuous operations. As a result, we have been able to assist with many COVID-19 projects. We are -- and this is vital to our business as an essential business and essential business supplier. I'm very proud of the effort that our employees have gone to, to maintain safety in the plant. They are all wearing masks, social distancing, they're doing temperature scans on arrival and at any point in time throughout the day that they feel like that it's necessary. When they clock in, in the mornings or in the evenings, whichever -- at the beginning of their shift, they certify through a wellness reporting system in our clock in. So we did have some absenteeism because of coronavirus. In June, we had -- about the second week of June, we had a substantial decline in attendance. It bottomed out in mid-June and was mostly restored in the second week of July. I'm very happy to say that we had very good results with our people returning to work healthy and this was a temporary impact for that period of time I described. And we are mostly recovered on attendance, and these people came back very healthy, ready to work. Now I'd like to turn the call over to Scott Asbjornson, our Chief Financial Officer.

I'd like to begin by discussing the comparative results of the 3 months ended June 30, 2020, versus June 30, 2019. Net sales were up 5.2% to $125.6 million from $119.4 million. Net sales for the quarter are up due primarily to our increased sheet-metal production from the additional Salvagnini machines that were placed into operation as well as our price increases we implemented in 2019. Our gross profit increased 26.2% to $38.1 million from $30.2 million. As a percentage of sales, gross profit was 30.4% in the quarter just ended compared to 25.3% in 2019. We continue to see overall raw material cost decrease. The company has improved its labor and overhead efficiencies through increased production and absorption of fixed costs. Selling, general and administrative expenses increased 23.4% to $15.9 million from $12.9 million in 2019. Additionally, as a percentage of sales, SG&A increased 12.7% of total sales in the quarter just ended from 10.8% in 2019. SG&A is up due to increases in profit-sharing, employee incentives, driven by increased earnings and largely to a $1.25 million contribution to Winifred, Montana Public Schools on behalf of Norman H. Asbjornson in recognition for his transition from CEO to Executive Chairman. This equates to roughly $0.025 per share. Income from operations increased 28.4% to $22.2 million or 17.7% of sales from $17.3 million or 14.5% of sales in 2019. Our effective tax rate decreased to 20.0% from 22.7%. The company's estimated annual 2020 effective tax rate, excluding discrete events, is expected to be approximately 25.1%. Net income increased to $17.8 million or 14.2% of sales compared to $13.4 million or 11.2% of sales in 2019. Diluted earnings per share increased by 36.0% to $0.34 per share from $0.25 per share. Diluted earnings per share were based on 52,750,000 shares versus 52,747,000…

Thank you, Scott. Looking at the balance sheet, you'll see that we had a working capital balance of $143.2 million versus $131.5 million at December 31, 2019. Unrestricted cash totaled $61.3 million at June 30, 2020. Our current ratio is approximately 2.9:1. Our capital expenditures were $33.5 million. We expect capital expenditures for the year to be approximately $73.2 million. The company had stock repurchases of $15.9 million during the 6 months ended June 30, 2020. Shareholders' equity per diluted share is $6.1 at June 30, 2020, compared to $5.51 at December 31, 2019. I'd now like to turn the call back over to our CEO and President, Gary Fields.

So net sales have increased. This is due, by and large, as Scott mentioned earlier, to the Salvagnini machines that allowed us to produce the sheet metal required to build our units. So once we produce the sheet metal, then it becomes more impacted by human activity. So absent of the time frame through June and the first week or 2 of July, we had been producing on a daily basis at a record pace, the highest production numbers per day. So once absenteeism is stabilized, which has begun to do quite well, we're nearly restored on that. So we believe that our production has also stabilized. Of course, this coronavirus is such a quick thing that can impact you, I suppose it could occur again. But we've done pretty well with that. So the projects that we have produced in relation to coronavirus, we've talked about last quarter, some of those for New York. There's also been some other facilities that we produced equipment for, that -- for instance, in the state of Maine, there's a company up there that manufactures the swabs that are used for testing. And they've expanded their facility substantially. We've already supplied quite a few units to them for their first expansion. And I think we're closing in on an order for another expansion that they have planned. They were very happy with what we did on the first one. So that's kind of the the jobs that are directly related. No there's been a lot of indirect relationship in that there's been some community hospitals that have come out of mothballs that we've been able to provide some equipment to help renovate and update these. There's been a myriad of facilities that are -- as a result of coronavirus, there was an awareness…

[Operator Instructions] Your first question comes from the line of Brent Thielman.

Gary, maybe first off, I mean that despite some of the disruption seemingly late in the quarter, the gross margins are holding up pretty well. I guess your -- thanks for the -- at least some view on what you think sales can do through the remainder of the year. And I know that's subject to a lot of things. But how do you feel about sort of maintaining these margins at these sort of levels and -- given all the variant factors out there and barring any change in the inflationary environment?

Well, we had June -- we look at each month stand-alone as they occur. And June was surprisingly good. This absenteeism at that PTO time for those people is accrued. And so it doesn't affect us in a negative way. The thing that you don't get is you don't get the dilution of the fixed cost when you don't have the revenue. So I think that I'm very proud of what our team did in managing cost and managing the people for the best outcome. June, as a stand-alone month, was relatively representative on a gross margin basis for the whole quarter, as I recall. Yes. I'm getting a nod of approval from my accounting and -- folks here. So June was relatively on par with that. We've not -- since we just closed out July, we've not seen those numbers. But revenue in July looked fairly similar to June. Yes. So having the same sort of controls in place on the efficiency and just the scrutiny to every little detail in the business, I would expect that July performed somewhat on par with June, maybe slightly less, but somewhat on par. August is starting off with really, really good production and good attendance. And so I think that August -- and we've got good backlog to run through September at this rate and good prospects on the horizon. So I think that the stability in gross margin performance is very probable.

Okay. And Gary, just to clarify, I mean, I think typically, third quarter is 1 of your stronger quarters. Do you expect a step-up in revenue from the second quarter?

I don't. And it's because those first roughly 10 days of July -- 10, 11 days that we were below production numbers, because of attendance, if that had not occurred, then, yes, I would say so. If we were in the range -- and I've not seen the forecast yet, we're just -- Normally, about mid-quarter, my production team would give me a pretty good forecast of what revenue is going to look like Because they've got their production schedule fairly solidified, and they've got their rhythm for it. So we're about a week early for being able to determine that. But I would expect Q3 probably to be in the same range as Q2. It won't be the normal bump up that you've seen historically. And again, that was largely affected by the absenteeism on these first 10 or 11 days of July. Do you agree -- both of you agree with that?

I would tend to say so. I think effectively, the impact we had from coronavirus was split half between the end of June and the beginning of July.

Yes.

And so you're going to probably see somewhat of a mirror image.

Yes. That's the way I saw it as well. Thank you, Scott.

Okay. And just to clarify, given the lead times have shortened, I've seen -- all the all the work in your backlog reflects most current pricing and that's out there, you don't have much going through from prior price increases. Yes, yes.

I had no price increase. No, no. We had, as I recall, it was relatively across the board price increase in June of '19. That's fully enabled in the production, I would say, even Q2 was fully enabled. There was a small price increase, selected price increase in December. Again, I think some part of Q2 captured that. And I would say that Q3 is entirely on that. But that was very inconsequential to the overall gain. Because it was on select equipment, even though it was 4% or 5%, it was on probably -- let's see, it was on Longview equipment in line 5?

Correct.

Yes. So it was affected on somewhere around 20% of our revenue. That we -- we got about half of Q2 with that price level on the plant floor.

Got it. Last one, then I'll get back in queue. The indoor air quality upgrades, is that considered a part sale or is that a full-on replacement of a unit?

Full on replacement of the unit for most of these facilities. When you go get -- let's see you go to an elementary school that was built even 15 years ago. And let's say they did not purchase AAON equipment. So the equipment that they purchased, the fan that supplies the air to the space and recirculates it, doesn't have the capability of overcoming these additional filtration levels that we're talking about. The other thing is, is those units that a lot of our competitors sold on those projects don't have the space in them for these virus-killing devices. And so our units accommodate both and that strategy in our units has been available for many years. So we didn't have to do any new design, redesign or anything like that. We have a project that we are supplying to the Carrollton-Farmers Branch, Texas School District. I think there's nearly 600 units. And they are adding the virus-killing device and then we added the higher filtration. And so that's just 1 example of a school district that recognize this. And that was all planned before coronavirus. And they came in and added this virus-killing device once they saw the effect of it with coronavirus.

Our next question comes from the line of Joe Mondillo.

I wanted to start with following up on Brent's last question. And just to expand on that, what kind of units are you referring to? Or is it water-source heat pumps or rooftops? And then in addition to that, is there other types of units that maybe you don't manufacture, other types of systems that could be a substitute at all? And then lastly, as far as the uniqueness that you mentioned regarding the static pressure, could you expand on that? And how many producers out there can provide what you're referring to there?

Okay. So let's divide this up a little bit. So in indoor units, virtually every competitor we have, has this capability because indoor units don't tend to be so commoditized, they're not an in-stock-on-the-shelf kind of a unit. They're built to order. So virtually everyone who's building indoor air handling units has the capability of providing a fan system that is capable of overcoming this. Indoor air handling units typically go with chiller water systems. For the products that we produce in Longview, Texas, we have a high percentage of buyers that are, what's called a, split system. They also include a condensing unit, and they have refrigerant run through their coils rather than chilled water. So when you're talking about those indoor split systems, you start narrowing this down a little bit. Because a lot of our competitors don't have a real effective offering of this style of split system with these kind of capabilities. So for many years, our successes of the split systems we produce in Longview were due to the attributes they had with some application strategies. In other words, a lot of projects with chilled water, which are typically your larger central projects -- central plant projects, we were able to duplicate that kind of performance with a split system and scale that down. So some projects need an indoor air unit because they don't have roof structure or roof square footage available for a rooftop unit. So that buys well for Longview. Now when we're talking about packaged rooftop units, when we're talking about units that are 25 tons and smaller, then virtually all of our competitors, with a small exception, and that would be Daiken, their fan systems will not accommodate this additional static pressure for these higher filtration requirements. So we have essentially 1 competitor that can match us on fan performance on these 25 ton and smaller units, and that would be Daikin. And when we look at it from a competitive standpoint, that's quite nice to compete against them. When we go above 25 tons, then it starts sprinkling in a few manufacturers here and there, between 25 and 50 tons, we'll say, that can do these sorts of things. Now once we get above 50 tons, then it becomes even more of those manufacturers are capable of doing that. So our most substantial opportunity is in the 2- through 25-ton sized equipment that our strategy and our value proposition are extraordinary. Water-source heat pumps. We do have a fan capability to step up the filtration capabilities in those. That was 1 of our innate designs. Because we recognizes this ability, even before coronavirus, that there were many applications that would desire a higher level of filtration. So as far as water-source heat pump manufacturers going head-to-head, we do have unique capabilities once again in that facet.

Okay. And have you -- I don't know which one would be maybe the most ideal fitted for sort of COVID air quality. If there is one, have you seen any -- I guess, just broadly, have you seen any indication that you've started to see increased demand? Or is it still too early?

To the increased filtration or the virus-killing-devices going in the units?

I guess, just anything related to putting in COVID-related systems because of air quality and filtration

I think we're on the early part of that, Joe. And let me tell you, ASHRAE is our industry resource for research and development. And it's done on a -- all of our peers participate on these committees and on these research opportunities. And so this is a collaboration between the entire industry. And ASHRAE published a paper recently describing what they thought were best practices for how to handle this airborne virus, this aerosol virus. And that was increased filtration levels. It's called a MERV level, M-E-RV, increased MERV level filtration as well as coupling that with 1 of the 3 strategies for virus killing. So UV lights are an obvious choice for killing a virus. But the problem is, is that to have the intensity required to kill the virus at any speed as it goes through the unit and its normal speed, the intensity has to be much higher than what we were accustomed to having in the past. Most of the UV devices that the industry has been installing in their units was to kill any surface-borne viruses and bacterias that might accumulate on the cooling coil. So this strategy of increasing the intensity of UV is rather new, and it's something that ASHRAE put in 1 of the recommendations. There's also some ionization-type virus killing devices that are getting some attention as well as a plasma device that will kill this virus. So there's really 3 technologies out there that are working their way through to see which 1 is the most viable, which 1 is the best value. But if you couple all of these with this higher level of filtration because when they kill that virus, you want to capture those particles in a throwaway filter.

I see. Very interesting. How about as far as your COVID-related end market trouble spots being retail, office, hotels, they make up 40% to 50% of your revenue. Construction is overall 50% or so of your revenue. How do you view maybe the positive aspects of COVID-related demand to some of the adverse effects to the pandemic in terms of those end markets?

Well, I think what you've described is relatively accurate that some of these markets are declining. As far as new construction, they're definitely in jeopardy of declining because Architectural Billing Index has been a great indicator, and it's 4 months in a row that it's been below the benchmark of 50. That says things are going in a positive direction. So there will be more emphasis on replacement business. It's something that -- when I came here nearly 4 years ago now, that I recognized was a significant market opportunity for us. And we've been putting strategies in place to increase that. And I think we're making good traction with that. Our sales channel. As a whole, as we improved it, some of the characteristics of the improved partners that we selected were due to that aspect of their business that they had a focus on this aftermarket replacement solutions-type business. So I think that a lot of the improvements we made in the sales channel are going to have a beneficial impact to us shifting from 50-50, 50% new construction, 50% replacement. I would look for over the next 18 months for our ratio to change somewhat and our new construction to be a smaller percentage and our replacement business to be a larger percentage. When it comes to water-source heat pumps, particularly, that is an absolute strategy that must be utilized because the new construction, some of the biggest markets for water-source heat pumps were hotels and high-rise condominiums, both of which I think are going to be substantially curtailed. But on the other hand, if they're not building new hotels and not building new condominiums, they've got units that have got age on, that are failing, that have got to be replaced. So we have had a…

5% for the quarter.

5% for the quarter and that was somewhat constrained by the absenteeism. We would have been up a decent amount more than that if we would have not had to add absenteeism. So we're going in the opposite direction of a lot of our competitors and peers. We are gaining market share. Our value proposition is more appreciated now than ever. And I've always said, and this is something that Norm has validated for me is in these times of downturn, that's when we actually flourish. Because people have time to consider the value proposition, and we win that very often.

Okay. I just wanted to also just follow-up on sort of the backlog and the effect to what that has. And you gave sort of an indication of what you're thinking for the third quarter. I'm just trying to think sort of further out than the third quarter. Did this sort of mishap or maybe not mishap that, but the issues with your absentees. Did that affect -- where your backlog is today, which is relatively pretty high, if you look back 2 years ago. It's about 20%, 25% higher than where it was 2 years ago, even though it's down year-over-year from here. To that extent, how much did this sort of effect going into the fourth quarter? Do you think, say, you get sort of maybe flat to modest growth in orders in the third quarter? Do you see a recovery starting in the fourth quarter in that sort of scenario?

I think that's reasonable to assess it that way. When we look at the commentary we're having with our sales channel partners, the general tenor is that things are improving as things began to open back up. Things are beginning to move. A good many of them believe that there's adequate opportunities out there to kind of maintain our position. But then we keep getting presented with these unique opportunities. This large manufacturing opportunity that's being presented to us right now is very lead time sensitive. And because of our increased capacity, we are absolutely able to meet their scheduled requirements. And when the discussion with some of the other contenders for the project, they're all challenged by that. They're not willing to commit to this very aggressive schedule. So when I go back to the planning we did a couple of years ago, realizing that we didn't have as much production capacity as we need it, and we started getting things rearranged, clean up in the plant, reutilizing some space, better utilizing it, getting more Salvagnini machines in here. We have -- when we built our new laboratory, for instance, we had an existing laboratory here in Tulsa. We have two manufacturing buildings here. The West building is our biggest footprint building, the East building was our original manufacturing building, and we build our smaller tonnage units there. And -- but we also had our original laboratory in there. But once we got the new laboratory up and going, we demoed that space. And working with our manufacturing engineering group here in the office, we devised a whole new manufacturing line for 1 of our most popular products. One of our products that caused us to go out to an exorbitant lead time last year, 35, 40 weeks lead…

One thing just to make sure that we're all understanding is our backlog is expected to potentially still decline in the sense that it's supposed to represent roughly about 2 months' worth of our production. And that historically has been -- we have found to be kind of an ideal range overall for us. And that may be where we end up by the end of the year.

Yes. So if we can end up the year with the -- across the board lead time being that 8 weeks with some opportunity for some 5 and 6 week lead time on certain product groups, then that's going to put us in a very, very strong position going into 2021.

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

If you don't mind, I just have a couple of follow-ups.

Sure, sure. Go ahead, Joe.

So just as far as capacity right now, what size backlog -- just so we sort of have an idea, what size backlog could you increase to where your lead times don't get extended or it doesn't cap your revenue. I'm just wondering how much revenue can this business sort of handle at this point?

Well, it's a moving target because we continue to add manufacturing capacity. The new building in Longview, for instance, we went from 234,000 square foot original facility down there, we're building 220,000 square feet. They're going to turn that building over to me in late November. We'll have that capacity coming online Q1. And so we'll have more capacity for Longview. Right now, if I segment Longview's backlog out there, they're at about 12 weeks right now, I think?

12 weeks, they are.

Yes. And that's a more backlog -- a more lead time-sensitive product group than what we produce here in Tulsa. Ideal down these 5 to 6 weeks. Well, rather than curtail the orders, I want to increase the manufacturing capacity. So that will come on January 1. And so the ideal backlog today for Longview would be substantially less than what it is. The ideal backlog for Longview starting January 1, is going to be about where it is right now, okay? So that's that moving target. Now Longview has traditionally been, what, 10%, 12% of our revenues, is that about right?

Roughly.

Yes, roughly, 10% to 12%. So if the Tulsa products were to become stagnant, which they won't, but if they were, then Longview's -- we're expecting good growth opportunity out of Longview in 2021. We've got multiple programs that we're working on with software development to expedite the processing and billing materials generation so we can shorten lead times to utilize that manufacturing capacity. Then here in Tulsa, we still don't have all of our Salvagnini machines installed that we ordered for accretive capacity. We've got 1 machine right now that looks to be probably 2 weeks away from coming online. So that will be some incremental capacity growth. So to answer your question, today -- with the capacity I have today, the ideal backlog looks somewhere between $90 million and $100 million. But I have increasing capacity coming on incrementally over the next few months. So that's going to be a moving target.

One of the things we're also working on is trying to make sure that we have capacity to deal with short lead time requests in a growing effort as we move forward.

Yes, we've got to have headroom between demand and production capacity. If we don't have that headroom, then you begin to discourage these people because they call and say, "Hey, I need this unit in this lead time." And if you have to say no, they look for either an alternative solution or they just give up altogether. And so having additional manufacturing capacity to have that headroom for that peaking. So over the last 2 or 3 years, you've not seen the bell curve that had existed through most of the life of the company. I believe in 2021, that we're more likely to see that bell curve begin to reestablish itself. And by 2022, I think it will be firmly in place. That being that Q2, Q3 have higher revenue numbers than Q1, Q4.

Got it. How about raw materials? About 12 to 18 months ago, your -- the spread between input prices and output prices sort of squeezed your margins. And I believe that sort of started to reverse in the other direction. But now we're seeing copper is pretty high historically and some other raw materials have been rising. So where are we on price-cost situation.

I have a sheet that they give me from our purchasing group that has about 70% of all of our purchase materials. Rather, those are fixed -- I mean, no, finished goods, like compressors and motors or rather they're raw materials like copper or aluminum, steel and stainless steel. Overall, that's quite stable right now. We've had some things go down, some things go up. As a trend, it was down just a little bit year-to-date. And we were able to lock in some pricing protection on certain aspects of that for -- do you remember how long we were able to lock in that steel?

A little bit of 12 to 18 months, I guess.

Yes. So in the 12 to 18-month range on some of these materials, we've been able to lock in a buy price. So if those things begin to go up, and I've got this locked in price, then I kind of like my chances with that. I think we've done quite well. So just to summarize that, Joe, I think right now, what I'm seeing and what I've been given for the next 6 month outlook on material pricing is it's no impact, positive or negative. It's neutral.

Okay, good. And then as far as the SG&A, I think I may have missed it, but was that inflated? I thought I heard -- maybe Scott said there was a donation in the SG&A.

Yes. You did miss that, Joe. You did miss that. So on May 12, when the Board of Directors so graciously appointed me the CEO, that is the same-day that Norm was appointed Executive Chairman. And so that's a next step for both of us. And in honor of that, the Board voted for and granted a onetime contribution to the Winifred, Montana independent school district, which is where Norm was born and raised. And I'm proud to say that Norm, Scott, myself and Doug Wichman went there and presented that check in person to them for $1.25 million. So that was an SG&A expense in Q2. And if you look at that... What's it, Scott?

It was roughly $0.025 a share on a pretax basis and a little bit under $0.02 a share on an after-tax basis.

Yes. So even with our absenteeism, if you'll make an allowance for that contribution, we were pretty darn close to earnings expectations. And our SG&A would have been pretty much in line with what you had previously thought.

Yes. Yes, correct. Even with taking that out though, it's -- the SG&A is still up 14%. But I guess, property... Yes.

Profit sharing, don't forget my employees. We allocate 10% of our pretax earnings to profit sharing. We issued a check, the check goes out Monday, give me that exact amount, $1,256?

I don't know the exact number off the top of my head. But I'll get for you, Gary and Joe.

Get it real quick. So it was $1,686, the first quarter, and I believe the number was $1,256. This is per employee. All employees with the exception of...

$1,276.19 per eligible employees.

I was short just by $20.

Roughly equivalent to about $2.45 per regular hour worked.

Yes. So that profit sharing is an SG&A expense, and it's our biggest variable. The 2 biggest variables in our SG&A expenses typically are warranty and profit sharing. And so warranty is down and profit sharing is up. And that's the way we want it to be.

Same period last year, that amount was $1,091.

Okay, so that's a 25% increase.

Almost.

Almost?

Yes.

27% increase over last year. So at this point in time this year, on a dollars per hour basis, give me that calculation.

It was $2.45 per regular hour worked.

That was for the quarter?

For the quarter.

Year-to-date were $2.80

$2.80. I don't remember the exact amount.

Yes. Yes. So for year-to-date, our employees have gotten $2.8 an hour year-to-date in profit sharing bonus.

It's the only part of SG&A we like to see going up.

All right. With no further questions, I want to thank all of you for participating and listening today. We'll talk to you in November for our third quarter results. Have a nice day.

That concludes today's call. Thank you for your participation and you may now disconnect. Have a great evening, and stay safe everyone.