AAON, Inc.

Good afternoon, ladies and gentlemen, and welcome to the Aon Inc. second quarter of 2024 earnings conference call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question and answer session. If at any time during this call you require immediate assistance, please press star zero for the operator. This call is being recorded on Thursday, August 1st, 2024. I would now like to turn the conference over to Joe Mondillo, Director of Investor Relations. Please go ahead.

Thank you, Operator, and good afternoon, everyone.

The press release announcing our second quarter financial results was issued after market closed today and can be found on our corporate website, aaon.com. The call today is accompanied with a presentation that you can also find on our website, as well as on the Listen Only webcast. Joining me on today's call is Gary Field, CEO, Matt Tobolsky, President and COO, and Rebecca Thompson, CFO and Treasurer. Please turn to slide 2. We begin with our customary forward-looking statement policy. During the call, any statement presented dealing with information that is not historical is considered forward-looking and made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995, the Securities Act of 1933, and the Securities and Exchange Act of 1934. Each is amended. As such, it is subject to the occurrence of many events outside of AN's control, and that could cause AN's results to differ materially from those anticipated. You are all aware of the inherent difficulties, risks, and uncertainties in making predictive statements. Our press release in Form 10-Q that we filed this afternoon details some of the important risk factors that may cause our actual results to differ from those in our predictions. Please note that we do not have the duty to update our forward-looking statements. Our press release and portions of today's call use non-GAAP financial measures as defined in Regulation G. You can find the related reconciliations to GAAP measures in our press release and presentation. With that, I will turn the call over to Gary.

Good afternoon. Starting on slide three, our second quarter performance exceeded expectations. Production issues from the first quarter were largely resolved, leading to increased volume output and productivity across all three segments. This resulted in record sales, earnings, and backlog. The basic segment had an exceptional quarter. Net sales at this segment were up 58.3% from one year ago and 103.7% compared to the first quarter. This is especially notable considering that the reconfiguration of the production layout within the Redmond, Oregon facility, which disrupted operations in Q1, continued into Q2. The growth at BASICS has been largely fueled by the data center market. Sales of our BASICS branded data center equipment produced at both our Oregon and Texas facilities were up year over year 142.4%. We stated on our Q1 call that data center sales made up approximately 10% of total net sales for 2023 and about 20% of bookings. In the first half of this year, sales in this market made up 10.5%, and in Q2, it was 13.7%. In our packaged rooftop business, which makes up most of the Aon, Oklahoma segment, we are continuing to realize growth, but at a moderated rate compared to the last couple of years. Considering our volume was up 48.7% over the last two calendar years, along with the softening micro conditions and disruptions related to the refrigerant transition, we are pleased with the performance. All of these factors make for a difficult operating environment as well. Near term visibility is more limited than was the case over the last few years, and week to week orders are volatile. This makes production planning much more difficult. Despite this, the operations team has been performing exceptionally well. Total company backlog at the end of the quarter was a record $650 million, up sequentially for a third straight quarter. Compared to a year ago, backlog was up 23.5%, and relative to the end of the first quarter, it was up 16.4%. The increase was largely driven by the basic segment and the data center markets. With that, I'll now hand it over to Matt Tobolsky, who will speak more in depth about our operational strategy.

Thank you, Gary. Please turn to slide four. The second quarter was an excellent quarter for the company. Many of the issues that weighed in our performance in Q1 were resolved, allowing for higher volumes and greater productivity. That said, the quarter did not go without its own challenges, which put the overall performance into an even brighter light. The disruptions related to reconfiguring the layout of BASIC's facility in Oregon continued into Q2. Equipment was still being rearranged, and the outsourcing of parts we would otherwise produce in-house was necessary. As a result, while productivity improved from Q1, there was room for continued improvement. Despite these challenges, this segment posted record sales and record gross profit. Most of the heavy lifting and temporary disruptions related to the production layout reconfiguration and capacity expansion is behind us. We expect the new capacity will be up and running by the end of the third quarter, positioning BASICS for robust growth and improved margins in the second half of the year, driven by increased throughput and operational efficiency. BASICS has a strong backlog entering the back half of the year and upbeat fundamentals amongst the data center market. Furthermore, beyond what is in the backlog at BASICS is a robust pipeline of data center projects in which we are heavily engaged and are optimistic we'll be able to convert into bookings. I will note the timing of backlog conversion at this segment is weighted more to Q4 and beyond than it is in Q3. This brings me to the Aon coil product segment, which is increasingly becoming an extension of BASICS in a manufacturer of data center cooling equipment. Similar to BASICS, this segment finished the quarter with a strong backlog and a robust pipeline of future opportunities within the data center vertical. In fact, Just last week, we landed a large liquid cooling order that increased the segment's backlog by over 50%. This order is associated with a large data center company and is the first tranche of a multi-phase, multi-year project. We are extremely excited where this business is headed. Like Basics, the capacity expansion project of this segment is on schedule and is expected to be finished by year-end, with production expected to commence early next year. The new space is allocated to basics-branded data center products and will add an incremental 245,000 square feet of manufacturing capacity, an increase in dislocation of roughly 50%. This will help absorb the immense growth we foresee in the data center market for both airside and liquid cooling projects. It will also help improve productivity. In fact, we've already begun to see this. In the second quarter, gross margin of the segment was 41.9%, up from 24.9%, And in the first half of the year, gross margin was 38.3%, up from 23.1% in the first half of 2023. Finally, the Aon Oklahoma segment's performance from an operational perspective was also outstanding, particularly considering the softening construction environment and disruptions related to the new refrigerant regulations. Over the last couple of years, our Tulsa, Oklahoma manufacturing facility has transformed into what I described as a well-oiled machine. The engineering team has never been stronger, and manufacturing is as precise and efficient as it has ever been. The costs this business is facing when compared to the last couple of years are very tough, and yet we've been able to maintain volumes comparable to a year ago. Furthermore, as I stated, the macro environment has become more challenging, and the new refrigerant transition has created disruption. As a result, bookings have been unusually volatile this year from a week-to-week and month-to-month perspective. Bookings as a segment through the first half of the year are up from a year ago, but the increased volatility introduces challenges when it comes to production planning. All that considered, the operational performance has been superb. As for the back half of the year, the operations team will have to remain nimble. While we still think demand will increase somewhat ahead of our phase-out dates of our 410A refrigerant equipment later this year, our visibility is limited. A positive thing we have going for us is our lead times are still an industry best, which means we can likely expect orders for our fourth NA equipment later than most of our competitors. If we do see an increase in near-term demand, this could position us to have a strong finish through Q4. It is important to note that this scenario could also result in a soft order book in Q4, which would result in a slow start to 2025. At this point in time, we're unsure exactly how it will play out, but the bottom line is that we expect continued volatility in the near term, and we are confident we will manage through it better than most. Looking to next year, we've been producing R-54B equipment longer than any of our competitors. That means we are best prepared when it comes to inventory and production. Additionally, for us, the cost of manufacturing new refrigerant equipment versus our old refrigerant equipment is not changing at all, potentially giving us an edge as some of our competition has messaged increasing costs associated with their new refrigerant equipment. Regardless, We are already more cost competitive than we were years ago as the price premium of our higher quality equipment is the narrowest it has ever been. Beyond product evolution associated with the refrigerant transition, we continue to lead the industry in innovation and are well ahead of anyone in the development of cold climate air source heat pumps. Sales of our traditional heat pumps continue to outperform overall Aon Oklahoma sales in Q2, and sales of our cold climate heat pumps outperform traditional heat pump sales. Overall, While the near-term sales of heat pumps may be volatile, we're very optimistic regarding the medium to long-term. With that, I will hand it off to Rebecca to walk you through financials.

Thank you, Matt. Please turn to slide five. Net sales increased 10.4% to $213.6 million from $284 million in the second quarter of 2023. The year-over-year growth was largely driven by the basic segment, which realized an increase in net sales by 58.3%, a majority of which was spurred by sales related to the data center cooling solutions. Sales at Aon Oklahoma and Aon Coil product segments grew 3.4% and 4.3% respectively. Moving to slide six, gross profit increased 20.3% to $113.1 million from $94 million. As a percentage of sales, gross profit was 36.1% compared to 33.1% in the second quarter of 2023. The realization of price increases, along with the slowing of inflation for raw materials at the Aon Oklahoma and Aon Coil product segments, improved overall consolidated margin performance. Please turn to slide 7. Selling, general, and administrative expenses increased 16.9% to $45.9 million from $39.3 million in the second quarter of 2023. As a percent of sales, SG&A increased to 14.6% from 13.8%. The increase relative to sales is primarily attributable to an increase in investments made in technology, professional and legal fees, increased travel and consulting expenses. Moving to slide eight, diluted earnings per share was 62 cents, up 12.7% from a year ago. Our tax rate in the quarter was 22.1%. The company's estimated annual effective tax rate, excluding discrete events, is expected to be approximately 25%. Turning to slide nine, our balance sheet remains strong, with a current ratio of 3.0. Cash, cash equivalents, and restricted cash totaled 12.1 million on June 30, 2024, and debt at the end of the quarter was 85.9 million. Our leverage ratio was 0.3 times. Year-to-date, cash flow from operations was 127.9 million, up from 59.9 million in the comparable period a year ago. Capital expenditures for the first half of the year, including expenditures related to software development, increased 24.4% to $75.4 million. During the quarter, we also repurchased $100 million of shares outstanding, reflecting our confidence in the long-term prospects of the company and our commitment to delivering value to our shareholders. The combination of the capital investments and share repurchases led us to draw down on our revolving line of credit. We anticipate paying just over half of that off by the end of the year. All in, our financial position is strong, giving us flexibility and allowing us to continue to fully focus on growth opportunities. With that, I'd now like to turn the call back over to Gary.

Please turn to slide 10. We feel really good about our current position. The growth of the Aon Oklahoma segment in the first half of the year was below our expected targets, but I want to remind everyone that the volume of equipment at this segment was up 48.7% from 2021 to 2023. That type of volume growth is unheard of for this industry. Furthermore, we've been operating all year with normal lead times and a lean backlog in this segment. That's far different than some of our competition who are still trying to catch up, since the peak of the supply chain issues. All considered, including the slowing microenvironment and disruptions from the refrigerant transition, the fact we have maintained comparable volumes to a year ago is terrific. The bottom line is we have the highest quality package rooftop equipment in the industry, currently selling for the smallest price premium in our history. Our sales channel continues to strengthen, and we are leading in innovation. If recent commentary coming from our competition regarding their cost of manufacturing the new refrigerant equipment is accurate, we're going to be in an even more advantageous position than we already are today. Either way, our package rooftop business is in great shape, and we expect growth will accelerate next year when some of these external issues are behind us. Matt spoke at length regarding data center opportunities at both basics and Aoncoil product segments. But I just want to add one comment and stress another that he mentioned. First, we are in the early stages of this cycle. The big increase in CapEx plans that our customers have announced occurred in 2024 through 2026. We are just scratching the surface. This is why we continue to speak to this pipeline of opportunity

Beyond what is already in our . Which is the content I want . for the smallest price premium in our history. Our sales channel continues to strengthen and we are leading in innovation. Recent commentary coming from our competition regarding their cost of manufacturing equipment is accurate we're going to be even more advantageous position than we already are Either way, our package of top business is in great shape, and we expect growth will accelerate next year when some of these external issues are behind us.

Matt spoke at length regarding data center opportunities at both basics and AonCorp product segments. But I just want to add one comment and stress another that needs to be mentioned.

First, we are in the early stages of this cycle. The big increase in CapEx plans that our customers have announced occurred in 2020 through 2026.

We are just scratching the surface. This is why we continue to speak to this pipeline of opportunity beyond what is already in our backlog, which is the comment I want to stress. I always say nothing is a guarantee until it makes it last year, but not enough to press on very hard. But the data center bookings have been tremendous. We'll have a little bit of a struggle to get any of it built in Q3 for any material amount because of both getting parts and pieces in and getting production facilities ready to go. The production facilities are coming along nicely and on schedule, as we said in the earlier part of the call.

Got it. That's helpful. And in terms of, you know, both Oregon and Texas, it sounds like you're getting there.

Did you say earlier in the call that you're talking about increasing data center capacity even further beyond that? Because of the pipeline of the work and the backlog of the work. COMPASSION. Sure. We'll have a little. material amount because of both getting parts and pieces in and getting production facilities ready to go. The production facilities are coming along as we said.

Got it. That's helpful. And in terms of both Oregon and Texas, it sounds like you're getting there. Did you say earlier in the call that you're talking about increasing data center capacity even further beyond that, or did I

and even shipments January 1st.

Right. But you also make R410A, so you could, if that's what the market wants and the rest of the year, you could make that.

We can throughout 2024. Then it becomes kind of a cat and mouse game. You know, if you anticipate a certain number of orders and you have inventory of parts for that and you have a staffing for run rates, that will allow you to build it before December 31st, wonderful. But then you're going to have to determine exactly when that cutoff is in order to not put at risk the ability to build it before December 31st.

for December 31st. So we've published that table of when we're cutting off certain products. We already, our longest lead product Certainly Q3 is not going to be showing a huge but really market really reflecting that single order we mentioned kind of after quarter close. throughout 2024, then it becomes kind of a cat and mouse game. You know, if you anticipate a certain number of orders, you have inventory of parts for run rates that will allow you to build it before December 31st, wonderful.

But then you're going to have to determine exactly when that cutoff is in order to not put at risk the ability to produce it before December 31st. So we've published that table of when we're cutting off certain products.

We already, our longest lead product is open. Hey, thanks.

Good evening, all. Gary, I want to come back just to the expectations through the rest of the year. It sounds like... essentially all the growth is being driven by the ramp-up at basics and kind of the data center product.

Can you help me kind of flesh out how you're thinking about the rooftop business from a sales perspective over the next couple of quarters? Because it sounds like maybe you think you'll have some wind over there. It's going to have . Thank you. Custom engineers. Custom engineers.

percentage of revenue coming out of Longview driven by data centers in the latter half of this year. So there's definitely a lot of activity in conversion.

Very good. Thank you.

Your next question comes from Timothy Voges with Baird. Your line is open.

Hi, everybody. Good afternoon.

Good afternoon.

Hey, Gary, just on the, you know, the orders in the backlog, I was just kind of curious if you could give us a little bit of, you know, kind of added color on, you know, what you're seeing on the data center side. It sounds like it's several, you know, orders, but I guess I want to kind of confirm that and just, you know, maybe what parts of the business or what products are you seeing, you know, some of the bookings and the backlog kind of grow in?

Yeah, with regards to the data center portion, it is multiple customers.

Many of these customers have been on board with this for a while, and we've increased activity and conversion Well, those are great questions, and we did discuss them. Hi, everybody. Good afternoon. Hey, Gary, just on the, you know, the order in the backlog, I was just kind of curious if you could give us a little bit of, you know, kind of added on what you're seeing on the data center side.

It sounds like several orders, but I guess I want to kind of confirm that and just you know, maybe what parts of the business or what products are you seeing, you know, some of the bookings and the backlog kind of growing?

Yeah, with regards to the data center portion, it is multiple customers. Many of these customers have been on board with this for a good while. And as we've increased our production capabilities, if if we want to keep our margins we need to keep the run rate up there where it's at now or or grow the run rate that takes care of a lot of the fixed cost and keeps that margin where it's at so all of that looks real good for us

If we are a premium to these people now, which we are, and they go up 8%. any of these . On a. you

So we still have air side cooling in combination with liquid cooling for a variety of ancillary equipment. And so the overall kind of project opportunity for us continues to evolve and get larger from a central pricing standpoint. And then just on the margin side, you know, it's a comparable margin to what we're doing today. So it's what we're selling at today. It's not markedly different from kind of a margin expectation perspective.

Okay. Matt, thank you very much. Appreciate the color. Of course.

There are no further questions at this time. Joe Mandillo, please continue.

All right.

I'd like to thank everyone for joining on today's call. days and weeks, please feel free to reach out to myself. Have a great rest of the day. We look forward to speaking