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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to the AAON Fourth Quarter Full Year 2018 Sales and Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Gary Fields. Please go ahead.
Good afternoon. I'd like to read a forward-looking disclaimer. To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated. Please see the risk factors contained in our most recent SEC filings, including the annual report on Form 10-K and the quarterly report on Form 10-Q.
Now I would like to introduce Scott Asbjornson, our CFO.
Thank you. I'd like to begin by discussing the comparative results of the 3 months ended December 31, 2018 to December 31, 2017. Net sales were up 7.9% to $112.3 million from $104.2 million. The increase in net sales was the result of price increases made since November of 2017.
Gross profit decreased 10.6% to $27.8 million from $31.1 million. As a percentage of sales, gross profit was 24.7% in the quarter just ended compared to 29.8% in 2017. The decrease in gross profit was due to production inefficiencies during the quarter.
Selling, general and administrative expenses decreased 17.9% to $11.3 million from $13.7 million in 2017. As a percentage of sales, SG&A was 10.0% of total sales in the quarter just ended compared to 13.2% in 2017. The decrease in SG&A was primarily due to decreases in our warranty costs.
Income from operations decreased 4.7% to $16.5 million or 14.7% of sales from $17.4 million or 16.7% of sales.
Our effective tax rate increased to 24.0% from 9.6%. The Tax Cuts and Jobs Act enacted on December 22, 2017 lowered the corporate income tax rate from 35% to 21%. Due to this change, the company remeasured its deferred tax asset and liabilities on the enactment date, which resulted in a $4.4 million benefit to our income tax provision in the fourth quarter of 2017, lowering the effective tax rate compared to the same period in 2018.
Net income decreased 20.5% to $12.5 million or 11.2% of sales from $15.8 million or 15.1% of sales. Diluted earnings per share decreased by 19.7% to $0.24 per share from $0.30 per share. Diluted earnings per share were based on 52,421,000 shares versus 52,932,000 shares in the same quarter a year ago.
The results of the year ended December 31, 2018 to December 31, 2017. Net sales were up 7.1% to $433.9 million from $405.2 million. Most of the increase in revenues is due to our price increase from November 2017. Additionally, our part sales and water-source heat pump sales continued to grow with increases of $6.4 million and $4.7 million, respectively.
Gross profit decreased $19.9 million to $103.5 million from $123.4 million. As a percentage of sales, gross profit was 23.9% in the year just ended compared to 30.5% in 2017. The company has seen increases in its raw material pricing as well as having experienced elevated staffing levels that have caused production inefficiencies.
Selling, general and administrative expenses decreased 3% to $47.8 million from $49.2 million in 2017. As a percentage of sales, SG&A decreased to 11.0% of total sales in the year ended from 12.2% in 2017. The decrease from SG&A is primarily due to decreases in warranty and profit-sharing expense.
Income from operations decreased 24.7% to $55.8 million or 12.9% of sales from $74.1 million or 18.3% of sales.
Now our effective tax rate decreased to 23.9% from 26.8%. As already mentioned, this decrease was a result of the changes from the Tax Cuts and Jobs Act.
Next, net income decreased 21.9% to $42.6 million or 9.8% of sales from $54.5 million or 13.4% of sales. Diluted earnings per share decreased by 21.4% to $0.81 per share from $1.03 per share. Diluted earnings per share were based on 52,668,000 shares versus 53,079,000 shares in the same period a year ago.
At this time, I'll turn it over to our Chief Accounting Officer, Rebecca Thompson, for a discussion of the balance sheet.
Thanks, Scott. If you look at the balance sheet, you'll see we had a working capital balance of $92.8 million versus $103.7 million at December 31, 2017. Cash and investments totaled $2 million at December 31, 2018. Our current ratio is approximately 2.9:1.
Our capital expenditures were $37.3 million. We expect our capital expenditures for 2019 to be approximately $40 million.
Shareholder's equity per diluted share is $4.70 at December 31, 2018 compared to $4.47 at December 31, 2017.
I'd now like to turn the call over to Gary Fields, our President.
So I'd like to discuss sales increases and the related impact. So we've had price increases November of '17, June of '18 and December of '18. What that has done for us is we do have an improving, throughout the year, opportunity on gross margin and net profit.
So currently, snapshot taken today of our current backlog, I'll give it to you in percentage of how this backlog sits with regards to our pricing. So we have 3% of our backlog that is prior to June 15 price increase. We have 47% of our backlog today on the June 15 price increase. We have 50% of our backlog today on our December price increase, and then we have another price increase coming here next week. So we are moving towards a better position with regards to our price increases and how we had lagged in the past on those. We were a little behind the curve from '17, but we're catching up.
Now I'd like to talk about the water-source heat pumps. This business is beginning to materialize as we envisioned a long time ago. It's been painstaking to make it happen. But some of the statistics are that in 2017, we shipped 2,485 units. That was a 2% market share in commercial, a 0.3% market share in geothermal, giving a combined market share of about 1.3%. That was 2017. 2018, we shipped over twice as many units, 5,334 units. That was 115% growth over 2017. The units sold were 21.2% of all AAON units sold, and they represented 3.8% of the AAON sales dollars in 2018.
Another aspect to keep in mind is that 115% growth year-over-year in number of units, we're now on a pace to do that again. 2019 current production pace, as far as what's coming in the door and what's going out the door on water-source heat pumps, illustrates to us the opportunity to double 2018 volume.
Lead time is much improved. We got AHRI certification completed last year. A lot of these things are bringing this heat pump around like we had envisioned earlier. So it's now starting to take a course that resembles what we had charted.
We are always redesigning products to make sure that they are at their utmost efficiency, both in cost efficiency to the customer, cost efficiency to manufacturing, and energy efficiency. There's been a lot of development going on over the last few years that's beginning to manifest itself. We have several units now that are absolute top of the -- they fit the bar with regards to energy efficiency. And with our new laboratory, some aspects of it online now and other aspects coming online over the next few months, we're able to accelerate that.
Our replacement market versus new construction for the year 2018 remained at about 50-50. Our market segments didn't change materially, but there was a slight change. Manufacturing went from 16% down to 15%. Commercial went from 20% to 21%, so they kind of swapped a percent there. And then in our other category, which currently comprises about 6%, a good portion of that is data center. So we may be clearly identifying data center as its own pie segment because it's beginning to accelerate for us.
I have spoken before about the indoor growth facilities commonly associated with the cannabis industry. That is another aspect of our business that has shown some reasonable growth to it and a lot of prospect for growth going forward.
The backlog at December 31, 2018, was $151.8 million versus $81.2 million a year ago, so an increase of 87%. If we were able to get personnel, the people that would take these units sooner than we're able to currently provide to them, so we are working on many aspects of improving our onboarding and training processes. And we have seen a significant improvement in retention as a result of that, so we're beginning to experience a very slight headcount appreciation, which will turn into more accounts [ middle ] out the door.
So looking at the outlook for '19, the water-source heat pump, as I mentioned a while ago, it is now going out at a rate that is 2x what the aggregate rate for 2018 was. About 45, 60 days ago, I appointed a young woman named Whitney Wakefield to manage that entire production facility. She is now dedicated to it instead of it being a shared responsibility across the plant. We've seen marvelous improvements in the organization and management as a result of this personnel change and addition.
The laboratory is, as I said, it's somewhat beneficial to us now. It's about 20% of utilization at this point. I toured the lab earlier today. There's a very significant portion of the lab that is scheduled to come on stream April 1, and it looks to be on target to do that. We've already got units scheduled, substantial magnitude to be tested in there for customers. And so we're looking forward to that.
With the backlog percentages that I gave, it seems more than obvious that gross profit has an opportunity to improve nicely this year. And so I think we can look forward to that.
CapEx for the year, we're looking at about 40 million. Some of this is replacing worn-out equipment, some of this is facilities improvement, and some of this is a little additional manufacturing equipment capacity.
We are not currently very active with the new site for the air handlers. We have kind of put that on pause so that we can get our water-source heat pump business on a more solid foundation and not diverting the attention. We do have some insignificant opportunities with regards to that air handler opportunity that we'll be doing in 2019, but it won't be anything material for this year.
With that, I'd like to turn it over to Norman Asbjornson, our founder and Chairman, CEO, for some comments he'd like to make.
Good afternoon. I'm Norm Asbjornson, the founder of AAON, and I'd like to give you a summation of AAON's present position. AAON has, for 30 years, over that time period, had a compounded overall annual growth of approximately 10% per year in revenue and a compounded annual growth of 14% per year in profitability. However, in recent years, we have been doing less than this. And thus, we've been focusing on making our product attractive enough to our customers to return to these historic growth rates in revenue and profit.
In the fall of 2016, Gary Fields, who just spoke with you, came in as the new President of the Company. He brought with him an astoundingly successful background of being in a sales operation in this industry for 32 years. He understood very well what we needed to do to become more attractive to our customers and immediately set upon addressing these issues by helping us correct those which were internal to AAON and replacing or training the sales force where necessary. This resulted in the outstanding improvement in sales orders which occurred in the second quarter of 2018, which virtually doubled our backlog.
Simultaneously to this, several other things were occurring. Our business climate improved considerably in 2017 and 2018, introducing an inflation and low employment rates. Simultaneously with this, many senior managers who had told me they would stay until I relinquished the presidency, started to retire. These people were very skilled in various managerial levels within the company. While we plan their replacements, and had very capable people to take over their jobs, new people came with much less experience. So in the past 2 years, we have changed myself and many other managers in the 60-, 80-year range down to new managers in the 30- to 50-year range. We basically almost jumped a whole generation going down that far, but we got super good people that will take this company to new heights.
The 3% unemployment area which we find ourselves working in required considerable change in our methodologies. Many of these people had not been working in their life, or had been unemployed for considerable period of time. Thus, we went from introductory time to -- from a few hours when bringing them onboard to a full day of introduction. Due to the lack of recent work, we had to revise the way we managed them for the few -- first few days as they were not ready to work a full day.
Bringing these people onboard has required numerous other changes in how we bring them into the workforce. We believe we have largely overcome these issues. And while it is not easy to deal with [ flat-out ] low unemployment rates, we feel comfortable in saying we know how to obtain the employees we need and we need to -- how to teach them to become productive employees. Due to inflation and the employment situation in the past 2 years, we have increased the across-the-board salary increases to personnel.
For many years, we have been in the water-source heat pump business and geothermal markets with large complex products. We decided to enter the volume part of this market, which is high in volume in 0.5 to 5 tons. We designed a technologically advanced product and spent considerable money doing this and building a manufacturing capability in our company. The manufacturing capability is very advanced, utilizing all the known metrics of automation, which we could find on a worldwide search. This gave us 4 virtually automated portions to our manufacturing line, all with different software systems. We had to integrate -- these software systems into an overall software system which automated the conveyor portion of the line as well as controlling the parts and line-rate. We have spent the past 2 years teaching people how to run this line, debugging the software and resolving other issues. This is largely behind us, and we are now producing small units at a level of $1 million per month, with continuing rapid growth in the future, limited primarily by our ability to teach all employees how to build the product.
For 20-plus years of planning and evolving, we have built a new lab, the equal of which we do not believe exists anywhere in the world. We believe no lab is capable of casting over 100 tons of work comp units exists anywhere other than this lab, which has capability to test to 300 tons -- in other words, 3x anything we can possibly believe anybody has, we now have in this lab. We also believe, and perhaps even more importantly, other labs do not have the ability to do a performance test simultaneously with obtaining acoustical information regarding all elements of noise on the product. This lab has that capability. We are presently about, as Gary said, about a 20% operating point with rapid expectation of additional capabilities and being fully operational by the early part of the fall.
At this point, this has been a significant drag on our P&L. The new lab has already brought in business, however, which we might not otherwise have gotten. And as Gary mentioned, we are going to be testing a very important job in the lab within the next few months, and we probably wouldn't have gotten that job if we hadn't had this capability, a very high profile job. We have just shipped a very high profile job, which we tested in the lab. Again, that one on the West Coast and the one I just spoke of on the East Coast, so it's already starting to pay for itself.
However, it has not brought any actual money in. It will, however, have additional capability to bring in money from our customers who are willing to pay us to run certain tests and start creating an income stream, whereas up until now, it has been strictly a cash input situation.
The information we create with this lab is going to greatly enhance future products. There are a number of other items of improvement in the redoing of existing products make them more profitable and attractive to customers, which have been and will continue to happen as we go forward.
The low point in our transition of all these issues occurred in the first quarter of 2008 (sic) [ 2018 ] when we added more complex -- add more complexity to it by giving $1,000 bonus due to the income tax change to every employee and this totaled $2.4 million expense in the first quarter of 2018.
In retrospect, the only area in which we had done something different had to do with the price increase timing and the size of the price increase input we put out in 2017. We've been playing catch-up ever since due to the enormous backlog of approximately 4 months' worth of production, which we presently have. The price increases in the backlog have only begun to appear on the bottom line, as Gary enumerated to you. However, to kind of reiterate, we had a price increase in December '17, which was not large enough. And then we had one in June of 2018. We had another in December of 2018. And we're going to have another one in March of 2019. Thus, an analysis of our past quarters would find that the volume has started to increase more in the second quarter 2018 than the first, and again, another increase in the third and another one in the fourth. And the profitability likewise was increasing through those 3 quarters.
We know we have a lot to do. We have largely done it and now we're waiting for the good results. Then my long-term effort to assure that this company returns to historic growth and profitability levels or higher, I believe almost everything is done to make that occur.
I thank you very much for your time. And now we'll open up to questions. Do we have our moderator?
Yes, sir.
Would you open it to questions, please?
[Operator Instructions] And your first question comes from the line of Joe Mondillo.
I just want to start it off by saying I'm in an airport right now. So if there's any noise disturbances, I apologize for that. But I wanted to ask about the gross margin. Given the -- I appreciate actually, Gary, you sort of talking about the backlog there and in terms of the price increases. If 50% of the backlog is still on June 15 pricing or earlier, I was wondering, how did you achieve the 29% gross margins in the third quarter? Was that because of the steel that you bought way early in the year and now that you've already depleted that, that's why the gross margins ticked down so much sequentially in the fourth quarter?
Okay. So first off, the 47% of the backlog is post-June 15, and then there's another 50% that's post-December. So third quarter --
[ 3% before? ]
Yes, the 3% was before June. So a good portion of 2018, we built with only the 3% price increase on it. We began to get another 5% price increase, which went into effect in June, but due to the backlog, it really didn't start to show up until very late in the third quarter. It began to manifest itself a bit in the fourth quarter, but at the same time, we started running out of some of the less expensive materials. They ran out at end of the third quarter, and we started to get the more expensive materials utilized in the fourth quarter. So there was some offset of that price increase. The other thing about fourth quarter that weakened it a bit was just some labor inefficiencies that are -- that you can easily attribute them to holidays, but those happen every year. This year, I think one of the things that seemed, I won't say visibly apparent, but somewhat apparent was we ran our people very, very hard all through the year. Because we normally, we have a little turn-down in the fourth quarter as far as demand. We didn't have a turn-down, and these people hadn't had vacations. So we had probably an inordinate number of people that were gone, so we just couldn't produce as much. We had as much as 24% of our factory workforce that were gone on vacation at periods of time in the fourth quarter. So we just didn't get the revenue we needed to dilute the fixed overhead. I think that was charted in one of the material things.
Okay. So sticking with sort of the price-cost situation, in terms of where you are in pricing and where you are in steel pricing, because I know steel pricing that you've realized in cost of goods sold has ramped up through the fourth quarter. Where are you on that cost-spread relative to the cycle? Do we start to improve gross margins on a price-cost basis starting in the first quarter? Or is it more later in the year?
Yes, it's already happening, Joe. See, fourth quarter, we didn't have full implementation of that June price increase. We only enjoyed it for part of the fourth quarter. So first quarter would -- like we said, we've only got 3% of the prior to June backlog yet to build. It's pretty inconsequential. So everything we're building in the first quarter, with small exception, it is on that June price, which offset a good bit of these price increases on materials. So I think we'll have a slight improvement in Q1. And then in Q2, we'll be building somewhat of the December priced material -- December-priced work orders. And so we've got another 5% of appreciation on that with no real strong headwinds on material or salaries beyond what we'll see in the first quarter. It's pretty much all based [indiscernible].
Okay. Okay. And then I -- and then on productivity, this has been a challenge for many quarters now. It seems to be sort of a [ bolzo ] situation. Could you sort of give us your thinking on where we are with labor and just overall operational productivity? Is this going to be a 4- to 8-quarter kind of an improvement type of thing? Or do you think you can achieve historical productivity levels in a matter of a couple of quarters? Give us your idea there.
Well, my production control people are pretty confident that they can achieve that within a couple of quarters. We began to make some significant changes in our onboarding, training, recruiting process probably -- what would you say, Scott, mid-third quarter? Yes, he's agreeing with me, about mid-third quarter.
Right around the end of November.
Right. So we started seeing -- we went from a retention rate of new hires within the first 30 days being -- what's the math on 134 out of 500, that's like 15%? I don't know. Here let me do the math for you real quick. We had a 26% retention rate on people that we hired at one snapshot back in the summer. And we've changed that to a 90% retention rate for that same 30-day snapshot most recently. So our onboarding and training procedures have really shown improvement. That being said, one of the other things we were doing, because our retention rate was so low, we were bringing so many people in here to try to and make up for that, and they were disrupting us. Well now with a 90% retention rate over this 30-day period of time, we don't have to bring as many people in to get an accretive headcount -- and that accretive headcount. So it's been much less disruptive. So I believe that first quarter, we're going to see some production improvements due to that. Second quarter I think will be more production improvement. And then like I said, they're telling me that over a couple of quarters with this new procedure in place that we've had for a few months now, that they believe we'll have an accretive headcount that will be an effective headcount as well.
Okay, great. Last question for me, on the revenue side of things, backlog is up more than double at the end of January. Your lead times have doubled, which make me -- leads me to believe that your volumes are increasing a lot, which is why you're putting these price increases on. So with volume up and your pricing obviously aggressively coming up, is there any reason that we should not expect revenue growth rates should be much higher in 2019 than in 2018?
It will be absolutely higher in 2019 than 2018 for all the reasons you just cited. You're 100% correct.
[Operator Instructions] Your next question comes from the line of Brent Thielman.
Gary or Norm, I'm trying to kind of parse out in the actions AAON has been taking to sort of gain some market share. And obviously you've got a huge backlog that continues to grow. Could you talk a little bit about just the demand environment? Outside of that, I mean what do you hear back from people on the ground, maybe just even through your core units? You mentioned data centers, these indoor growth facilities, but what about kind of the more traditional non-residential end sectors?
Well, you mentioned there, we basically, and Gary went over it with you, we started working seriously on trying to improve our customer satisfaction several years ago. And we were gaining a lot of strength. And one of the reasons that Gary was brought into the position is I consider him maybe the preeminent person in the commercial business with knowing how to satisfy customers, he had a long history of highly successful sales, not only personal, but he was a partner in what is now our largest company Texas Air, in Texas, with offices in Dallas, Fort Worth, Austin, San Antonio and Houston. And during his tenure from the time he started working as a salesman until he was kind the lead partner, the company evolved from about 10 people to over 200 people and went from $7 million, $8 million in sales to up in $200-some million dollars in sales and has continued. So when he sold out to take retirement, and I started working to try and bring him into the company fold again and getting back to the working world, he finally came back because he is a very competitive person and when he decided to retire, didn't have a lot of competitiveness to it. So he's back onboard full time. And as you see, there is -- it's not by accident that shortly after he came back in, and I said, instead, that he came back -- came to work as president in fall of 2016. And by the early part of 2018, we were doubling our backlog. A lot of that had to do with him bringing in a lot of knowledge of little, small things that we weren't paying as much attention to or hadn't resolved, and he got them resolved. And then he also went out and changed out some of our weaker sales offices. And he implemented a training course, which has been very successful, we in fact have about 20 people in place right now. We have them in, every couple of weeks, we have another group that we're training our existing sales force. So all of this has been geared toward making a happier customer base, and that's been across the board. It's been all of our business has been benefiting from this. Product is more satisfactory to them, the way we treat them, with the exception of the lead time. And we are very honest with them and telling them that, so we're losing orders right now because of our long lead time. We understand that thoroughly, but we also understand that they're trying to adjust because they want to buy our equipment and they're accepting these long lead times and not canceling orders. When they give us the order, they know it's long lead time, yet we try very diligently to meet that long lead time or improve upon it. So it's just -- we're just a better company with a better product than it was not very long ago. And that's what's bringing the customers in. So it's no particular area, the customers at all, no particular industry or anything else. It's across the board.
Okay, okay. And then you doubled water-source heat pump units in '18 over '17. And it sounds like you think you could do that again in '19. I understand...
Gary just told you, and we're quite certain of -- I feel very comfortable with what he said.
Yes. The January production rate and the February production rate right now is on -- if you annualize that, then we are double what we did in 2018. And we have no believe -- no reason to believe that it's going to weaken. In fact if we can stay pace with production and beat lead time, continue to beat lead time, that's one place that we've improved. A lot of source heat pumps, we had let them get out a few weeks longer than we wanted, while we were getting some of this production line streamlined and vetted out. And now we're meeting their expectations and we've actually shortened the lead time on those. We announced a 1-week improvement about a month ago, and we've been staying right on target with requested dates versus shipped dates. So I think the only throttle to our water-source heat pump business is getting these people in and training them so that we can produce more. It's not that -- we can get the sales in the door, it's a matter of what we can get out. And as I said, right now, we're running at 2x the production rate than we did on the aggregate of 2018.
Okay. But Gary, I think these units have different price points. I think in '17, you did what, 9 million in sales and a little over $15 million of sales in '18. So should we translate -- if you're going to double it in '19, could we translate that to something like $25 million in sales?
Yes, that's what our targets are. Yes, Brent.
Okay. Okay. And then if you guys get this lab fully up and running and utilized -- I fully understand it's helping you from an orders perspective -- could you remind the direct revenue opportunity I guess you're hoping to get or realize from that facility?
Well the direct revenue, it's going to start off a pretty small percentage. There's 3 significant activities for this laboratory. One is virtually every piece of equipment we manufacture is subject to some sort of AHRI certification program. And AHRI as a maintenance to that program, they pull a certain quantity of your units of each category annually. While it's just prudent that you have those -- that you're constantly run-testing those units to make sure that they're meeting your certification requirements. So that's one aspect to this lab. One aspect to this lab is an R&D function in developing product, and that's about equal to the proof of concept. Then the other 1/3 use of the lab is these projects such as -- what we described earlier where we as part of the sales process, we include some laboratory testing. But we do charge for those services. We're not yet sure if we're charging appropriately for them because we haven't done enough of it, but we're definitely got income stream for about 1/3 of the activity out there. So we're not doing these tests for free. But again, I don't know until we run the lab for a little while and can see what some of these costs and how to amortize them and distribute them, to know for sure are these profitable that we're doing? Or are they more of a sales tool than sales concession? At this point in time, I'd have to categorize them as a little bit of both, a little bit of income and a little bit of sales cost.
Okay. I guess, last one for me. Scott, it looks like SG&A kind of came back to levels you've been looking for. I didn't see any larger warranty expenses. I assume that's all behind you here.
Yes, we believe so.
Thank goodness, and it took long enough.
[Operator Instructions] There are no further questions at this time.
We thank you for listening, and we'll talk to you again soon. Have a good day.
This concludes today's conference call. You may now disconnect