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Edited Transcript of AAON earnings conference call or presentation 2-Nov-17 8:15pm GMT

Q3 2017 Aaon Inc Earnings Call

TULSA Nov 3, 2017 (Thomson StreetEvents) -- Edited Transcript of Aaon Inc earnings conference call or presentation Thursday, November 2, 2017 at 8:15:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Gary D. Fields

AAON, Inc. - President and Director

* Norman H. Asbjornson

AAON, Inc. - Chairman of the Board and CEO

* Scott M. Asbjornson

AAON, Inc. - CFO and VP of Finance

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Conference Call Participants

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* Brent Edward Thielman

D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst

* Brian Gustavson

* Joseph Logan Mondillo

Sidoti & Company, LLC - Research Analyst

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Presentation

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Operator [1]

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Good afternoon, ladies and gentlemen. Welcome to AAON, Inc. third quarter sales and earnings call. There will be a question-and-answer period after management's brief presentation. This call will last approximately 45 minutes to 1 hour. I would now like to turn the call over to Mr. Scott Asbjornson. Please go ahead, sir.

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Scott M. Asbjornson, AAON, Inc. - CFO and VP of Finance [2]

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Hello, and welcome to our third quarter investor conference call. I'd like to start this call by reading a forward-looking disclaimer. To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995. As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated. Please see the risk factors contained in our most recent SEC filings, including the annual report on Form 10-K and the quarterly report on Form 10-Q.

I'd like to begin by discussing the comparative results of the 3 months ended September 30, 2017, to September 30, 2016. Net sales were up 8.7% to $113.7 million from $104.6 million. Sales increased primarily due to a favorable product mix.

Our gross profit increased 7.8% to $35.7 million from $33.1 million. As a percentage of sales, gross profit was 31.4% in the quarter just ended compared to 31.6% in 2016.

Selling, general and administrative expenses increased 25.3% to $13.0 million from $10.4 million in 2016. As a percentage of sales, SG&A increased to 11.5% of total sales in the quarter just ended from 9.9% in 2016. The overall increase in SG&A was primarily due to increased warranty expenses.

The company has been working on modifications and refinements to its warranty policy. These modifications more clearly define what qualifies as a warranty claim and place a deadline for when claims may be submitted. This has increased our warranty reserve and increased our warranty expense for the 3 months ended September 30, 2017.

Income from operations decreased 0.3% to $22.6 million or 19.9% of sales from $22.7 million or 21.7% of sales.

Our effective tax rate increased to 35.3% from 31.1%. The company's estimated annual 2017 effective tax rate, excluding discrete events, is expected to be approximately 36%. The rate is higher for 3 months ended September 30, 2017, due to shifts in income to states with a higher tax rate and a smaller excess tax benefit from stock compensation.

Net income decreased to $14.7 million or 12.9% of sales compared to $15.7 million or 15% of sales in 2016.

Diluted earnings per share decreased by 3.4% to $0.28 per share from $0.29 per share. Diluted earnings per share were based on 53,014,000 shares versus 53,394,000 shares in the same quarter a year ago.

The results of the 9 months ended September 30, 2017, to September 30, 2016. Net sales were up 3% to $301.1 million from $292.3 million. The company saw an 8.8% increase in total units sold. However, due to growth in volume of less expensive units, revenues increased at a slower pace.

Our gross profit increased 0.8%, $92.3 million from $91.6 million. As a percentage of sales, gross profit was 30.7% in the 9 months just ended compared to 31.3% in 2016.

Selling, general and administrative expenses increased 18.9% to $35.5 million from $29.9 million in 2016. As a percentage of sales, SG&A increased to 11.8% of total sales in the 6 months just ended from 10.2% in 2016. The overall increase in SG&A was primarily due to the increased warranty expenses we mentioned earlier.

Income from operations decreased 8.1% to $56.7 million or 18.8% of sales from $61.7 million or 21.1% of sales. Our effective tax rate decreased 32.1 million from 32 -- or decreased to 32.1% from 32.4%. Net income decreased to $38.7 million or 12.9% of sales compared to $42 million or 14.4% of sales in 2016.

Diluted earnings per share decreased by 6.4% to $0.73 per share from $0.78 per share. Diluted earnings per share were based on 53,103,000 shares versus 53,457,000 shares in the same period a year ago.

Looking at the balance sheet. You'll see that we have working capital balance of $103.5 million versus $101.9 million at December 31, 2016. Cash and investments totaled $39.9 million at September 30, 2017. Investments have maturities ranging from 1 month to 12 months. Our current ratio is approximately 2.7:1.

Our capital expenditures were $26.4 million. We originally expected capital expenditures for the year to be approximately $42 million but have now raised it to $48.5 million to accelerate acquisition of sheet metal equipment.

The company had stock repurchases of $13 million year-to-date. Shareholders' equity per diluted share is $4.10 at September 30, 2017, compared to $3.85 at December 31, 2016. We continue to remain debt-free.

I would now like to turn the call over to Gary Fields, our President, who will discuss our results in further detail, along with the new products and the outlook for the remainder of the year.

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Gary D. Fields, AAON, Inc. - President and Director [3]

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Good afternoon. The net sales increased 8.7% for the quarter. This was primarily due to volume. Potential on the water-source heat pump continues to accelerate.

The various markets. The replacement market versus new market remains steady at about a 50-50 mix.

Commercial and retail. Commercial remain steady with our earlier statements. Retail seems to be weakening just a bit, primarily with regards to some of the larger grocery stores. They seem to be a little scared by what Amazon has done.

Office buildings are remaining relatively steady. Medical and health care has continued to be strong. Education, towards the third quarter, we typically see a lot of product go out the door, not quite so much coming in. And as far as new orders, we've had some conversations with some various school districts that are longtime advocates of our products, and they're looking at how they're moving their purchasing to an earlier portion of the year. We're doing this through various direct sale functions, still through the rep force but not going through the traditional long bidding process that, again, is traditional.

Manufacturing, not really seeing any change there. Lodging, it seems to be a little bit sporadic. We'll see it have little spurts. We recently saw another spurt where we've had a decent little input of orders from our various national accounts with lodging. Municipalities are not seeing any real change there other than, like I said, in the education with K-12.

The backlog at September 30, 2017, is $73.8 million compared to $62.2 million a year ago. The backlog usually represents somewhere between 45 and 60 days of our production. So we look for production to remain strong while we get this backlog back in the reasonable level -- historic level.

For the remainder of '17, we're accelerating the production again because our backlog is -- sorry, handing that over to Norm.

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Norman H. Asbjornson, AAON, Inc. - Chairman of the Board and CEO [4]

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Thank you. The remainder of 2017 is looking strong this year, just like it looked strong a year ago on shipments. Unlike a year ago, when we were getting weak input on orders, the orders appear to be strong this year. So we can only conclude to further belief that last year, we got the slowdown in orders due to hesitancy during the election cycle.

The water-source heat pumps are starting to grow significantly. If we are estimating correctly, we will build about as many -- build and ship about as many water-source heat pumps in the fourth quarter as we did in the preceding 3 quarters, which is -- should give you an idea about the market growth. The biggest thing on the water-source heat pump is that the timing was bad. We had anticipated we'll be able to move some things a lot faster than we were able to move them, and so that set everything back. The actual product is coming off very well. The quality is excellent. The shipping to the customers is pretty much on time for when they want it. So the only real major change is how fast we've been able to get our design work done and all of our approval work done and start getting orders.

The backlog, we think, will be better than it was a year ago and therefore launches into 2018 much better than we did last year. This will have a lot of positive effects because last year, when we came out of 2015 with a low backlog, we were having to cut back on personnel and reduce the run rate in the factory. This, of course, then started turning around with new orders coming in, in the first quarter of 2016. And we had to turn around. Within a few months, we started hiring additional personnel and basically ran behind where we would like to have been for the first half of this year and then have locked ourselves in a position of having to deploy catch-up in the last 2 quarters. As you can see, we did a pretty good job deploying catch-up during the third quarter and got ourselves back in the positive for the total shipments and have quite a significant improvement quarter-to-quarter in shipments.

Gross profit. We believe we'll maintain pretty much where it is. We do have a price increase, which is going into effect on November 15. That will be on orders coming in. And of course, those orders will go into backlog, and they will take somewhere about 8 weeks or thereabouts to begin coming out of the backlog. So it will be in the middle of the first quarter before we start seeing any noticeable improvement with pricing on what goes out the door.

Capital expenditures, as was noted, is going to be approximately $48.5 million. We are moving very, very quickly in a lot of areas, including capital and additions to what we're doing. The 2 big areas of capital expenditures have been the establishment of the water-source heat pump production line and the new R&D lab, which we're building.

This lab is -- for those of you who haven't heard, it's 162,000 square feet, very significant. We believe in many facets of it, it's the largest lab in the world. And about a year from now, we will be up and running with it. The building itself is pretty well finished on the outside, and what we're doing now is putting all the testing and equipment into this thing. We will have 10 individual testing areas in it. And there's a lot of internal work to do to put all those test cells and all the things in and verify their accuracy and get everything ready to start functioning.

I'd like to open it now to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Okay, our first question is going to come from the line of Brent Thielman, D.A. Davidson.

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Brent Edward Thielman, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [2]

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Scott, the SG&A was a little bit of a surprise to us, just the additional warranty reserve and expense associated with it. I thought that will roll off after last quarter. Should we be thinking about an elevated level here into the second half? Or do you still think that comes in?

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Scott M. Asbjornson, AAON, Inc. - CFO and VP of Finance [3]

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Well, this particular quarter that we're coming into, I think we'll still have some trailing expenses coming through. We just had a couple of different issues that all kind of snowballed on us at the same time at the end of Q2. The main one we were aware of was our policy change. We had a few problems with paint process and some vendor issues that caused us to have additional charges in Q3 that we believe are fully under control. But the costs are going to taper off into Q4. So we don't anticipate anything going into next year however.

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Brent Edward Thielman, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [4]

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Got it. And then just with regard to kind of waiting on the certification for the new pump line, can you remind me the importance of that? You're obviously getting orders as we speak, and it sounds like 4Q is going to be a good shipping period for you. What's the relevance of this certification?

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Gary D. Fields, AAON, Inc. - President and Director [5]

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This is Gary. So the relevance of the certification is probably several factors. One of the ones that's most significant is a lot of these projects are seeking energy rebates from an energy provider. And that energy provider wants to have certified data by this AHRI certification agency to validate your claims of energy performance. So if there is an energy rebate involved, until you get the certification, they will not make you eligible for it. Now we have sold some projects where the energy provider says, "Hey, we know you've submitted for it. We trust you because of all the other equipment that you have in all the other categories that's certified. We have confidence that you're going to be, once you achieve the certification, then we'll issue these people their energy rebates." That's happened on a couple of isolated cases. But you're not going to get broad support for that kind of activity. I mean, those are people that have got long history with us that know our reputation very well. So that's one facet of it. Then another facet of it is in the plan and spec market, when a consulting engineer specifies the products for the project, this is a standard feature of the specifications. So you're not eligible to be at his project lacking that certification. And so the projects that we've gotten so far have been with favorable circumstances that the certification didn't hinder it, but that's not a widespread situation. So it is a significant hurdle to our sales -- or obstacles to our sales that we got to get past. Now the good news is August 27, we submitted to that certificate agency the 7 pieces of equipment that they requested. And they don't initially give you a test schedule for that. They gave us a test schedule just last week. November 13 is when they'll begin their testing. Again, they don't tell you how long the testing will take. But our experience says that it will take a couple of weeks. So we're anticipating that somewhere in the next 30, outside 45 days that we should have that certification accomplished. So I'm not looking for that to be a hurdle or an obstacle that we have to maneuver around beginning 2018.

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Brent Edward Thielman, D.A. Davidson & Co., Research Division - Senior VP & Senior Research Analyst [6]

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Okay. Gary, that's very thorough. Appreciate that. Then on the -- yes, I guess the question is you guys are out securing these initial orders for the pump line. Any sense of what the response has been from competition? Are they offering discounts, taking prices down? Any readout there?

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Gary D. Fields, AAON, Inc. - President and Director [7]

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There is a readout there. No, they haven't discounted and taken prices down because I don't think they can afford to. They were already at a level that was pretty much where they needed to be. And when you look at the fact that NIBE has purchased -- we just learned of other companies they purchased. They purchased ClimateMaster. They purchase WaterFurnace. They purchased, was it, CGC, I think it was called. They purchased Enertech. We knew of $700 million they'd invested in this, and then we learned of these other companies. So it's something upward of $700 million. Well, they're thinking that they bought a pretty nice sports car when you looked at it. So they're not really anxious to go in there and cut the prices, it looks like. What's interesting is I was in Phoenix last week at our representative. They had a customer event, and they had several manufacturers there with equipment on the display. And the ClimateMaster, as we've told you guys before, most of our reps, or about half of them anyhow, represent a competing line like ClimateMaster. These particular people did. So the ClimateMaster regional sales manager was there. And I had a moment to visit with him. [I said], "Well, you probably don't want me looking at your product." And he says, "Well, you can look at my product all you want." He says, "It's antique compared to yours." So he threw in the towel there on the design. And as we chatted just a little bit, he hands me his business card and says, "Please keep this." Well, that's the second manufacturer, regional sales manager that's done that. The other one was with Florida Heat Pump at a similar event back in March. I think these people realize what we're going to do to this industry. But they don't really have a lot of room to move pricewise without totally devastating what profits they have and recovering their investments.

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Operator [8]

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Our next question is going to come from the line of Joe Mondillo, Sidoti & Company.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [9]

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So I wanted to ask if you've noticed any sort of acceleration in orders ahead of the price increase that sometimes you've historically noticed?

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Gary D. Fields, AAON, Inc. - President and Director [10]

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Yesterday was the first day that I felt any kind of forward push at all. Up until yesterday, it has been running along at a pace that had been pretty consistent. Yesterday, we booked about 2x a normal day, which I felt like was a bit of a forward push. Today, I haven't checked it. But earlier in the day, it was back on a normal track. I think we're probably a few days away. Reps are notorious for procrastinating until the last minute, especially if they don't have any delivery pressure. So I think I will have a better sense of this in another week or 10 days. But we do expect some forward push.

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Norman H. Asbjornson, AAON, Inc. - Chairman of the Board and CEO [11]

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Joe? Hello?

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [12]

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I'm sorry, can you hear me?

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Operator [13]

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Yes, we can hear you now. Go ahead.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [14]

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Sorry about that. I just wanted to know in terms of your inefficiencies within the operations in the first half of the year. Just wondering -- it looks like the turnover of backlog was still maybe a little slow. I don't know if that's a correct read or not. But I'm just wondering if you could update us on the inefficiencies that you saw in the first half. Are those mainly behind us?

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Gary D. Fields, AAON, Inc. - President and Director [15]

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Well, I want to say they are a work in progress going in the right direction. We have been able to reduce the backlog. I think the highest we ever saw was about $90 million. I think the highest at any reporting point was in the mid-80s and now we're in the low 70s. So we're working the backlog in the right direction. The guys are doing a really good job. We're becoming more efficient but we're not back to where we were pre-changeover of the management. We're still using a few more people to produce the dollars. But it is headed in the right direction. The other thing that's headed in the right direction that's affecting our bottom line is the warranty. Some of the issues that -- in addition to the warranty policy change, which really -- I began that almost immediately when I got here because I was being notified of various timing situations that I didn't think were suitable. So I was trying to get some of that cleared up and really did a lot of that in the first quarter and some of it trailed into the second quarter. Kind of the bit of a surprise was a vendor issue and some paint process issues that Scott mentioned earlier that kind of caught us right at the peak there during that changeover of that management. Not necessarily due to their fault but the timing was about the same. Well, we got ahold of the vendor issue and we got ahold of the paint process issue. But it had a duration that caused us some expense. Those have both been resolved, and we're now down to just the last vestiges of people sending in their reimbursement. And actually, I think we're pretty much digested on that now. So I look for both of those things to improve, fourth quarter, the labor efficiency to improve, the warranty expense situation to improve.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [16]

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Okay, great. Good to hear. And then also wanted to ask regarding the product offering on the water-source heat pump. I know you guys own the -- have a certain percentage of the entire market worth of product offering at this point in time. Could you just update us on where you're at with that and sort of what your goal is to get to a bulk of the market offering so that you could hit all pieces of that market?

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Gary D. Fields, AAON, Inc. - President and Director [17]

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Sure. So our product development road map, it kind of goes in line with our construction of these additional facilities that Norm mentioned earlier. So our facility, we termed it A, B and C or call it Phase 1, 2 and 3. So Phase 1 or A is what we completed a year ago. It's what we've been using to vet out the process, and that's what we're using to build product now. Phase B is due to be completed in the next 45 to 60 days. And at the same time, we're designing more product, widening the product offering in the product family that will be built on that Phase B. Phase C will be a little bit of additional product but it'll be more of a high production line. For instance, we just, last week, finished a big run. All of the units were identical. There's actually 380 units that are identical. And the third phase of our line is to take advantage of those sort of orders to where we can run them at a higher rate with not a lot of variance. So to answer your question, we'll have more product to address more markets starting January 1. Throughout the entire year of '18, we will add more and more product that by the end of '18, we'll have a complete family offering from the entire desirable product line. The percentages of the market that each one of those address tapers off the further you go down the line. So what we have done right now addresses somewhere around 38 -- the line 6A addresses about 38% of the available market. Line B addresses about 34% of the available market. So that puts us at 72% really around the first quarter of the year. And we should have product to go on that line mostly by the end of the first quarter. So 70-something percent of the available market, we will be prepared with product design certified and a facility to build it. That last 28% will come throughout the year.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [18]

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Okay, perfect. And I wanted to -- I don't know if you have this. I don't know if you have this. If you don't, no problem. But do you guys have any sort of financial goals for 2018 for us to think about regarding the water-source heat pump? I know you don't give guidance, and that's okay, if you don't have any.

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Gary D. Fields, AAON, Inc. - President and Director [19]

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No, Joe, I want to stay away from that right now. We're still -- that would be kind of peeling out a segment there and giving too much forward guidance if I gave it in dollars. So we'll just say that we can address 70% of the available market. And eventually, by the end of next year, we're going to be able to address 100% of the available market. And as I've said before, we're looking at a runway of between 3 and 5 years to get to our aspirations of 20% market share. All of which are looking very attainable, the orders that are coming in now, everything's occurring that we thought would occur. Some of it is just taking a little longer. As Norm would say...

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [20]

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Sure. CapEx, I know you sort of guided to the, I think, $47 million to $50 million in 2017. What -- how can we think about 2018 in terms of the budget with the laboratory and everything else that you have going on? Any sort of [color]?

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Scott M. Asbjornson, AAON, Inc. - CFO and VP of Finance [21]

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We're still in about the $35 million to $40 million range. We're still finalizing all of our budgeting plan for what we're going to get done next year. I do want to point out that if you look at our balance sheet, you'll notice that we have assets in place. Our cash flow is lower than we would anticipate, but part of that is due to getting equipment up and released and the payments finalized.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [22]

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Okay. And then just last question from me. It's about the laboratory. Just wondering if you could expand on that. I know that's been a very sizable investment relative to this year's and next year's CapEx budget, which have been quite inflated compared to past years. I'm just wondering what your sort of thinking is regarding return on investment. How do you get a return on investment with that laboratory? What's the logic or thinking behind how you can monetize that laboratory? Just trying to get an idea of return on investment regarding that facility.

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Gary D. Fields, AAON, Inc. - President and Director [23]

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Yes, certainly. So we're in the midst of developing strategic plans, written strategic plans for the whole company. And that is one segment that we've -- I won't call it segment, one aspect of the business that we've got. Clearly, we're developing a strategic plan for that aspect of the business. So in that strategic plan, we've had 2 preliminary sessions. And in those preliminary sessions, we've talked about things such as our representatives that have customers that want to have a mockup, for instance, of a conference room with an equipment room next to it. Particularly, right there in your city, our representative from New York City, when they were here 2 weeks ago and looked at it, they said, "Hey, Joe, chalk mark around that corner over there and say that, that's my corner. I want a build a mockup that's got an office, a conference room and an equipment room." Well, then they can put various types of equipment that we manufacture in there, and they can -- they don't have to model with computers what's going to happen. They can physically show you what's going to happen, what's the noise level, how's the vibration, how's all these feel. So that's one aspect of it that we anticipate that not just those kind of mockups but test that our representative organizations are going to bring their customers in here to show them exactly what their equipment does and how it does it. Well, that eventually could be as much as 50% of the activity of this laboratory. And that's all of revenue activity. Another significant activity, of course, is going to be research and development for new product development for us. We've got a product road map -- product development road map that currently goes out into 2019 of products that we either want to refine what we have now or expand our product families like we've done with this water-source heat pump. And we've got other products and ideas. So we've got a very broad, very comprehensive product development road map that we'll be developing in that lab. So rather than build the product and hope you know what it does and put it out there in the field and make the field be your laboratory, we can actually -- we have modeling capabilities to model what we're going to build. Then we can build it and we prove our models. So it helps to validate our modeling process so you gain more and more confidence in your modeling as you prove it in your laboratory. So there's that aspect of it. And then there's other industries that have expressed an interest and a desire for testing facilities that we have because our environmental testing and our acoustical testing exceed those available of any other laboratory in North America. We've got really a minimum of 3 primary activities that we plan on a regular basis, 2 of which are outside revenue streams, 1 of which will be internally. I told them they're going to have to build a justification story for that product so that we don't want to spend a lot of lab time and a lot of value, say, $1 million value if the product won't revenue and produce a profit that would absorb that logically. So that's kind of what we're looking at.

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Joseph Logan Mondillo, Sidoti & Company, LLC - Research Analyst [24]

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Okay. And what is the timing at this point of it sort of being finished?

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Gary D. Fields, AAON, Inc. - President and Director [25]

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Well, to be 100% finished and what they call commissioned and certified, we believe that we'll be able to accomplish that about this time next year, somewhere in the October, November range. But I was going over it with them yesterday. We sold a major project on the West Coast to a major end user, owner of their building that has a desire for this sort of witness testing that I mentioned earlier, the rep bringing in the revenue for that. They have a desire to test this equipment. Well, their schedule is June and July. And so I was going over the lab schedule just yesterday with our people that are managing that, and we have figured out a schedule where we can accommodate that. So we will have certain aspects of this lab that will be available for use in as early as June -- I don't know if it's 6 or 11, but the first week or 2 of June next year is on the schedule. But to have it absolutely complete, have a grand opening and say, Joe, come see my new lab, I'm looking at probably October, maybe November.

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Operator [26]

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And our next question is going to come from the line of Brian Gustavson, 1060 Capital.

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Brian Gustavson, [27]

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Just on gross margins, can you kind of just conceptualize where you think those are going to -- where they might play out next year? I know 2016 was a good year for gross margins, and 2017 has been a dip. But can we get back to 2016 levels? Can you talk about the pressures and the positives and negatives on the gross margin?

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Gary D. Fields, AAON, Inc. - President and Director [28]

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Well, the gross margin percentage of '16 was one to be admired and appreciated. But it's not easily duplicated. The real driving goal here is to put more dollars to the bottom line. Now we've had a few things that we believe are essentially not exactly onetime occurrences, but this warranty expense and the inefficiency from the changeover from the historical product and project management and plant management to the newer guys, those were somewhat behind us. So we will see a return to some of the margin percentage -- some of it that we've lost, we'll regain with that. The other thing is this price increase that we just put into effect, it's going to at least keep us from having any erosion. The -- when you look at the percentage of materials and the percentage of price increases that we're seeing on those materials, that pretty much absorbs 1% of our 3% price increase. One of the percent. About 1% is in salaries and hourly wage increases. The other 1% percent might possibly help the bottom line a little bit, but it might also just absorb some of the less visible things like the gas bill goes up, the electric bill goes up, things like that. So those miscellaneous things. So we believe that there won't be any margin erosion due to material cost, labor cost and those miscellaneous things. And then the most serious margin erosion that occurred in '17 was the efficiency going from people that had managed the plant for eons to young guys. And these young guys have done a really, really outstanding job. I mean, they have now produced product that's a better product at a higher rate than has ever been produced out of this plant before. This was a record revenue quarter and they've got it going in the right direction. They will get the efficiency back. But to get to those 2016 margin percentages, that's a pretty lofty goal. I would like to keep a lid on our price increases and not have to have any more than we have to, get the top line up, get the dollars to the bottom line up and let the margin be a little bit of a float.

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Brian Gustavson, [29]

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Got you. Just on SG&A, I think someone asked about that. But kind of given the stuff you're talking with the innovation lab, do you think there's uptick in SG&A next year? Or do you kind of maintain this level that you're kind of at now?

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Gary D. Fields, AAON, Inc. - President and Director [30]

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Well, that's part of my strategic planning process to figure out exactly how that lab's going to affect that SG&A. But we have every intent of not letting it push us in.

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Scott M. Asbjornson, AAON, Inc. - CFO and VP of Finance [31]

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Warranty expense, expecting that will go down will lower SG&A in all probability going forward.

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Brian Gustavson, [32]

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Okay. Got you. And just on the water-source heat pump, when do those start shipping? Like when should we see significant...

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Gary D. Fields, AAON, Inc. - President and Director [33]

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Water-source heat pump is...

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Brian Gustavson, [34]

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They're shipping now?

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Gary D. Fields, AAON, Inc. - President and Director [35]

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Yes, we've been shipping. And like Norm said in some of his earlier comments there, in the fourth quarter, we will ship more units or as many units as we shipped year-to-date.

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Brian Gustavson, [36]

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Okay. What's the margin impact there? Like what's the -- if you ship a lot of water-source heat pumps, does that help margins, hurt margins?

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Gary D. Fields, AAON, Inc. - President and Director [37]

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Well, the thing is if it was a significant portion of revenue, then it might hurt it for a period of time. But when you look at it percentage-wise of revenue and what we believe is going to happen, then even though its distinct margin is below the benchmark for the rest of the company. It can't move the whole margin more than just a small click or 2, one way or another. We do know that the margin is going to start off lower than our benchmark. But I'll share something with you that was pretty interesting. We've been building these things where we'll have 3 or 4 units of one configuration followed by 3 or 4 more units of a different configuration alternating down through the lines. There's 15, 16 units on the assembly line at one moment. And there could be 3 to 4 different configurations. So they don't get catch any rhythm. One of them they do, we'll say is a -- that looks like a basketball and the next one they do looks like a football, okay. So they don't catch a lot of rhythm. And so we know what the margin was on those and it was lower than our benchmark margin. Well, we had this order for 380 identical units, of which we ran a 190 of them, nose to tail, just random. And our margins were very nice. We looked at that and said, okay, now we get it. So when you catch that rhythm, when you got that muscle memory where people don't have to stop and think, what do I have to do next, well then you get this efficiency. So when we get the flow line put together, A, B and C. A, we'll always have -- the intention is it will always handle that variance. There'll be footballs and basketballs and baseballs going down that line at any one moment. Line B, will be more unique units, bigger tonnages, bigger configurations. Line C, which we're going to build throughout next year, will be for those high-volume lines. So we're probably a year to 18 months from having experience and facilities that will allow us to get pretty close to what we believe the end goal would be for an overall product line gross margin.

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Norman H. Asbjornson, AAON, Inc. - Chairman of the Board and CEO [38]

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So just to summarize, some of the stuff we've got going on has definitely got a negative margin attached to it. Some of it is breakeven. And on this one large job, we probably made a little bit, not standard margin that you're accustomed to but we were definitely in the black. So it's going to vary. Day to day it varies, depending upon a whole host of things, including how well people are able to make it happen and whether or not there's some glitch in the whole system that shuts the system down for some reason. So we're still in the startup phase, and that's probably going to go on for several months yet. And then we'll get down to where it will be very rare of when we have one of these issues. We're going to have an issue every 15 or 20 minutes to having an issue every 2 or 3 hours.

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Brian Gustavson, [39]

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I see. But just on the water-source heat pumps, like when you might you think you'll cross the line to kind of profitability? Like what kind of volume do you need? Or like what point of next year do you think you'll be -- those lines will cross?

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Norman H. Asbjornson, AAON, Inc. - Chairman of the Board and CEO [40]

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We'll be crossing in the middle of the year, I think. Where it's really going to start becoming noticeable on the bottom line in any significant scale, I think it's going to be the very end of next year and possibly into 2019. Recognize what we have done here. Let's just summarize it a little bit. We have a totally new product, which is state of the art, way out advanced from anything else that's out there in many areas. We've designed and built a production line which might be a state of the art for any industry anywhere. Think of this, a piece of sheet metal, aluminum sheet metal that's sitting in the tower. About 2 hours later, that piece of sheet metal was shipping down the road as a finished product. In other words, the work in process on that piece of sheet metal is just a matter of minutes. It's not a matter of days or months or hours. It's a matter of minutes. Each individual unit gets an individual set of sheet metal. So we have no run rate or minimum run or changeover or anything. Every unit is a changeover. Every unit is unique. And that has to be done in a very sophisticated manner because when we're up and running on the production line we've got right now, we think that run rate per unit is about 4.5 minutes. So everything will totally change every 4.5 minutes possibly or the run rate will be just [for any] 4.5-minute units we put together. So this is a very unusual situation. We thought we could put this kind of line together. We thought we could leave the challenges. We undertook to do it and we've succeeded. So it's going to be very interesting to see what that will do to us on the bottom line once we really fully understand how to run it and each of the individual people working on the line fully understand it because we have no cost at all in storage and warehouse, taking it to the warehouse, bringing it back from the warehouse. There's a whole lot of things that just don't exist in this line. We have 0 people working on fabricated sheet metals. It's all automated. We have 0 people fabricating copper. It's all automated. We have 0 people fabricating insulation. It's all automated. We have minimum time necessary to bring the purchased parts down because we have installed 28-foot high towers with 40 shelves and the shelf comes down and delivers the right product with the right unit at the right time and there's the next one and brings a different shelf down. So we load the whole shelves during the nighttime, and in the daytime, there's nobody hauling parts to the line. These parts come down right at the line when they just put over on the line and it's simple. So this has been an enormous challenge we've had and we're rapidly getting into the final stages of it. We know we can make it work now. We know it is working. What we haven't done is perfected all the potential that it has, and that's only going to take time and additional run time. There's been a lot of concern, as you can imagine, among a lot of people because of the -- how far out into the future we went in our product and in our manufacturing methodology. All of that is now proving itself to be good. Everybody is thrilled with where we are. But we aren't where we're going to be in a year from now.

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Operator [41]

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And at this time we have no further questions. I'll turn the call back over to management for closing comments.

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Scott M. Asbjornson, AAON, Inc. - CFO and VP of Finance [42]

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We appreciate everyone for listening into our third quarter conference call. And we'll look forward to speaking to you again when we have our fourth quarter results. Thank you.

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Norman H. Asbjornson, AAON, Inc. - Chairman of the Board and CEO [43]

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Thank you from the rest of the -- all of us.

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Gary D. Fields, AAON, Inc. - President and Director [44]

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Thank you. Bye-bye.

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Norman H. Asbjornson, AAON, Inc. - Chairman of the Board and CEO [45]

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Bye.

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Operator [46]

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Once again, we'd like to thank you for participating in today's conference call. You may now disconnect.