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AAON, INC. - Quarter Report: 2019 September (Form 10-Q)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2019
or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________________ to ____________________
 
Commission file number:  0-18953
AAON, INC.
(Exact name of registrant as specified in its charter) 
Nevada87-0448736
(State or other jurisdiction(IRS Employer
of incorporation or organization)Identification No.)
2425 South Yukon Ave.,Tulsa,Oklahoma74107
(Address of principal executive offices) (Zip Code)
(918) 583-2266
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes                                   No 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes                                   No                                
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of "large accelerated filer", "accelerated filer", "small reporting company", and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
Accelerated filer
Non-accelerated filerSmaller reporting company
Emerging growth company

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
                                                   
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes                                   No 

Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Common StockAAONNASDAQ

As of October 29, 2019, registrant had outstanding a total of 52,097,581 shares of its $.004 par value Common Stock.



PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.
AAON, Inc. and Subsidiaries
Consolidated Balance Sheets
(Unaudited)
 September 30, 2019December 31, 2018
Assets(in thousands, except share and per share data)
Current assets:  
Cash and cash equivalents$28,373  $1,994  
Accounts receivable, net56,083  54,078  
Income tax receivable3,870  6,104  
Note receivable28  27  
Inventories, net80,623  77,612  
Prepaid expenses and other1,559  1,046  
Total current assets170,536  140,861  
Property, plant and equipment:  
Land3,274  3,114  
Buildings99,705  97,393  
Machinery and equipment230,806  212,779  
Furniture and fixtures17,310  16,597  
Total property, plant and equipment351,095  329,883  
Less:  Accumulated depreciation175,357  166,880  
Property, plant and equipment, net175,738  163,003  
Intangible assets, net331  506  
Goodwill3,229  3,229  
Right of use assets1,724  —  
Note receivable594  598  
Total assets$352,152  $308,197  
Liabilities and Stockholders' Equity  
Current liabilities:  
Revolving credit facility$—  $—  
Accounts payable11,118  10,616  
Accrued liabilities42,764  37,455  
Total current liabilities53,882  48,071  
Deferred tax liabilities15,034  10,826  
Other long-term liabilities3,669  1,801  
Commitments and contingencies
Stockholders' equity:  
Preferred stock, $.001 par value, 5,000,000 shares authorized, no shares issued
—  —  
Common stock, $.004 par value, 100,000,000 shares authorized, 52,119,295 and 51,991,242 issued and outstanding at September 30, 2019 and December 31, 2018, respectively
209  208  
Additional paid-in capital2,680  —  
Retained earnings276,678  247,291  
Total stockholders' equity279,567  247,499  
Total liabilities and stockholders' equity$352,152  $308,197  

The accompanying notes are an integral part of these consolidated financial statements.

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AAON, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
 Three Months Ended 
 September 30,
Nine Months Ended 
 September 30,
 2019201820192018
(in thousands, except share and per share data) 
Net sales$113,500  $112,937  $346,759  $321,607  
Cost of sales86,115  80,174  263,406  245,869  
Gross profit27,385  32,763  83,353  75,738  
Selling, general and administrative expenses12,994  13,190  37,476  36,495  
Loss (gain) on disposal of assets  296  (9) 
Income from operations14,385  19,571  45,581  39,252  
Interest income, net 36  49  171  
Other (expense) income, net(7)  (16) 11  
Income before taxes14,387  19,612  45,614  39,434  
Income tax provision560  5,527  7,924  9,398  
Net income$13,827  $14,085  $37,690  $30,036  
Earnings per share:  
Basic$0.27  $0.27  $0.72  $0.57  
Diluted$0.26  $0.27  $0.72  $0.57  
Cash dividends declared per common share:$—  $—  $0.16  $0.16  
Weighted average shares outstanding:  
Basic52,111,444  52,238,796  52,086,209  52,315,719  
Diluted52,722,127  52,627,541  52,624,583  52,715,390  
 
The accompanying notes are an integral part of these consolidated financial statements.

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AAON, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
(Unaudited)
Nine Months Ended September 30, 2019
 Common StockPaid-inRetained 
SharesAmountCapitalEarningsTotal
 (in thousands)
Balances at December 31, 201851,991  $208  $—  $247,291  $247,499  
Net income—  —  —  37,690  37,690  
Stock options exercised and restricted494   11,281  —  11,283  
stock awards granted     
Share-based compensation—  —  7,858  —  7,858  
Stock repurchased and retired(366) (1) (16,459) —  (16,460) 
Dividends—  —  —  (8,303) (8,303) 
Balances at September 30, 201952,119  $209  $2,680  $276,678  $279,567  
Three Months Ended September 30, 2019
Common StockPaid-inRetained
SharesAmountCapitalEarningsTotal
(in thousands)
Balances at June 30, 201952,118  $209  $1,586  $262,774  $264,569  
Net income—  —  —  13,827  13,827  
Stock options exercised and restricted110  —  3,598  —  3,598  
stock awards granted
Share-based compensation—  —  2,785  —  2,785  
Stock repurchased and retired(109) —  (5,289) —  (5,289) 
Dividends—  —  —  77  77  
Balances at September 30, 201952,119  $209  $2,680  $276,678  $279,567  
Nine Months Ended September 30, 2018
Common StockPaid-inRetained
SharesAmountCapitalEarningsTotal
(in thousands)
Balance at December 31, 201752,422  $210  $—  $237,016  $237,226  
Net income—  —  —  30,036  30,036  
Stock options exercised and restricted301   3,503  —  3,504  
stock awards granted
Share-based compensation—  —  5,614  —  5,614  
Stock repurchased and retired(513) (2) (9,117) (9,241) (18,360) 
Dividends—  —  —  (8,391) (8,391) 
Balances at September 30, 201852,210  $209  $—  $249,420  $249,629  
Three Months Ended September 30, 2018
Common StockPaid-inRetained
SharesAmountCapitalEarningsTotal
(in thousands)
Balances at June 30, 201852,290  $209  $—  $238,228  $238,437  
Net income—  —  —  14,085  14,085  
Stock options exercised and restricted75  —  1,205  —  1,205  
stock awards granted
Share-based compensation—  —  1,915  —  1,915  
Stock repurchased and retired(155) —  (3,120) (2,893) (6,013) 
Balances at September 30, 201852,210  $209  $—  $249,420  $249,629  

The accompanying notes are an integral part of these consolidated financial statements.

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AAON, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
 Nine Months Ended 
 September 30,
 20192018
Operating Activities(in thousands)
Net income$37,690  $30,036  
Adjustments to reconcile net income to net cash provided by operating activities:  
Depreciation and amortization17,627  12,865  
Amortization of bond premiums—  11  
Provision for losses on accounts receivable, net of adjustments91  67  
Provision for excess and obsolete inventories1,003  55  
Share-based compensation7,858  5,614  
Loss (gain) on disposition of assets296  (9) 
Foreign currency transaction gain(17) (20) 
Interest income on note receivable(19) 27  
Deferred income taxes4,208  864  
Changes in assets and liabilities:  
Accounts receivable(2,096) 146  
Income taxes2,234  (649) 
Inventories(4,014) (7,071) 
Prepaid expenses and other(513) (792) 
Accounts payable782  4,328  
Deferred revenue263  (1,644) 
Accrued liabilities5,190  364  
Net cash provided by operating activities70,583  44,192  
Investing Activities  
Capital expenditures(30,831) (34,328) 
Cash paid in business combination—  (6,377) 
Proceeds from sale of property, plant and equipment68  11  
Investment in certificates of deposits(6,000) (7,200) 
Maturities of certificates of deposits6,000  7,920  
Purchases of investments held to maturity—  (9,001) 
Maturities of investments—  13,320  
Proceeds from called investments—  495  
Principal payments from note receivable39  32  
Net cash used in investing activities(30,724) (35,128) 
Financing Activities  
Stock options exercised11,283  3,504  
Repurchase of stock(15,437) (17,500) 
Employee taxes paid by withholding shares(1,023) (860) 
Cash dividends paid to stockholders(8,303) (8,400) 
Net cash used in financing activities(13,480) (23,256) 
Net increase (decrease) in cash and cash equivalents26,379  (14,192) 
Cash and cash equivalents, beginning of period1,994  21,457  
Cash and cash equivalents, end of period$28,373  $7,265  

The accompanying notes are an integral part of these consolidated financial statements.
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AAON, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements
(Unaudited)

1. General

Basis of Presentation
 
The accompanying unaudited consolidated financial statements of AAON, Inc., a Nevada corporation, and our operating subsidiaries, all of which are wholly-owned, (collectively, the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (“SEC”). These financial statements have not been audited by the Company's independent registered public accounting firm, except that the consolidated balance sheet at December 31, 2018 is derived from audited consolidated financial statements. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. The financial statements reflect all adjustments (all of which are of a normal recurring nature) which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. Interim results are not necessarily indicative of the results that may be expected for a full year. Certain disclosures have been condensed in or omitted from these consolidated financial statements. The accompanying unaudited financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018. All intercompany balances and transactions have been eliminated in consolidation.
 
We are engaged in the engineering, manufacturing, marketing and sale of air conditioning and heating equipment consisting of standard, semi-custom and custom rooftop units, chillers, packaged outdoor mechanical rooms, air handling units, makeup air units, energy recovery units, condensing units, geothermal/water-source heat pumps, coils and controls.
 
Use of Estimates
 
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Because these estimates and assumptions require significant judgment, actual results could differ from those estimates and could have a significant impact on our results of operations, financial position and cash flows. We reevaluate our estimates and assumptions as needed, but at a minimum on a quarterly basis. The most significant estimates include, but are not limited to, the fair-value of acquisitions, inventory reserves, warranty accrual, worker's compensation accrual, medical insurance accrual, income taxes and share-based compensation. Actual results could differ materially from those estimates.
 
Accounting Policies
 
A comprehensive discussion of our critical accounting policies and management estimates is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2018.

Business Combinations

We record the assets acquired and liabilities assumed in a business combination at their acquisition date fair values.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. Fair value is based upon assumptions that market participants would use when pricing an asset or liability. We use the following fair value hierarchy, which prioritizes valuation technique inputs used to measure fair value into three broad levels:

Level 1: Quoted prices in active markets for identical assets and liabilities that we have the ability to access at the measurement date.
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Level 2: Inputs (other than quoted prices included within Level 1) that are either directly or indirectly observable for the asset or liability, including (i) quoted prices for similar assets or liabilities in active markets, (ii) quoted prices for identical or similar assets or liabilities in inactive markets, (iii) inputs other than quoted prices that are observable for the asset or liability, and (iv) inputs that are derived from observable market data by correlation or other means.
Level 3: Unobservable inputs for the asset or liability including situations where there is little, if any, market activity for the asset or liability. Items categorized in Level 3 include the estimated business combination fair values of property, plant and equipment, intangible assets and goodwill.

The fair value hierarchy gives the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable inputs (Level 3). In some cases, the inputs used to measure fair value might fall into different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to a fair value measurement requires judgment, considering factors specific to the asset or liability.

Intangible Assets

Our intangible assets include various trademarks, service marks and technical knowledge acquired in our February 2018 business combination (see Note 3). We amortize our intangible assets on a straight-line basis over the estimated useful lives of the assets. We evaluate the carrying value of our amortizable intangible assets for potential impairment when events and circumstances warrant such a review. 

Goodwill

Goodwill represents the excess of the consideration paid for the acquired businesses over the fair value of the individual assets acquired, net of liabilities assumed.  Goodwill at September 30, 2019 is deductible for income tax purposes. Goodwill is not amortized, but instead is evaluated for impairment at least annually. We perform our annual assessment of impairment during the fourth quarter of our fiscal year, and more frequently if circumstances warrant.

Recent Accounting Pronouncements

Changes to U.S. GAAP are established by the Financial Accounting Standards Board ("FASB") in the form of Accounting Standards Updates ("ASUs") to the FASB's Accounting Standards Codification ("ASC").

We consider the applicability and impact of all ASUs. ASUs not listed below were assessed and determined to be either not applicable or are expected to have minimal impact on our consolidated financial statements and notes thereto.

In August 2018, the FASB issued ASU 2018-13, Fair Value Measurements: Changes to the Disclosure Requirement for Fair Value Measurements. The ASU includes additional disclosure requirements for unrealized gains and losses for Level 3 fair value measurement and significant observable inputs used to develop Level 3 fair value measurements. The ASU is effective for the Company beginning after December 15, 2019. We do not expect ASU 2018-13 will have a material effect on our consolidated financial statements and notes thereto.


2.  Revenue Recognition
 
On January 1, 2018, we adopted the new accounting standard FASB ASC 606, Revenue from Contracts with Customers, and all the related amendments to all contracts using the retrospective method. The impact at adoption was not material to the consolidated financial statements. The new accounting policy provides results substantially consistent with prior revenue recognition policies.

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Disaggregated net sales by major source:
Three months ended 
 September 30,
Nine months ended 
 September 30,
2019201820192018
(in thousands)
Rooftop Units$78,432  $86,498  $255,532  $244,978  
Condensing Units4,416  5,356  13,622  14,492  
Air Handlers6,523  5,686  18,150  17,479  
Outdoor Mechanical Rooms181  311  1,488  2,178  
Water Source Heat Pumps8,751  3,112  21,417  10,240  
Part Sales10,313  5,030  25,602  17,692  
Other4,884  6,944  10,948  14,548  
Net Sales
$113,500  $112,937  $346,759  $321,607  

Disaggregated units sold by major source:
Three months ended 
 September 30,
Nine months ended 
 September 30,
2019201820192018
Rooftop Units3,520  4,053  11,079  11,696  
Condensing Units418  611  1,291  1,647  
Air Handlers552  713  1,669  2,067  
Outdoor Mechanical Rooms  28  35  
Water Source Heat Pumps1,311  1,162  5,977  3,780  
Total Units
5,808  6,547  20,044  19,225  

The Company recognizes revenue when it satisfies the performance obligation in its contracts. Most of the Company’s products are highly customized, cannot be resold to other customers and the cost of rework to be resold is not economical. The Company has a formal cancellation policy and generally does not accept returns on these units. As a result, many of the Company’s products do not have an alternative use and therefore, for these products we recognize revenue over the time it takes to produce the unit. For all other products that are part sales or standardized units, we satisfy the performance obligation when the title and risk of ownership pass to the customer, generally at time of shipment. Final sales prices are fixed based on purchase orders. Sales allowances and customer incentives are treated as reductions to sales and are provided for based on historical experiences and current estimates. Sales of our products are moderately seasonal with the peak period being July - November of each year.

In addition, the Company presents revenues net of sales tax and net of certain payments to our independent manufacturer representatives (“Representatives”). Representatives are national companies that are in the business of providing HVAC units and other related products and services to customers. The end user customer orders a bundled group of products and services from the Representative and expects the Representative to fulfill the order. Only after the specifications are agreed to by the Representative and the customer, and the decision is made to use an AAON HVAC unit, will we receive notice of the order. We establish the amount we must receive for our HVAC unit (“minimum sales price”), but do not control the total order price that is negotiated by the Representative with the end user customer.

We are responsible for billings and collections resulting from all sales transactions, including those initiated by our Representatives. The Representatives submit the total order price to us for invoicing and collection. The total order price includes our minimum sales price and an additional amount which may include both the Representatives’ fee and amounts due for additional products and services required by the customer. These additional products and services may include controls purchased from another manufacturer to operate the unit, start-up services, and curbs for supporting the unit (“Third Party Products”). All are associated with the purchase of a HVAC unit but may be provided by the Representative or another third party. The Company is under no obligation related to Third Party Products.

The Representatives’ fee and Third Party Products amounts (“Due to Representatives”) are paid only after all amounts associated with the order are collected from the customer. The amount of payments to our Representatives were $12.7 million and $11.7 million for the three months ended September 30, 2019 and 2018, respectively and $34.4 million and $36.6 million for the nine months ended September 30, 2019 and 2018, respectively.

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The Company also sells extended warranties on parts for various lengths of time ranging from six months to 10 years. Revenue for these separately priced warranties is deferred and recognized on a straight-line basis over the separately priced warranty period.
 
3. Business Combination

On February 28, 2018, we closed on the purchase of substantially all of the assets of WattMaster Controls, Inc., (“WattMaster”). The assets acquired consisted primarily of intellectual property, receivables, inventory and fixed assets. The Company also hired substantially all of the WattMaster employees. These assets and workforce have allowed us to accelerate the development of our own electronic controllers for air distribution systems.  We funded the business combination with available cash of $6.0 million. We paid the final working capital settlement of $0.4 million with available cash in May 2018. We have included the results of WattMaster's operations in our consolidated financial statements beginning March 1, 2018.   
 
The following table presents the allocation of the consideration paid to the assets acquired and liabilities assumed, based on their fair values, in the acquisition of WattMaster described above:
(in thousands)
Accounts receivable$1,082  
Inventories1,380  
Property, plant and equipment340  
Intellectual property700  
Goodwill3,229  
Assumed current liabilities(354) 
     Consideration paid
$6,377  

Goodwill represents the excess of the consideration paid for the acquired businesses over the fair value of the individual assets acquired, net of liabilities assumed. Goodwill represents a premium paid to acquire the skilled workforce of the business acquired and is deductible for federal income tax purposes.

4.  Leases
 
We adopted ASU No. 2016-02, Leases (Topic 842), as amended, as of January 1, 2019, using the transition method, which becomes effective upon the date of adoption. The transition method allows entities to initially apply the new leases standard at the adoption date (January 1, 2019) and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. In addition, we elected the package of practical expedients permitted under the transition guidance within the new standard, which among other things, allowed us to carry forward the historical lease classification. We have also elected the short-term lease measurement and recognition exemption which does not require balance sheet presentation for short-term leases. The Company historically does not enter into numerous or material lease agreements to support its manufacturing operations. Furthermore, any lease agreements entered into are usually less than a year and for leases on non material assets such as warehouse vehicles and office equipment. 

Adoption of the new standard resulted in the recording of additional lease right of use assets and lease liabilities of approximately $1.8 million as of January 1, 2019, which mostly relates to the multi-year facility lease assumed in the 2018 WattMaster acquisition. The cumulative-effect adjustment to the opening balance was immaterial to the consolidated financial statements as a whole. The standard did not materially impact our consolidated net earnings or cash flows. 


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5.  Accounts Receivable

Accounts receivable and the related allowance for doubtful accounts are as follows:
 
 September 30,
2019
December 31, 2018
 (in thousands)
Accounts receivable$56,436  $54,342  
Less:  Allowance for doubtful accounts(353) (264) 
Total, net
$56,083  $54,078  
 
 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
Allowance for doubtful accounts:(in thousands)
Balance, beginning of period$392  $208  $264  $119  
Provisions for losses on accounts receivables, net of adjustments(37) (31) 91  67  
Accounts receivable written off, net of recoveries
(2) —  (2) (9) 
Balance, end of period$353  $177  $353  $177  
 
6.  Inventories

Inventories are valued at the lower of cost or net realizable value. Cost is determined by the first-in, first-out (“FIFO”) method. We establish an allowance for excess and obsolete inventories based on product line changes, the feasibility of substituting parts and the need for supply and replacement parts.

The components of inventories are as follows:
 September 30,
2019
December 31, 2018
 (in thousands)
Raw materials$74,950  $67,995  
Work in process2,271  4,060  
Finished goods5,602  6,767  
Total, gross
82,823  78,822  
Less:  Allowance for excess and obsolete inventories(2,200) (1,210) 
Total, net
$80,623  $77,612  
 
The related changes in the allowance for excess and obsolete inventories account are as follows:
  Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
Allowance for excess and obsolete inventories:(in thousands)
Balance, beginning of period$2,350  $1,407  $1,210  $1,118  
Provisions for excess and obsolete inventories(150) (263) 1,003  55  
Inventories written off—  (30) (13) (59) 
Balance, end of period$2,200  $1,114  $2,200  $1,114  


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7.  Intangible Assets

Our intangible assets consist of the following:

September 30,
2019
December 31, 2018
(in thousands)
Intellectual property$700  $700  
Less: Accumulated amortization(369) (194) 
       Total, net$331  $506  

Amortization expense recorded in cost of sales is as follows:

  Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
(in thousands)
Amortization expense$58  $58  $175  $136  


8.  Supplemental Cash Flow Information
 
 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
Supplemental disclosures:(in thousands)
Interest paid$—  $—  $—  $ 
Income taxes paid$1,116  $2,500  $1,510  $9,183  
Non-cash investing and financing activities:  
Non-cash capital expenditures$(116) $1,159  $(280) $288  
 
9.  Warranties

The Company has warranties with various terms ranging from 18 months for parts to 25 years for certain heat exchangers. The Company has an obligation to replace parts if conditions under the warranty are met. A provision is made for estimated warranty costs at the time the related products are sold based upon the warranty period, historical trends, new products and any known identifiable warranty issues.  

Changes in the warranty accrual are as follows:
 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
Warranty accrual:(in thousands)
Balance, beginning of period$11,666  $11,458  $11,421  $10,483  
Payments made(2,023) (2,355) (5,200) (6,078) 
Provisions2,707  3,050  6,129  7,748  
Balance, end of period$12,350  $12,153  $12,350  $12,153  
Warranty expense:$2,707  $3,050  $6,129  $7,748  
 
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10.  Accrued Liabilities

Accrued liabilities were comprised of the following:

 September 30,
2019
December 31, 2018
 (in thousands)
Warranty$12,350  $11,421  
Due to representatives11,890  11,024  
Payroll4,465  4,182  
Profit sharing1,613  1,835  
Worker's compensation619  567  
Medical self-insurance1,074  1,207  
Customer prepayments2,819  2,367  
Employee vacation time4,050  3,173  
Other3,884  1,679  
Total
$42,764  $37,455  
 
11.  Revolving Credit Facility

Our revolving credit facility ("BOK Revolver"), as amended, provides for maximum borrowings of $30.0 million, which is provided by BOKF, NA dba Bank of Oklahoma (“Bank of Oklahoma”). Under the line of credit, there is one standby letter of credit totaling $1.3 million. Borrowings available under the revolving credit facility at September 30, 2019 were $28.7 million. Interest on borrowings is payable monthly at LIBOR plus 2.0%. No fees are associated with the unused portion of the committed amount. We had no outstanding balance under the revolving credit facility at September 30, 2019 and December 31, 2018. The revolving credit facility expires on July 26, 2021.

As of September 30, 2019, we were in compliance with our financial covenants. These covenants require that we meet certain parameters related to our tangible net worth and total liabilities to tangible net worth ratio. At September 30, 2019, our tangible net worth was $279.6 million and met the requirement of being at or above $175.0 million. Our total liabilities to tangible net worth ratio was 0.3 to 1, and met the requirement of not being above 2 to 1.

On October 24, 2019 we amended the BOK Revolver to allow for the occurrence of transactions associated with the New Markets Tax Credit transaction (Note 16). This amendment also removed section 8.1.4 which required our Chief Executive Officer, Norman Asbjornson, to maintain ownership of 25% of the Company. As Mr. Norman Asbjornson does not currently, and has not for several years maintained this level of ownership, a limited waiver of default was also added to the amendment.


12.  Income Taxes

The provision (benefit) for income taxes consists of the following:
 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
 (in thousands)
Current$464  $5,101  $3,716  $8,534  
Deferred96  426  4,208  864  
$560  $5,527  $7,924  $9,398  

The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate before the provision for income taxes.

- 11 -


The reconciliation of the Federal statutory income tax rate to the effective income tax rate is as follows:
 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
Federal statutory rate21.0 %21.0 %21.0 %21.0 %
State income taxes, net of Federal benefit1.3  5.0  4.2  5.9  
Amended Oklahoma tax returns(4.5) —  (2.0) —  
Excess tax benefits(1.7) (2.1) (3.1) (3.1) 
Return to provision adjustments(7.1) 4.2  (2.1) 0.5  
Other(5.1) 0.1  (0.6) (0.5) 
Effective tax rate3.9 %28.2 %17.4 %23.8 %

Upon completion of the Company's 2018 tax return, the Company recorded an additional benefit due to higher than expected research and development credit of $0.6 million. Historically, the Company has taken advantage of the Oklahoma Investment/New Jobs Credit ("OK Credit"). This OK Credit allows the Company to take a credit equal to 1% of eligible investments each year for five years, beginning with the year of investment. The Company determined it could take advantage of an additional 1% tax credit for years in which the Company's location was deemed to be within an enterprise zone. The additional OK Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law resulted in a benefit of $0.3 million for 2018 and $0.9 million for our 2015, 2016 and 2017 amended returns, combined.

The Company's estimated annual 2019 effective tax rate, excluding discrete events, is approximately 24%. Our estimated effective tax rate for 2019 decreased due to the additional credit we expect to realize in Oklahoma. We file income tax returns in the U.S., state and foreign income tax returns jurisdictions. We are subject to U.S. income tax examinations for tax years 2014 to present, and to non-U.S. income tax examinations for the tax years 2014 to present. In addition, we are subject to state and local income tax examinations for the tax years 2014 to present. The Company continues to evaluate its need to file returns in various state jurisdictions. Any interest or penalties would be recognized as a component of income tax expense.


13. Share-Based Compensation

On May 22, 2007, our stockholders adopted a Long-Term Incentive Plan (“LTIP”) which provided an additional 3.3 million shares that could be granted in the form of stock options, stock appreciation rights, restricted stock awards, performance units and performance awards, in addition to the shares from the previous plan, the 1992 Plan. Since inception of the LTIP, non-qualified stock options and restricted stock awards have been granted with a five years vesting schedule. Under the LTIP, the exercise price of shares granted could not be less than 100% of the fair market value at the date of the grant.

On May 24, 2016, our stockholders adopted the 2016 Long-Term Incentive Plan ("2016 Plan") which provides for approximately 6.4 million shares, comprised of 3.4 million new shares provided for under the 2016 Plan, approximately 0.4 million shares that were available for issuance under the previous LTIP that are now authorized for issuance under the 2016 Plan, and an additional 2.6 million shares that were approved by the stockholders on May 15, 2018. Under the 2016 Plan, shares can be granted in the form of stock options, stock appreciation rights, restricted stock awards, performance awards, dividend equivalent rights, and other awards. Under the 2016 Plan, the exercise price of shares granted may not be less than 100% of the fair market value at the date of the grant. The 2016 Plan will be administered by the Compensation Committee of the Board of Directors or such other committee of the Board of Directors as is designated by the Board of Directors (the “Committee”). Membership on the Committee shall be limited to independent directors. The Committee may delegate certain duties to one or more officers of the Company as provided in the 2016 Plan. The Committee will determine the persons to whom awards are to be made, determine the type, size and terms of awards, interpret the 2016 Plan, establish and revise rules and regulations relating to the 2016 Plan and make any other determinations that it believes necessary for the administration of the 2016 Plan.

Options - The total pre-tax compensation cost related to unvested stock options not yet recognized as of September 30, 2019 is $26.8 million and is expected to be recognized over a weighted average period of 3.8 years.

- 12 -


The following weighted average assumptions were used to determine the fair value of the stock options granted on the original grant date for expense recognition purposes for options granted during the nine months ended September 30, 2019 and 2018 using a Black Scholes-Merton Model:
 
 Nine months ended
 September 30, 2019September 30, 2018
Directors and Officers:  
Expected dividend rate$0.32  $0.26  
Expected volatility29.54%  29.73%  
Risk-free interest rate2.40%  2.20%  
Expected life (in years)5.05.0
Employees:  
Expected dividend rate$0.32  $0.26  
Expected volatility29.54%  29.82%  
Risk-free interest rate2.39%  2.48%  
Expected life (in years)5.05.0
 
The expected term of the options is based on evaluations of historical and expected future employee exercise behavior. The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected life at the grant date. Volatility is based on historical volatility of our stock over time periods equal to the expected life at grant date.
 
The following is a summary of stock options vested and exercisable as of September 30, 2019:
 
Range of
Exercise
Prices
Number
of
Shares
Weighted
Average
Remaining
Contractual Life
(in years)
Weighted
Average
Exercise
Price
Intrinsic
Value
(in thousands)
$7.18  -$33.20  350,549  5.29$21.07  $8,717  
$33.40  -$40.87  124,622  7.7935.63  1,284  
$41.37  -$50.68  4,070  0.6741.37  19  
Total479,241  5.90$25.03  $10,020  
 
The following is a summary of stock options vested and exercisable as of September 30, 2018:

Range of
Exercise
Prices
Number
of
Shares
Weighted
Average
Remaining
Contractual Life
(in years)
Weighted
Average
Exercise
Price
Intrinsic
Value
(in thousands)
$5.67  -$32.80  362,715  5.54$18.14  $7,132  
$32.85  -$33.80  5,484  4.0833.18  25  
$34.00  -$40.60  81,417  5.8734.32  283  
Total449,616  5.58$21.25  $7,440  

- 13 -


A summary of option activity under the plans is as follows:
SharesWeighted
Average
Exercise
Price
Outstanding at December 31, 2018
2,445,849  $30.77  
Granted
1,965,520  41.46  
Exercised
(394,024) 28.63  
Forfeited or Expired
(293,299) 36.71  
Outstanding at September 30, 2019
3,724,046  $36.17  
Exercisable at September 30, 2019
479,241  $25.03  
 
The total intrinsic value of options exercised during the nine months ended September 30, 2019 and 2018 was $7.0 million and $5.0 million, respectively. The cash received from options exercised during the nine months ended September 30, 2019 and 2018 was $11.3 million and $3.5 million, respectively. The impact of these cash receipts is included in financing activities in the accompanying Consolidated Statements of Cash Flows.

Restricted Stock - Since 2007, as part of the LTIP and since May 2016, as part of the 2016 Plan, the Compensation Committee of the Board of Directors has authorized and issued restricted stock awards to directors and key employees. Historically, restricted stock awards granted to directors vest at one-third each year. As of May 2019, all new restricted stock awards granted to directors vest ratably over each director's remaining elected term. All other restricted stock awards vest at a rate of 20% per year. The fair value of restricted stock awards is based on the fair market value of AAON, Inc. common stock on the respective grant dates, reduced for the present value of dividends.

These awards are recorded at their fair value on the date of grant and compensation cost is recorded using straight-line vesting over the service period. At September 30, 2019, unrecognized compensation cost related to unvested restricted stock awards was approximately $7.6 million, which is expected to be recognized over a weighted average period of 2.8 years.

A summary of the unvested restricted stock awards is as follows:
 
SharesWeighted
Average
Grant Date
Fair Value
Unvested at December 31, 2018
292,450  $28.54  
Granted
112,018  40.92  
Vested
(109,514) 26.99  
Forfeited
(12,103) 33.87  
Unvested at September 30, 2019
282,851  $33.81  
- 14 -


A summary of share-based compensation is as follows: 
Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
Grant date fair value of awards during the period:(in thousands)
Options$244  $53  $20,315  $12,633  
Restricted stock—  18  4,584  3,379  
Total$244  $71  $24,899  $16,012  
Share-based compensation expense:
Options$1,874  $1,076  $5,156  $3,202  
Restricted stock911  839  2,702  2,412  
Total$2,785  $1,915  $7,858  $5,614  
Income tax benefit/(deficiency) related to share-based compensation:
Options$233  $379  $964  $980  
Restricted stock 26  462  245  
Total$240  $405  $1,426  $1,225  
 

14.  Earnings Per Share

Basic net income per share is calculated by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share assumes the conversion of all potentially dilutive securities and is calculated by dividing net income by the sum of the weighted average number of shares of common stock outstanding plus all potentially dilutive securities. Dilutive common shares consist primarily of stock options and restricted stock awards.

The following table sets forth the computation of basic and diluted earnings per share:
 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
 (in thousands, except share and per share data)
Numerator:  
Net income
$13,827  $14,085  $37,690  $30,036  
Denominator:  
Basic weighted average shares
52,111,444  52,238,796  52,086,209  52,315,719  
Effect of dilutive stock options and restricted stock
610,683  388,745  538,374  399,671  
Diluted weighted average shares
52,722,127  52,627,541  52,624,583  52,715,390  
Earnings per share:  
Basic
$0.27  $0.27  $0.72  $0.57  
Diluted
$0.26  $0.27  $0.72  $0.57  
Anti-dilutive shares:  
Shares
1,834,379  1,950,343  1,886,728  1,929,453  

- 15 -


15. Stockholders’ Equity

Stock Repurchase - The Board has authorized three stock repurchase programs for the Company. Al1 other repurchases from directors or employees are contingent upon Board approval. All repurchases are done at current market prices.

The Company may purchase shares on the open market from time to time, up to a total of 5.7 million shares. The Board must authorize the timing and amount of these purchases. In May 2018, the Board authorized up to $15.0 million in open market repurchases and on May 18, 2018, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement expired on March 1, 2019. In February 2019, the Board authorized up to $20.0 million in open market repurchases and on March 5, 2019, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement will expire on March 4, 2020.

The Company also has a stock repurchase arrangement by which employee-participants in our 401(k) savings and investment plan are entitled to have shares in AAON, Inc. stock in their accounts sold to the Company. The maximum number of shares to be repurchased is contingent upon the number of shares sold by employee-participants.

Lastly, the Company repurchases shares of AAON, Inc. stock from certain of its directors and employees for payment of statutory tax withholdings on stock transactions.

Our repurchase activity is as follows:
Nine months ended 
 September 30,
20192018
(in thousands, except share and per share data)
ProgramSharesTotal $$ per shareSharesTotal $$ per share
Open market5,799  $200  $34.46  116,289  $3,840  $33.02  
401(k)335,139  15,237  45.46  373,129  13,661  36.61  
Directors and employees24,948  1,023  41.00  24,457  860  35.15  
Total
365,886  $16,460  $44.99  513,875  $18,361  $35.73  

Our repurchase activity since Company inception, including our current authorized stock repurchase programs, are as follows:
Inception to date
(in thousands, except share and per share data)
ProgramSharesTotal $$ per share
Open market4,101,566  $69,806  $17.02  
401(k)7,382,915  115,778  15.68  
Directors and employees1,978,209  19,398  9.81  
Total
13,462,690  $204,982  $15.23  

Subsequent to September 30, 2019 and through October 29, 2019, the Company repurchased 27,532 shares for $1.3 million from our 401(k) savings and investment plan.

Dividends - At the discretion of the Board, we pay semi-annual cash dividends. Board approval is required to determine the date of declaration and amount for each semi-annual dividend payment.

Our recent dividends are as follows:
Declaration DateRecord DatePayment DateDividend per Share
May 18, 2018June 8, 2018July 6, 2018$0.16  
November 8, 2018November 29, 2018December 20, 2018$0.16  
May 20, 2019June 3, 2019July 1, 2019$0.16  


- 16 -


16. New Markets Tax Credit

On October 24, 2019, the Company entered into a transaction with a subsidiary of an unrelated third-party financial institution (the “Investor”) and a certified Community Development Entity under a qualified New Markets Tax Credit (“NMTC”) program pursuant to Section 45D of the Internal Revenue Code of 1986, as amended, related to an investment in plant and equipment to facilitate the expansion of our Longview, Texas manufacturing operations (the “Project”). In connection with the NMTC transaction, the Company received a $23.0 million NMTC allocation for the Project and secured low interest financing and the potential for future debt forgiveness related to the expansion of its Longview, Texas facilities.

Upon closing of the NMTC transaction, the Company provided an aggregate of approximately $15.9 million to the Investor, in the form of a loan receivable, with a term of twenty-five years, bearing an interest rate of 1.0%. This $15.9 million in proceeds plus capital contributed from the Investor was used to make an aggregate $22.5 million loan to a subsidiary of the Company. This financing arrangement is secured by equipment at the Company's Longview, Texas facilities and a guarantee from the Company, including an unconditional guarantee of NMTCs.

This transaction also includes a put/call feature that either of which can be exercised at the end of the seven-year compliance period. The Investor may exercise its put option or the Company can exercise the call, both of which could serve to trigger forgiveness of a portion of the debt.

The Investor is subject to 100 percent recapture of the NMTC it receives for a period of seven years, as provided in the Internal Revenue Code and applicable U.S. Treasury regulations in the event that the financing facility of the Borrower under the transaction (AAON Coil Products, Inc.) becomes ineligible for NMTC treatment per the Internal Revenue Code requirements. The Company is required to be in compliance with various regulations and contractual provisions that apply to the NMTC arrangement. Noncompliance with applicable requirements could result in the Investor’s projected tax benefits not being realized and, therefore, require the Company to indemnify the Investor for any loss or recapture of the NMTC related to the financing until such time as the recapture provisions have expired under the applicable statute of limitations. The Company does not anticipate any credit recapture will be required in connection with this financing arrangement.


17. Commitments and Contingencies
 
We are subject to various claims and legal actions that arise in the ordinary course of business. We closely monitor these claims and legal actions and frequently consult with our legal counsel to determine whether they may, when resolved, have a material adverse effect on our financial position, results of operations or cash flows and we accrue and/or disclose loss contingencies as appropriate. We have concluded that the likelihood is remote that the ultimate resolution of any pending litigation or claims will be material or have a material adverse effect on the Company's business, financial position, results of operations and/or cash flows.

We are occasionally party to short-term, cancellable and occasionally non-cancellable, fixed price contracts with major suppliers for the purchase of raw material and component parts. We expect to receive delivery of raw materials for use in our manufacturing operations. These contracts are not accounted for as derivative instruments because they meet the normal purchase and normal sales exemption. At September 30, 2019, we had one material contractual purchase obligation for approximately $3.4 million that expires in December 2020.


18.  Related Parties

The Company purchases some supplies from an entity controlled by the Company’s CEO. The Company sometimes makes sales to the CEO for parts. Additionally, the Company sells units to an entity owned by a member of the President's immediate family. This entity is also one of the Company’s Representatives and as such, the Company makes payments to the entity for third party products.  All related party transactions are made on standard Company terms.

- 17 -


The following is a summary of transactions and balance with affiliates:

 Three months endedNine months ended
 September 30,
2019
September 30,
2018
September 30,
2019
September 30,
2018
(in thousands)
Sales to affiliates$338  $298  $706  $890  
Payments to affiliates32  48  225  159  

 September 30,
2019
December 31, 2018
 (in thousands)
Due from affiliates$119  $79  
Due to affiliates—  —  


19. Segments

The following table summarizes certain financial data related to our segments. Transactions between segments are recorded based on prices negotiated between the segments. Sales of units represent the selling price of our units plus freight and other miscellaneous charges less any returns and allowances. Parts include sales of purchased and fabricated parts including our coils along with the related freight and less any returns and allowances. The “Other” category in the table below includes certain sales cost and expenses that are not allocated to the reportable segments.

Asset information by segment is not easily identifiable or reviewed by the chief operating decision maker. As such, this information is not included below.

 Three Months Ended 
 September 30,
Nine Months Ended 
 September 30,
 2019201820192018
 (in thousands)
Sales   
     Units$102,499  $104,957  $319,820  $300,623  
     Parts - External11,028  8,321  27,287  21,700  
     Parts - Inter-segment6,448  7,669  21,665  21,306  
     Other(27) (341) (348) (716) 
     Eliminations(6,448) (7,669) (21,665) (21,306) 
             Net sales$113,500  $112,937  $346,759  $321,607  
  
Gross Profit
     Units$27,713  $33,488  $84,998  $79,407  
     Parts - External5,074  3,893  13,245  9,880  
     Parts - Inter-segment44  (39) 889  325  
     Other(5,402) (4,618) (14,890) (13,549) 
     Eliminations(44) 39  (889) (325) 
             Net gross profit$27,385  $32,763  $83,353  $75,738  


- 18 -


Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto, which are included in this report, and our audited consolidated financial statements and the notes thereto, which are included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018. This discussion contains or incorporates by reference “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts, but rather are based on expectations, estimates, assumptions and projections about our industry, business and future financial results, based on information available at the time this report is filed with the SEC or, with respect to any document incorporated by reference, available at the time that such document was prepared. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those identified in the section entitled “Forward-Looking Statements” in this Item 2 of this Quarterly Report on Form 10-Q and in the section entitled “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018. We do not assume any obligation to update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, new information or circumstances or otherwise, except as required by law.

Overview

We engineer, manufacture and market air conditioning and heating equipment consisting of standard, semi-custom and custom rooftop units, chillers, packaged outdoor mechanical rooms, air handling units, makeup air units, energy recovery units, condensing units, geothermal/water-source heat pumps, coils and controls. These products are marketed and sold to retail, manufacturing, educational, lodging, supermarket, medical and other commercial industries. We market our products to all 50 states in the United States and all provinces in Canada. Foreign sales were approximately $11.5 million of our total net sales for the nine months just ended and $11.0 million of our sales during the same period of 2018.

Our business can be affected by a number of economic factors, including the level of economic activity in the markets in which we operate. The uncertainty of the economy has negatively impacted the commercial and industrial new construction markets. A further decline in economic activity could result in a decrease in our sales volume and profitability. Sales in the commercial and industrial new construction markets correlate closely to the number of new homes and buildings that are built, which in turn is influenced by cyclical factors such as interest rates, inflation, consumer spending habits, employment rates and other macroeconomic factors over which we have no control.

We sell our products to property owners and contractors through a network of manufacturers’ representatives and our internal sales force. The demand for our products is influenced by national and regional economic and demographic factors. The commercial and industrial new construction market is subject to cyclical fluctuations in that it is generally tied to housing starts, but has a lag factor of six to 18 months. Housing starts, in turn, are affected by such factors as interest rates, the state of the economy, population growth and the relative age of the population. Our sales strategy is currently balanced between new construction and replacement applications. The new construction market in 2018 and through the third quarter of 2019 has been robust, but showing signs of uncertainty. Thus, we continue to emphasize promotion of the benefits of AAON equipment to property owners in the replacement market.

The principal components of cost of goods sold are labor, raw materials, component costs, factory overhead, freight and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper and aluminum, and are obtained from domestic suppliers. We also purchase from domestic manufacturers certain components, including compressors, motors and electrical controls.

The price levels of most raw materials have started to decline in the past twelve months and we expect this trend to continue into 2020. For the nine months ended September 30, 2019, the price (twelve month trailing average) for galvanized steel increased by approximately 4.1% and copper and aluminum decreased by 2.7% and 1.1%, respectively, as compared to the nine months ended September 30, 2018.

We attempt to limit the impact of price fluctuations on these materials by entering into cancellable and non-cancellable fixed price contracts with our major suppliers for periods of six to 18 months. We expect to receive delivery of raw materials from our fixed price contracts for use in our manufacturing operations.

We continued construction of our three-story 134,000 square foot laboratory building with ten testing cells contained within it. This unique laboratory will have capabilities beyond anything known to exist in the world and will elevate AAON's research
- 19 -


and design capabilities accordingly. We have started testing in our new laboratory building in 2019 and expect to have the laboratory fully operational in 2020 with the completion of our 100 ton and environmental testing chambers.

The following are recent highlights and items that impacted our results of operations, cash flows and financial condition:

We continue to see improvement in our gross margin.
Overall units sold decreased approximately 11.3% for the three months ended and increased 4.3% for the nine months ended, respectively, as compared to the same period last year.
We invested $30.8 million in capital expenditures, continuing our work on projects such as our new research and development lab, water-source heat pump production line, and additional Salvagnini machines that will increase our sheet metal capacity.
Our order intake level continued to support our high backlog.

Backlog

The following table shows our historical backlog levels:
9/30/201912/31/20189/30/2018
(in thousands)
$165,325  $151,767  $126,843  


Results of Operations

Three Months Ended September 30, 2019 vs. Three Months Ended September 30, 2018

Units Sold
Three months ended 
 September 30,
20192018
Rooftop Units3,520  4,053  
Condensing Units418  611  
Air Handlers552  713  
Outdoor Mechanical Rooms  
Water Source Heat Pumps1,311  1,162  
Total Units
5,808  6,547  

Net Sales
 Three months ended 
 September 30,
 20192018Change% Change
(in thousands, except unit data) 
Net sales$113,500  $112,937  $563  0.5 %
Total units5,808  6,547  (739) (11.3)%

Net sales for the three months ended are up mainly due to increases in part and water source heat pumps sales.

- 20 -


Cost of Sales
 Three months ended 
 September 30,
Percent of Sales
 2019201820192018
(in thousands) 
Cost of sales$86,115  $80,174  75.9 %71.0 %
Gross profit27,385  32,763  24.1 %29.0 %

During the three months ended September 30, 2019, we experienced higher labor and engineering costs. Combined with the lower unit production as a result of decreased sheet metal production due to machine downtime our overall gross profit percentage decreased during the period. While the costs of some raw materials continue to increase, we continue to see over all raw material costs decrease, a trend we expect to continue into 2020.

Twelve-month average raw material cost per pound as of September 30:

20192018% Change
Copper$3.67  $3.77  (2.7)%
Galvanized Steel$0.51  $0.49  4.1 %
Stainless Steel$1.31  $1.31  — %
Aluminum$1.80  $1.82  (1.1)%


Selling, General and Administrative Expenses
Three months ended 
 September 30,
Percent of Sales
2019201820192018
(in thousands)
Warranty$2,707  $3,050  2.4%  2.7%  
Profit Sharing1,612  2,153  1.4%  1.9%  
Salaries & Benefits3,437  3,071  3.0%  2.7%  
Stock Compensation1,459  1,093  1.3%  1.0%  
Advertising146  176  0.1%  0.2%  
Depreciation400  223  0.4%  0.2%  
Insurance218  281  0.2%  0.2%  
Professional Fees693  448  0.6%  0.4%  
Donations155  102  0.1%  0.1%  
Bad Debt Expense(37) (31) —%  —%  
Other2,204  2,624  1.9%  2.3%  
Total SG&A$12,994  $13,190  11.4%  11.7%  

The Company's warranty expense continues to improve after making significant quality control improvements in the past two years.

- 21 -


Income Taxes
 Three months ended 
 September 30,
Effective Tax Rate
 2019201820192018
(in thousands) 
Income tax provision$560  $5,527  3.9 %28.2 %

The Company’s estimated annual 2019 effective tax rate, excluding discrete events, is expected to be approximately 24%. Upon completion of the Company's 2018 tax return, the Company recorded additional benefit due to higher than expected research and development credit of $0.6 million. Historically, the Company has taken advantage of the Oklahoma Investment/New Jobs Credit ("OK Credit"). This OK Credit allows the Company to take a credit equal to 1% of eligible investments each year for five years, beginning with the year of investment. The Company determined it could take advantage of an additional 1% tax credit for years in which the Company's location was deemed to be within an enterprise zone. The additional OK Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law, resulted in a benefit of $0.3 million for 2018 and $0.9 million for our 2015, 2016 and 2017 amended returns, combined.

Results of Operations

Nine Months Ended September 30, 2019 vs. Nine Months Ended September 30, 2018

Units Sold
Nine months ended 
 September 30,
20192018
Rooftop Units11,079  11,696  
Condensing Units1,291  1,647  
Air Handlers1,669  2,067  
Outdoor Mechanical Rooms28  35  
Water Source Heat Pumps5,977  3,780  
Total Units
20,044  19,225  

Net Sales
 Nine months ended 
 September 30,
 20192018Change% Change
(in thousands, except unit data) 
Net sales$346,759  $321,607  $25,152  7.8 %
Total units20,044  19,225  819  4.3 %

Total number of units sold increased by 4.3%. Our net sales increased by 7.8% mostly as a result of price increases we implemented in 2018 and 2019, part sales, and an increase in the number of water source heat pumps units sold.

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Cost of Sales
 Nine months ended 
 September 30,
Percent of Sales
 2019201820192018
(in thousands) 
Cost of sales$263,406  $245,869  76.0 %76.5 %
Gross profit83,353  75,738  24.0 %23.5 %

While the costs of some raw materials continue to increase, we continue to see overall raw material costs decrease, a trend we expect to continue into 2020. The Company continues to improve its labor and overhead efficiencies and expects that trend to continue as new sheet metal machines are placed into service in the last quarter of 2019 and early 2020.

Twelve-month average raw material cost per pound as of September 30:

20192018% Change
Copper$3.67  $3.77  (2.7)%
Galvanized Steel$0.51  $0.49  4.1 %
Stainless Steel$1.31  $1.31  — %
Aluminum$1.80  $1.82  (1.1)%


Selling, General and Administrative Expenses
Nine months ended 
 September 30,
Percent of Sales
2019201820192018
(in thousands)
Warranty$6,129  $7,748  1.8 %2.4 %
Profit Sharing5,148  4,382  1.5 %1.4 %
Salaries & Benefits10,602  9,513  3.1 %3.0 %
Stock Compensation4,302  3,161  1.2 %1.0 %
Advertising496  610  0.1 %0.2 %
Depreciation1,092  657  0.3 %0.2 %
Insurance594  886  0.2 %0.3 %
Professional Fees1,723  1,821  0.5 %0.6 %
Donations1,019  805  0.3 %0.3 %
Bad Debt Expense91  68  — %— %
Other6,280  6,844  1.8 %2.1 %
Total SG&A$37,476  $36,495  10.8 %11.3 %

The Company's warranty expense continues to improve after making significant quality control improvements in the past two years.

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Income Taxes
 Nine months ended 
 September 30,
Effective Tax Rate
 2019201820192018
(in thousands)
Income tax provision$7,924  $9,398  17.4 %23.8 %

The Company’s estimated annual 2019 effective tax rate, excluding discrete events, is expected to be approximately 24%. Upon completion of the Company's 2018 tax return, the Company recorded additional benefit due to higher than expected research and development credit of $0.6 million. The Company determined it could take advantage of an additional 1% tax credit in Oklahoma for years in which the Company's location was deemed to be within an enterprise zone. The additional OK Credit for being in an enterprise zone, or otherwise allowable under Oklahoma law, resulted in a benefit of $0.3 million for 2018 and $0.9 million for our 2015, 2016 and 2017 amended returns, combined.

Liquidity and Capital Resources

Our working capital and capital expenditure requirements are generally met through net cash provided by operations and the occasional use of our revolving credit facility.

Our cash increased $26.4 million from December 31, 2018 to September 30, 2019 and totaled $28.4 million at September 30, 2019.

Under the line of credit with Bank of Oklahoma, there was one standby letter of credit of $1.3 million as of September 30, 2019. At September 30, 2019, we have 28.7 million of borrowings available under the revolving credit facility. No fees are associated with the unused portion of the committed amount.

We had no outstanding balance under the revolving credit facility at September 30, 2019 and December 31, 2018. Interest on borrowings is payable monthly at LIBOR plus 2.0%. The termination date of the revolving credit facility is July 26, 2021.

At September 30, 2019, we were in compliance with all of the covenants under the revolving credit facility. We are obligated to comply with certain financial covenants under the revolving credit facility. These covenants require that we meet certain parameters related to our tangible net worth and total liabilities to tangible net worth ratio. At September 30, 2019, our tangible net worth was $279.6 million, which meets the requirement of being at or above $175.0 million. Our total liabilities to tangible net worth ratio was 0.3 to 1.0 which meets the requirement of not being above 2 to 1.

On October 24, 2019 we amended the BOK Revolver to allow for the occurrence of transactions associated with the New Markets Tax Credit transaction (Note 16). This amendment also removed section 8.1.4 which required our Chief Executive Officer, Norman Asbjornson, to maintain ownership of 25% of the Company. As Mr. Norman Asbjornson does not currently, and has not for several years maintained this level of ownership, a limited waiver of default was also added to the amendment.

On October 24, 2019, the Company entered into a transaction with a subsidiary of an unrelated third-party financial institution (the “Investor”) and a certified Community Development Entity under a qualified New Markets Tax Credit (“NMTC”) program pursuant to Section 45D of the Internal Revenue Code of 1986, as amended, related to an investment in plant and equipment to facilitate the expansion of our Longview, Texas manufacturing operations (the “Project”). In connection with the NMTC transaction, the Company received a $23.0 million NMTC allocation for the Project and secured low interest financing and the potential for future debt forgiveness related to the expansion of its Longview, Texas facilities.

Upon closing of the NMTC transaction, the Company provided an aggregate of approximately $15.9 million to the Investor, in the form of a loan receivable, with a term of twenty-five years, bearing an interest rate of 1.0%. This $15.9 million in proceeds plus capital contributed from the Investor was used to make an aggregate $22.5 million loan to a subsidiary of the Company. This financing arrangement is secured by equipment at the Company's Longview, Texas facilities, and a guarantee from the Company, including an unconditional guarantee of NMTCs.

Authorizations - The Board has authorized three stock repurchase programs for the Company. Any other repurchases from directors or employees are contingent upon Board approval. All repurchases are done at current market prices.

The Company may purchase shares on the open market from time to time, up to a total of 5.7 million shares. The Board must
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authorize the timing and amount of these purchases. In May 2018, the Board authorized up to $15.0 million in open market repurchases and on May 18, 2018, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement expired on March 1, 2019. In February 2019, the Board authorized up to $20.0 million in open market repurchases and on March 5, 2019, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement will expire on March 4, 2020.

The Company also has a stock repurchase arrangement by which employee-participants in our 401(k) savings and investment plan are entitled to have shares in AAON, Inc. stock in their accounts sold to the Company. The maximum number of shares to be repurchased is contingent upon the number of shares sold by employee-participants.

Lastly, the Company repurchases shares of AAON, Inc. stock from certain of its directors and employees for payment of statutory tax withholdings on stock transactions.

Repurchase Activity

Nine months ended 
 September 30,
20192018
(in thousands, except share and per share data)
ProgramSharesTotal $$ per shareSharesTotal $$ per share
Open market5,799  $200  $34.46  116,289  $3,840  $33.02  
401(k)335,139  15,237  45.46  373,129  13,661  36.61  
Directors and employees24,948  1,023  41.00  24,457  860  35.15  
Total
365,886  $16,460  $44.99  513,875  $18,361  $35.73  

Our repurchase activity since Company inception, including our current authorized stock repurchase programs, are as follows:
Inception to date
(in thousands, except share and per share data)
ProgramSharesTotal $$ per share
Open market4,101,566  $69,806  $17.02  
401(k)7,382,915  115,778  15.68  
Directors and employees1,978,209  19,398  9.81  
Total
13,462,690  $204,982  $15.23  

Dividends - At the discretion of the Board, we pay semi-annual cash dividends. Board approval is required to determine the date of declaration and amount for each semi-annual dividend payment.

Our recent dividends are as follows:
Declaration DateRecord DatePayment DateDividend per Share
May 18, 2018June 8, 2018July 6, 2018$0.16  
November 8, 2018November 29, 2018December 20, 2018$0.16  
May 20, 2019June 3, 2019July 1, 2019$0.16  

Based on historical performance and current expectations, we believe our cash and cash equivalents balance, the projected cash flows generated from our operations, our existing committed revolving credit facility (or comparable financing) and our expected ability to access capital markets will satisfy our working capital needs, capital expenditures and other liquidity requirements associated with our operations in 2019 and the foreseeable future.

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Statement of Cash Flows

The following table reflects the major categories of cash flows for the nine months ended September 30, 2019 and 2018. For additional details, see the consolidated financial statements.

Nine months ended 
 September 30,
 20192018
 (in thousands)
Operating Activities
Net Income$37,690  $30,036  
Income statement adjustments, net31,047  19,474  
Changes in assets and liabilities:
Accounts receivable(2,096) 146  
Income taxes2,234  (649) 
Inventories(4,014) (7,071) 
Prepaid expenses and other(513) (792) 
Accounts payable782  4,328  
Deferred revenue263  (1,644) 
Accrued liabilities & donations5,190  364  
Net cash provided by operating activities70,583  44,192  
Investing Activities
Capital expenditures(30,831) (34,328) 
Cash paid in business combination—  (6,377) 
Purchases of investments(6,000) (16,201) 
Maturities of investments and proceeds from called investments6,000  21,735  
Other107  43  
Net cash used in investing activities(30,724) (35,128) 
Financing Activities
Stock options exercised 11,283  3,504  
Repurchase of stock(15,437) (17,500) 
Employee taxes paid by withholding shares(1,023) (860) 
Cash dividends paid to stockholders(8,303) (8,400) 
Net cash used in financing activities$(13,480) $(23,256) 

Cash Flows Provided by Operating Activities

The Company manages cash needs through working capital rather than drawing on its line of credit. In 2018, the Company slowed vendor payments and benefited from more rapid customer payments to fund its WattMaster acquisition and large equipment purchases. In 2019, the Company's cash needs have lessened while collections and payments cycles have resumed a more normal pattern.

Cash Flows Used in Investing Activities

The capital expenditure program for 2019 is estimated to be approximately $48.3 million. The capital expenditures for 2019 relate to the completion of our R&D lab and water-source heat pump lines, along with expansion of our Tulsa facility. Many of these projects are subject to review and cancellation at the discretion of our CEO and Board of Directors without incurring substantial charges.

The Company invested excess cash flows in 2018 in investments along with completing a strategic business combination that allowed us to quickly develop our own electronic controllers for air distribution systems.

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Cash Flows Used in Financing Activities

Stock options exercised increased due to the increase in the number of employee options exercised and increases in our stock price.

Off-Balance Sheet Arrangements

We are not party to any off-balance sheet arrangements that have or are reasonably likely to have a material current or future effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources.

Contractual Obligations

We had one material contractual purchase obligation as of September 30, 2019 for approximately $3.4 million that expires in December 2020.

Critical Accounting Policies

There have been no material changes in the Company’s critical accounting policies during the nine months ended September 30, 2019.

Recent Accounting Pronouncements

See Note 1 of the Notes to the Consolidated Financial Statements for a discussion of recent accounting pronouncements.

Forward-Looking Statements

This Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “will”, “should”, and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date on which they are made. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Important factors that could cause results to differ materially from those in the forward-looking statements include (1) the timing and extent of changes in raw material and component prices, (2) the effects of fluctuations in the commercial/industrial new construction market, (3) the timing and extent of changes in interest rates, as well as other competitive factors during the year, and (4) general economic, market or business conditions.


Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

Commodity Price Risk

We are exposed to volatility in the prices of commodities used in some of our products and we may use fixed price cancellable and non-cancellable contracts with our major suppliers for periods of six to 18 months to manage this exposure.
 
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Item 4.  Controls and Procedures.
 
(a) Evaluation of Disclosure Controls and Procedures
 
As of the end of the period covered by this Quarterly Report on Form 10-Q, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer with the oversight of the Audit Committee, regarding the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended). Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded, as of the end of the period covered by this Quarterly Report, that our disclosure controls and procedures were effective.

(c) Changes in Internal Control over Financial Reporting

There have been no changes in internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



PART II – OTHER INFORMATION
Item 1. Legal Proceedings.

We are subject to various claims and legal actions that arise in the ordinary course of business. We closely monitor these claims and legal actions and frequently consult with our legal counsel to determine whether they may, when resolved, have a material adverse effect on our financial position, results of operations, or cash flows and we accrue and/or disclose loss contingencies as appropriate. We have concluded that the likelihood is remote that the ultimate resolution of any pending litigation or claims will be material or have a material adverse effect on the Company's business, financial position, results of operations or cash flows.

Item 1A. Risk Factors.

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2018. The risk factors described in our Annual Report could materially adversely affect our business, financial condition or future results. There have been no material changes to the risk factors included in our 2018 Annual Report.

Item 2.  Unregistered Sales of Equity and Securities and Use of Proceeds.

In May 2018, the Board authorized up to $15.0 million in open market repurchases and on May 18, 2018, executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement expired on March 1, 2019. In February 2019, the Board authorized up to $20.0 million in open market repurchases and on March 5, 2019, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement will expire on March 4, 2020. We have repurchased a total of approximately 4.1 million shares under the stock buyback programs for an aggregate price of $69.8 million, or an average price of $17.02 per share. We purchased the shares at current market prices.

On July 1, 2005, we entered into a stock repurchase arrangement by which employee-participants in our 401(k) savings and investment plan are entitled to have shares of AAON, Inc. stock in their accounts sold to the Company. The maximum number of shares to be repurchased is contingent upon the number of shares sold by employees. From inception through September 30, 2019, we repurchased approximately 7.4 million shares for an aggregate price of $115.8 million, or an average price of $15.68 per share. We purchased the shares at current market prices.

Periodically, the Company repurchases shares of AAON, Inc. stock from certain of its directors and employees. The number of shares to be repurchased is contingent upon Board approval. From inception through September 30, 2019, we repurchased approximately 2.0 million shares for an aggregate price of $19.4 million, or an average price of $9.81 per share. We purchased the shares at current market prices.

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Repurchases during the third quarter of 2019 were as follows:
 
 ISSUER PURCHASES OF EQUITY SECURITIES
Period(a)
Total
Number
of Shares
(or Units)
Purchased
(b)
Average
Price
Paid
Per Share
(or Unit)
(c)
Total Number
of Shares (or
Units) Purchased
as part of
Publicly Announced
Plans or Programs
(d)
Maximum Number (or
Approximate Dollar
Value) of Shares (or
Units) that may yet be
Purchased under the
Plans or Programs
July 201931,219  $50.90  31,219  —  
August 201930,420  46.51  30,420  —  
September 201947,675  47.91  47,675  —  
Total     109,314  $48.37  109,314  —  
 

Item 3. Defaults Upon Senior Securities.

None.

Item 4.  Mine Safety Disclosures.

Not applicable.

Item 4A.  Submission of Matters to a Vote of Security Holders.

None.

Item 5.  Other Information.

None.

Item 6.  Exhibits.
 
Exhibit #Description
101
Interactive data files pursuant to Rule 405 of Regulation S-T formatted in iXBRL (Inline Extensible Business Reporting Language): (i) our Consolidated Balance Sheets as of September 30, 2019 and December 31, 2018; (ii) our Consolidated Statements of Income for the three and nine months ended September 30, 2019 and 2018; (iii) our Consolidated Statements of Stockholders’ Equity for the three and nine months ended September 30, 2019 and 2018; (iv) our Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2019 and 2018; and (vi) the notes to our Consolidated Financial Statements.
104Cover Page Interactive Data File pursuant to Rule 406 of Regulation S-T formatted in iXBRL (Inline Extensible Business Reporting Language) and contained in Exhibit 101.
 
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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 AAON, INC.
   
   
Dated: October 31, 2019By:/s/ Norman H. Asbjornson
  Norman H. Asbjornson
 Chief Executive Officer
   
   
Dated: October 31, 2019By:/s/ Scott M. Asbjornson
  Scott M. Asbjornson
Chief Financial Officer

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