Good afternoon, ladies and gentlemen. Welcome to the AAON, Inc. Fourth Quarter Sales and Earnings Call. [Operator Instructions]. This call will last approximately 45 minutes to an hour. And I would now like to turn the meeting over to Mr. Gary Fields. Please go ahead, Mr. Fields.

Good afternoon, and welcome to our Q1 '21 earnings announcements. I have to read the forward-looking disclaimer to begin with. 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 joining me on the call today on Norm Asbjornson, our Executive Chairman; Rebecca Thompson, our newly promoted Chief Financial Officer. Rebecca is going to open by reviewing our financial performance. So Rebecca, the floor is yours.

Thank you, Gary. I'd like to begin by discussing the comparative results for the 3 months ended March 31, 2021, versus March 31, 2020. Net sales declined 15.8% to $115.8 million from $137.5 million. The first quarter of 2020 benefited from a high backlog that allowed the company to run at full capacity and set all-time record highs for net sales in the first quarter. The order intake began to slow in late 2020, and the company intentionally slowed production to keep its backlog at a healthy level. The year-over-year decline in net sales was primarily due to lost production days in January for planned maintenance and in February due to impacts of bad weather. Our gross profit decreased 22.8% to $33.2 million from $42.9 million. As a percent of sales, gross profit was 28.6% in the quarter just ended compared to 31.2% in the first quarter of 2020. The production days we lost in the quarter resulted in unfavorable labor and overhead inefficiencies, including the company's ability to absorb certain fixed costs, which caused the decrease in our gross profit. Selling, general and administrative expenses decreased 3.4% to $14.7 million from $15.2 million in 2020. As a percentage of sales, SG&A increased to 12.7% of total sales in the quarter just ended from 11.1% in the first quarter of 2020. The increase in SG&A as a percent of sales was due to an increase in insurance premiums and salaries and benefits. Income from operations decreased 33.6% to $18.5 million or 15.9% of sales from $27.8 million or 20.2% of sales in 2020. Our effective tax rate decreased to 11.4% from 21.5%. The unusually low tax rate was mainly related to a $1.8 million increase in our excess tax benefits associated with stock awards. The company's estimated annual 2021 effective tax rate, excluding discrete events, is expected to be approximately 27%. Net income decreased to $16.4 million or 14.1% of sales compared to $21.9 million or 15.9% of sales in the first quarter of 2020. Diluted earnings per share decreased by 26.8% to $0.30 per share from $0.41 per share. Turning to the balance sheet. You'll see that we had a working capital balance of $178.7 million versus $161.2 million at December 31, 2019. Our unrestricted cash totaled $97 million at March 31, 2021. Our current ratio is approximately 3.7:1. Our capital expenditures were $16.4 million for the quarter. We expect capital expenditures for the year to be approximately $70.7 million. The company had stock repurchases of $5.2 million during the 3 months ended March 31, 2021. Shareholders' equity per diluted share is $6.93 at March 31, 2021, compared to $6.67 at December 31, 2020. I'd now like to turn the call back over to our CEO and President, Gary Fields.

Good afternoon. So overall, we're happy with the first quarter performance. It was in line with our expectations. Unsurprisingly, sales were down year-over-year. But compared to fourth quarter, if you'll recall, when we had those announcements, I said that a good benchmark accomplishment for Q1 would be if we essentially duplicated Q4 that was because I have a good visual of the backlog and knew we needed to slow down production. So we slowed the production down. Probably the intentional portion was the longer shutdown around the holidays, and that allowed us to get ahead on some pretty heavy-duty maintenance. But then we had the adverse weather. So we ended up a little bit lower in revenue than what we actually thought we were going to do as a result of that weather shutdown, too. But after the moderation in bookings in the end of 2020, the bookings began to pick up sharply right after the first of the year. Now we did have a price increase that went into effect on January 11. So that's not unusual for January or any time to pick up bookings cadence right ahead of the price increase. But the fact that the bookings increase stayed very robust throughout the quarter told me that it was genuine growth in bookings. Normally, the pull forward from a price increase runs in the range of 30 to 45 days, and then it begins to kind of stabilize and see what the actual run rate is. So I think the number was - our bookings were up around 21%, 22% in Q1 of '21 versus Q1 of '20. That Q1 of '20, bear in mind, was largely unaffected by coronavirus because the virus didn't really start slowing anything down until Q2. And so this is a very…

Correct.

Yes. And $30 million of that is for replacement maintenance, worn out things. Looking across the street today and a beautiful things occurring, we have a crane over there setting new AAON units on our East side factory to be ahead of the curve and keep our employees well-conditioned, and these all have the latest indoor air quality virus mitigation procedures installed in them. Indoor air quality and virus mitigation procedures remain a topic of conversation with every customer that comes in contact today. I think that when ASHRAE published their best practices guidelines last summer and revised it 2 or 3 times with little tweaks, that everyone took notice of that. And so all replacement on new construction, they're at least giving it the credence of thinking what should we be doing. And it looks to me like a great many of these projects that they're including some form, if not all forms, of the best practices for virus mitigation. So we're optimistic heading into the second quarter. We're in the second quarter now. Things are running smoothly. Orders are coming in the door nicely. And we believe that we will be in our best ratios for absorption of overhead. And so where we had said we wanted to manage our gross profit between 28% and 32%, Q1, we were just slightly above that 28%. I believe as we go through second quarter here with better revenue, better production out the door that we'll have better absorption, and therefore, we'll be closer to that bull's eye target of 30% or so. So with that, I'm going to open up the call to any questions.

[Operator Instructions]. And we have our first question from Brent Thielman from D.A. Davidson.

Gary, you talked about the increase in the replacement orders. And I was curious if you had any sense sort of how much of that could be related to the sort of stuff you're just talking about, the air upgrade kind of circulation, medical-related upgrades for systems. Is there any way to tell from that?

It's a little difficult to give a real highly qualified definitive number on that. You can have a sense of what's going on, Brent. And it looks to me like the - we're up 22% on bookings over last year, and I would say that a significant amount of that is attributable to the indoor air quality, the virus mitigation procedures. Because last year, Q1 was a very nice bookings quarter very much within our - what we had anticipated, and it had the normal replacement business for schools. So for this year to be up this substantially in bookings, it really feels like a big part of that accretive bookings number is related to the virus mitigation procedures and people getting on top of that.

Okay. And Gary, I mean, I'm assuming this equipment sort of add more bells and whistles to it in order to meet those sorts of standards. Is there a way for us to think about the average value - or higher average value per unit for something like that to address the sort of things that ASHRAE is talking about?

Well, that's the wonderful thing about the AAON unit is these things are very inexpensive for us to add to our units. What it has done is our units themselves are much more - a much better value to go address these things. So we don't have to do very much at all. So for instance, our units are double-wall steel panel. The interior panel of our unit is solid steel, and it's washable. So you don't get bacterias and viruses attaching to a fiberglass liner like the majority of our competitors have. They don't have a steel liner. And that's inherent in our units from 2 tons all the way up to 240 tons. The next thing is that our fan will overcome the additional pressure drop to these higher-rated filters. While the difference in, say, a MERV 8 filter, which has been the most common filter used up until MERV 13 filter, which is pretty much what everybody is wanting to do, the cost in that filter is insignificant. It's - maybe in a 2-ton unit, it's $20; in a 100-ton unit, maybe it's $300. So it's not significant. But what is significant is that our unit was designed, and its fundamental design was to overcome that additional pressure drop in a very efficient manner. So we can put these filters in. We can have this nice, clean interior that doesn't collect bacteria and virus, and allow it to accumulate. They can clean these units easily. Then when you start putting infrared lights in there, again, you're talking in a 2-ton to 10-ton unit, which a lot of these school units, that's their range. You're talking about $125 on a several thousand-dollar unit. Now the one thing that does cost a little money, and we're not seeing a lot of it, but we're seeing a little bit is the bipolar ionization. That seems to be a small percentage of our customers want the better filtration. They want the lights, and then they want the bipolar. It's a very small percentage that want the bipolar.

Okay. Okay. Obviously, we see what's going on with steel and copper market and other rods out there. It sounds like you guys are getting ahead of it. One question I had was any issues just getting the materials and components you need. It seems like there's a lot of supply chain challenges around that just...

Well, it's an interesting conversation. The Board met for our Audit Committee meeting a couple of days ago, and every one of our Board members was present. Even though they're not all on that committee, they still read into it. And there was a discussion about our inventory levels. Our inventory is running about 15% to 17% of revenue. And if you look back historically, it was closer to 10% of revenue. And they said, "Do we see a time when we might lower that inventory level and get back into that historic ratio?" I mean, I said, "Gentleman and ladies, we're blessed that we have this inventory because it's keeping us from having supply chain issues. We have an abundance of materials in here. We struggled for some small things from time to time, but my purchasing department says that while it's a little extra work, they've not caused us to miss any shipments or commitments for shipments because of that." And so this was kind of a blessing in disguise that we have this. The other thing is, is that my pricing was more stable because we had a lot of these materials bought at a better price. So as things are escalating, the one thing you're proud of is you've got a big inventory of lower-priced materials. So I was able to get my price increase extended out further, June 1, and I won't be buying materials at that higher price until after that price increase actually hits the floor. So we're in real good shape with our supply chain. I'm very proud of this team that we have here and how aggressive they are in doing that. So for us, at this point in time at least, it's not been an issue.

Yes. Very good. Last one for me would just be, Gary, I want to kind of come back to the synopsis of what you're seeing out there in the market, and it seems to be a true reacceleration in orders. I guess, as we sit here today, I mean, it looks like through 2Q, 3Q, I mean, we should see some favorable top line comparisons based on what you can see right now.

Yes. Yes. And Q4 is coming somewhat into focus. Now it's still just a little fuzzy. It's out there far enough, but it's just a little fuzzy. So I don't want to absolutely commit that Q4 is not going to roll over on us. But again, Q4 of '20 was substantially lower than - it kind of resumed that bell curve that we'd had in the past. It was much lower than Q3. I don't have the exact numbers now. Do you remember what the percentage reduction was?

I don't.

Well, anyhow. So again, we're going to have favorable comps going forward. So this Q1 was anticipated to be lower. It's very tough comp with Q1 of '20 because we had such a huge backlog coming into '20. And so we knew this one was going to be tough. We told you folks about it last quarter or even before that. But going forward, I think we'll have some favorable comps, Brent.

We have our next question from Julio Romero from Sidoti.

So I guess, just on that last question, I wanted to just kind of stay on price cost and just thinking about price increases. Can you give us a refresher of maybe how often you reprice in a given year? And do you think it's more likely than not that we see a few more price increases in the third and fourth quarter?

Well, our purchasing group keeps a 6-month forecast a material cost in front of me at all times. So I have a rolling 6 months in front of me at all times. And again, going back to that higher inventory level, that's what allows me to have a good visual on 6 months out. So I can respond quick enough that I can give our sales channel partners very good notice, so that they don't get trapped with bids at a price that they can't afford due to a price increase. So knowing the cadence - all those years I spend on their side of the table, I know the exact cadence of their activity from bid day until they place an order with us. So I try and keep that in mind. And then with our lead times now under very good control, I know exactly how long it takes to get from the date we book an order at the new price to get it on the plant floor. And all of that is inside of the 6 months. So every month, I'm looking at the 6-month outlook on these material costs. If there's any change within the month, then they raise the flag quicker. But otherwise, our normal activity is, once a month, they furnish me an updated report that gives me the next 6 months. So it's a calculus as to how we do this and knowing all of the timing events, then we have this, so that we can do it. What I have as of today doesn't give me any indication for the next 6 months that I would have another price increase. I have the one coming June 1 that covers everything that I know for the next 6 months plus. So because we announced that, what, 2, 3 months ago?

It's the beginning of March.

Beginning of March, so a couple of months ago that we announced that. And so now I've got, let's say, 8 months runway that things are stable with what they told. There's been no changes in our outlook for the last 2 months. Everything that I got on this latest report was captured the same 2 months ago. So to your point, could we see other price increases? As of today, I don't see the necessity for that, but this could easily change if we have another big vessel lodged in the Suez Canal and can't get something here. I mean all kinds of things can happen quickly. But what I'm most proud about this team is that they now have very, very good data points that they utilize to provide the calculus for a necessity for a price increase. So hopefully, that answers your question.

It does, and I appreciate the color. And hopefully, we don't see another blockage in the Suez Canal. But you're right, anything like that could happen. So one other thing you mentioned, I think, is you called out K-12 is something that you're seeing picking up on the new construction side. What about on the replacement side? Is that something that we should pick up in the summertime as some of these schools are out of session? And are you seeing that in your bookings at this point in time?

We are. So K-12 historically for us has been about 50% planned replacement and 50% new. So a lot of these bond issues that we are a beneficiary of, they will do some wing additions to schools to expand the school itself. They'll do some updating modernization of some existing schools, and then they usually throw in building 2 or 3 new schools. So we got an order, and we're really - we're thrilled with this. This particular school district has now been purchasing equipment from us on an annual basis for 13 years straight. They're in North Texas. They purchased 811 units to be installed in '21. And this time, they were about 70% replacement and 30% new construction. And that's what I'm saying, they - it looks like our replacement is a bit higher than our new construction ratio that we were historically seeing. That's only one school district, but I've seen a multitude of others. And I was made aware at this sales conference last week of numerous school districts that had bond issues from last fall until as recently as 2 weeks ago on the - out to the voters. And all of these are being unanimously approved. And the format of a lot of these bond issues is more replacement than new construction. So I think that our favorability of our equipment for that kind of end-user is well recognized. So I believe that our percentage of replacement business versus new construction will continue to grow on the replacement side. Even though this new construction market might be somewhat depressed, we're going to do real well with this replacement. We're already doing real well with it.

Got it. And I guess you talked about you expecting sequentially next quarter's gross margins to be closer to the midpoint of your 28% to 32% targeted range. Is that all kind of related to volume absorption? Or is there any sales mix component?

It's mostly absorption, Julio. It's mostly absorption. I mean you've got depreciation and things that are fixed cost. There's so many fixed costs that now our run rate, if we've added all of this production capability, it comes with a penalty called depreciation. And we just put that new building in service in Longview. That one is hitting us pretty good on that line, and we're yet to recognize the revenue from that new building that it's capable of. Now I will say that the revenue from the Longview manufacturing has continued to grow as a result of the new building and as a result of the efficiency gains that this traveling team from Tulsa has been able to help collaborate with them on. Their latest monthly revenue numbers are up about - give me a quick calculator there. I'll hit this. I'll give you an exact because I know exactly what it is. They got a 21% increase in revenue as a result of the improvement in technique and the improvement of the new building. That's what we've recognized already, 21% over the best month that they've ever had prior to these things occurring. And we believe that there's a whole lot more to be had. Bear in mind, we put over 100% more physical capability in place. Now you got to get the people, you got to get them trained, you got to get them to a level of efficiency. And that's why I say it will take all year long to even approach what we dream is possible there or what we actually know is possible because of how we've done it before.

Got it. And then just last question for me here is just on the SG&A as a percentage of sales, which was expected. I think you called that out on the fourth quarter call, but is that kind of 150, 160 basis points or so increase representative of what we should expect throughout the year?

Well, bear in mind that it could be a higher actual dollar number and will be because of profit sharing, because that's in SG&A and recognized it in Q1. We just issued profit sharing announcement yesterday, and it was lower than any quarter in 2020. And so we're looking for a comparable favorable Q2 versus '20 favorable. And should that occur, then the actual dollar spend on SG&A will be higher. Now as a percent of revenue, I haven't done the math on that.

Yes. I mean I do think it'll be up a little, mainly driven by our insurance premium since those went up $2 million year-over-year. So that will be a driver of our SG&A. Then also looking forward into the second half of the year, as the country opens back up, we anticipate our selling expenses and our travel will increase as well.

Well, I'm proud to say, Rebecca, it's already started because I've had 3 major customer visits this week, and I have one more today. And we haven't had 3 customer visits in 1 week in over a year. And these people are coming in 6, 8, 10 at a time. And of course, we put them in hotels, we take them to dinner, and there's expense with that. On top of the fact that we just had this sales retreat last week. We weren't able to have one in 2020. We had to cancel it.

Right. Right. Our sales expenses in 2020 were extremely low just because we didn't have any of the normal activity that we will this year.

We have our next question from Jon Braatz from Kansas City Capital.

Question, Gary, on the water-source heat pump, when you started with the water-source heat pump, the thought was that you're getting into a market that maybe up to $500 million or something like that. And the hope was to really make - take some share of that. And I think last year, we did about $20 million in revenues in the water-source heat pump. Where do you stand today in terms of market opportunity, market potential of the water-source heat pump? Is it - it just hasn't been, I guess, fulfilling expectations that we maybe had earlier? But where do you stand at this time in terms of what's possible?

Well, I haven't seen a summary of what today's current market dollar volume is. The number of units on AHRI are down a few percentage points. So the dollars have to be down, too. Our number of units has been pretty steady. In fact, this the last month or 2, it's grown just a bit. And so we had validated a little over a 5% market share last year, and I believe we're holding steady at 5-plus now. Could be breaking through 6%. I won't see the final numbers on that for a few more days, but it's still in that mid-single-digit range. It's not the 20% that we believe we were capable of maintaining. Our biggest miss on that business was our marketing intelligence was what do people want. And everyone we were listening to was expert in new construction, and our sales channel just was not expert in replacement. And so we positioned this product very well for new construction. It's very much appreciated. And so we've had that steady business. It grew at a very brisk pace at onetime and then kind of leveled out. And then the new construction market itself went down. And for us to stay steady tells me we're getting an even higher percentage of the new construction business. However, this replacement market, our sales channel partners were not well attuned to that market. And so we put in several support services to help them with that. We've hired 3 people in the last couple of years, 2 of them in the last year that have really - they are expert in the aftermarket business. That's what their whole career has been, the people I've known most of my career and have great respect for them, bringing those resources in to help the sales channel partners develop this. All the sales channel partners are, with very little exception, are dedicated to an aftermarket strategy, and they are putting their resources behind this. And so I believe that when our new product that is designed with the aftermarket in mind, the replacement market, when we get that product introduced to them, I believe we'll resume growth, and we'll catch up relatively quickly to the expectations. So again, we made a mistake there, we admit the mistake. But I'll tell you what, there is no sin in my book for making mistakes. There's a sin in my book, a substantial note of not admitting them and not correcting them. While we've admitted the mistake, we've corrected the mistake, and we're on the cusp of introducing that correction and seeing exactly how well that performs.

Okay. So would that - with those changes, that correction, do you think - as you look back that 20% market penetration, do you think that's still a reasonable possibility?

It's absolutely reasonable. There's nothing changed in my mind on that. And the reason is that the sales channel partners, the commitment they've made and the success that they've had thus far tells me that it's very much in our grasp.

Okay. And then sort of the time line, when do you think we might cease some evidence of that - of those gains?

We're not anticipating having a material impact on the number of units going out the door until Q4. Yes. And that might even be just a little early to be very optimistic about it. But the new product will be available to them in Q4, and there are a lot of them that have said that they want to have an immediate stock in their inventory of that product because they think that's a good investment for them. So we would very likely be building units that we sell to them. We don't inventory them ourselves. We sell those units to them. So we could be filling their stock in Q4, and that's why I think there's a good opportunity to increase our number of units substantially. And then there could be a little low because they stocked all their warehouses. And then they've got to go out there and get their momentum going. So it could be that we have kind of an in rush Q4, a little bit of a low Q1, and then we resume a good, steady pace of business Q2 next year. But I think '22 as a year in whole, if we look at the year '22 in whole, then we can look for some good growth, good solid double-digit percentages of growth like what we had the first 2 or 3 years that we were in this business. I mean the first 3 years, we were like 100% growth year-over-year and then 77% and then 57%. And so we've seen how we can do that and we can supply that. And a major difference now, Jon, is a lot of our early on time was learning how to use this manufacturing facility. Now we've got a few years of using it. This product is a different configuration, but it's not a different manufacturing process.

Okay. When you look at it, I don't know if you can look at it in isolation, is - up until this point, is the water-source heat pump paying its way?

No. That would be foolish to say it was. When I look at it, no, it's not paying its way yet. I mean it is profitable. It's not a loser, but it is not at benchmark margins because we don't have the volume to offset the depreciation cost and the fixed cost of that facility. If we were to double the volume, we would triple the percentage of net profit because a lot of that profit comes at no additional fixed cost expense. And so we are absolutely - we have to double that volume to get these things close to benchmark margin levels. So the good thing about it now is, even though the margin percentage is lower, it's not that big of a volume to where it's that big of a burden. And so we have - and the other thing that I'll point out is when I came here, I had 30 years of experience in the sales channel, and I've been selling AAON since 1990, and I did a pretty good job of it and so did my company. But because we were so mature with our presentation of AAON equipment in the markets that my company was in, I really could visualize what the growth potential for those legacy products was in reference to my experience at my company. Well, as I began consulting for AAON, I began to realize that a substantial number of the sales channel partners were nowhere near that mature in their markets. But I didn't know exactly how that was going to come along. And it's come along very nicely. These - my efforts in consulting back there in '13 to early '16, those have all manifest themselves. The changes that I've made in the sales channel since they came onboard here the first of '16, those manifest themselves. When I first came here, we had 6 regions. And the difference in performance versus expectations was the lowest region was only reaching 65% of expectations, the highest region was about 5% over expectations, okay? Today, the range runs from 122% of expectations to 129% of expectations at this point in time. So it is very much - very uniformed effort and results across all of North America right now. So this sales channel improvement that we have been working on, going all the way back, I mean Norm worked on it before me but I'd put my effort into it starting in 2013, I mean it has paid off. We have a good uniform performing group across North America. And by the way, every one of them is growing. Every one of them.

[Operator Instructions]. There are no follow-up questions at this time. You may continue with the presentation.

Well, I think that's all that we have for today, and we look forward to speaking to you again in August for our second quarter results. And for those of you that would like to attend virtually, I believe that our shareholders' meeting on the 11th has a WebEx capability. And so we would welcome you to that as well. Have a nice time. Thank you very much. Bye-bye.

This concludes today's presentation. Thank you for participating. You may now disconnect.