Good afternoon, ladies and gentlemen, welcome to the AAON Incorporated Second Quarter Sales and Earnings Report Conference Call. There will be a question-and-answer period after management's brief presentation. This call will last approximately 45 minutes to an hour. I'd now like to turn the meeting over to Mr. Asbjornson. Please go ahead, Mr. Asbjornson.

Good afternoon. Norman Asbjornson here, I'm hosting this thing. Before we go forward, I would like to read the forward-looking disclaimer. To the extent any statement presented herein deals with the information that is not historical, including the outlook for the reminder 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. Thank you. I'd like to introduce our CFO, Mr. Scott Asbjornson.

Welcome to our conference call. I would like to begin by discussing the competitive results of the three months ended June 30, 2017 to June 30, 2016. Net sales were down 1% to $101.3 million from $102.3 million, sales decreased primarily due to changes in product mix despite increased volume. Our gross profit decreased 3.3% to $31.7 million from $32.7 million. As a percentage of sales gross profit was 31.3% in the quarter just ended compared to 32.0% in 2016. The decrease in gross profit is primarily due to increased raw material prices. Selling, general and administrative expenses increased 13.4% to $12.0 million from $10.6 million in 2016. As a percentage of sales SG&A increased to 11.8% of total sales in the quarter just ended from 10.3% in 2016. The overall increase from 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 warranty claim and puts a deadline for when claims maybe submitted. This has increased our warranty reserve and increased our warranty expense for the three months ended June 30, 2017. Income from operations decreased to 11.4% to $19.7 million or 19.4% of sales from $22.2 million or 21.7% of sales. Our effective tax rate decreased to 30.2% from 33.9%, the company's estimated annual 2017 effective tax rate excluding discrete events is expected to be approximately 36.0%. The difference between our expected effective rate and our actual effective rate is due to excess tax benefits from stock compensation. For the three months ended June 30, 2017 and 2016, the company recorded $1 million and $0.4 million respectively in excess tax benefits as an income tax benefit. Net income decreased to $13.8 million or 13.6% of sales compared to $14.7…

Good afternoon. While net sales were down 1% in the quarter, sales decreased due to changes in product mix despite the increased volume, potential on the water-source heat pump has come along a bit slower than what we had originally forecast due to getting some industry certifications completed. We are well on our way to those completions into two step process, the first step is completed, the second step is in process now and it is imminent. So, the water-source heat pump is, this is probably running a few weeks behind the schedule that we originally intended. So, the [indiscernible] business in the various market segments, replacement markets versus new construction, we find the ratios remaining very similar to what they were in the first quarter and we do quite a lot of replacement business in the K-12 markets at this time of the year and that's been very strong for us. Commercial and retail, we don't have very much retail penetration with our products; we do have some in the commercial market that's reasonably noteworthy. Office buildings remain steady as they were in the first quarter. Medical and the healthcare have both picked up a bit for us in recent months. The good thing about that is, as medical and healthcare tends to use our larger tonnage units, so we should see a bit of a shift back towards a few more larger tonnage unit. Education primarily K-12 that's what's been responsible for the smaller units. They tend to run in the smaller end of our scale with high number of quantity of units but low dollars per unit comparatively. We still got probably two more months of very heavy production of the K-12 market. Manufacturing has been steady, lodging has been steady, municipalities have been steady as well. A couple of areas that we would categorize as much smaller more unique niche markets have been what we call mission critical, some may know as them like data centers and this sort of market. We've made some significant in-roads on that with some of our products. The encouraging thing is the backlog at June 30, 2017 was $83.5 million that's up from $69.3 million at the same point a year ago. So, we have the orders in the door and they are in processing and with some of the management changes we have had in the manufacturing, the personnel changes that transition has moved along quite well, and Norm will speak to that a bit more here. So, I'm going to turn it over to Norm.

Okay. For the remainder of 2017, first of all, I kind of should summarize a little bit what has been occurring within AAON. We've had an enormous amount of things on the table to be managed and one of the things is management change over. There were a lot of us my age that were getting toward the end of our career and some of those people decided to leave us this past year. These were very critical people within our organization, the head of our manufacturing a gentleman, who is 76 years old and have an excess of 40 years experience about 30 of which [indiscernible] and 30 of which was here. Stayed on from last summer when he wanted to retire until March of this year, simply because of the number of management challenges we had around here with all the things we got on our plate to get change and all the changes we were doing. So, he left in March. Another gentleman who began to expect to leave quite so soon was a 58-year-old gentleman who was our shop floor supervisor, managed the people on the factory floor in our Tulsa facility for many years and he had somewhere around 30 years of experience doing that. He told us last fall -- late fall, that he wanted to retire, we asked him to likewise stay around and he stayed till March both of them are big fishermen and I think that played a little and what they talk they should do. At any rate that we bought on our new set of people to run the overall management, market or the manufacturing as well as the operation on a day-to-day basis at the floor level. These we made quite a significant shift. The one gentleman drops…

[Operator Instructions] Your first question comes from the line of Joe Mondillo [Sidoti].

Hi, Norm, Scott. Good afternoon.

Hello Joe.

So, I wanted to try to get a better idea of exactly what was going on with the management and production disturbances related to that. What was the timing of all this, does this go back a couple of quarters because you mentioned that both these individuals were going to retire last year, but then they got extended. So, I guess they were there. So, in that time period, I assume the production of your orders and such weren't that disturbs, was this just a second quarter issue? And also were you turning down orders throughout this time period or was it just the case in point where production was just not as efficient and lead times got extended a little bit more. Any further color on the timing the extent of the issues that this caused?

Joe, this is Gary Fields. So, the two gentlemen we spoke of Bob Ferguson, Ed Johnson both retired in March. So, the transition -- that the two young man that took their places really began transitioning back in probably November, December to some extent shadowing both Bob and Ed. But, the last day for Bob and Ed was the same day, it was in March. So that the entire quarter -- second quarter was produced by the two new young men. So, as you can imagine the first few weeks was a little bit I like the way you called it, disturbance, that's a good way to categorize it. And it was like there was a ripple in the water kind of disturbance, but it wasn't big splash, it was just a ripple. Well, that's began to smooth out and we did extent lead times to your point that's why the backlog grew. We have extended lead times probably on average two weeks in some cases three weeks from what we had historically been producing. Now, we are beginning to gain steam on that and actually as Norm had mentioned it's grown much stronger and they are running at pace ahead of anything we have ever done. So, they had some catching you to do and they have done that. And they have actually gotten ahead of the curve now to some degree. And the other thing that they had a little more focus on getting some efficiencies as they saw them. And so there was some -- again, a little disturbance in that and trying to get people to change their culture a bit just some new efficiencies. And I think it made great headway. We get a daily report telling us how we are doing on a year-to-date basis every morning and we have been in the green for a little bit now.

Talking about being in the green, it either flashes a red to us that we are not progressing or it flashes a green to us that we are progressing that measure several things bought our company and tells us that every morning before we come to work. So, we know how we are doing. We get a daily report of the computer telling us how we are doing. We are in the green which means we are advancing pretty consistently now.

And it compares to the previous year, which of course 2016 was a record year.

How would you compare -- or how would you look at the industry overall, because it seems like listening to some of your peers that things have slowed a little bit, it's tough to tell exactly how you would have done the things where running smoothly. It sounds like you would have done better, but I don't know what you are talking 200 or 300 basis points of growth or 500 to 1000 basis points, it sounds like maybe the former, do you sense in the first half of that overall the industry had slowed a bit at all?

Well, I think the industry as a whole has, that our segments of the industry that are anywhere between flat to very, very slightly up. Norm and I were just looking at the water-source heat pump report for the first six months of this year versus the first six months of last year. And overall, it was up -- I think it was 1% …

1.4%.

Yes, 1.4%. So, it's -- that's not much. I haven't examined our core products being the rooftop unit, but I haven't looked at the same report, but at the last time I did look at it, we were either -- most categories were flat, some of them were slightly behind.

Very definitive form to tonnage size, somewhat significantly hit, somewhere pretty flat and somewhere down. So depends for which part of that market tonnage wise you have your strength as to how it was affecting.

I think in fact that our backlog is that significantly, see can you do the math there and say we produced very close to what we did in 2016, so far. We are just a little bit behind that as far as what's going out the door, but the backlog has grown and say you can put the math to that and analyze what might occur as we produce that backlog.

When you look at your order in take trends, do you feel like throughout the first half of the year up until now that things have started to slowly get better in terms of the order trends?

Exactly, our order intake trended up beginning with the first month of the year, it actually started turning around towards the end of the fourth quarter, but we have again using that green and red scenario, we have stayed in the green virtually everyday all year long on order intake. I mean there is some days that will be a little behind, but when you start getting enough data points out there. Then the trend for order in take is actually -- it's been up very nicely.

Of course suffering as units out to board and that's when we have been talking a lot about but why that was. And now, as we said, we are now running it faster, we have ever run, so all the troubles which we had -- most of all, earlier part of this year either not having orders from the fourth quarter or from the fact that we managed our workforce and then had to replenish it. They are pretty much behind us now.

Okay. And I know it's probably tough to sort of address first also just in terms of the gross margins. You mentioned a little bit I think how mix has been a little unfavorable in terms of smaller unit, but I also assume that these production issues have weight on efficiencies and now that things are sort of better and it sounds like mix may even be -- you mentioned healthcare maybe sort of transitioning to maybe a little more of a favorable mix. Do you anticipate gross margins to start to improve on the year-over-year basis, again, in the back half of the year?

Gary?

Yes. The margins are being impacted as well the commodity cost and the component cost, and commodity cost are going up with respect to copper. And so, we are trying to offset some of that with getting the efficiencies back up in the actual assembly process and hopefully if commodity costs will stabilize, we will be able to evaluate what that impact is going to be going forward and we maybe putting in some price increase later in this year.

Okay. Okay. I will hop back in queue right now. I have a few more questions, but I will let somebody else in. Thanks.

Thank you, Joe.

[Operator Instructions] You have a follow-up from Joe Mondillo.

All right.

Welcome, Joe.

Hello. Couple of other questions. So, number one for the water-source heat pump, do you have anything in backlog and if so can you quantify what you have in backlog related to that.

We have variable backlog. We have been producing about as fast we get them the NIM. And we have been spending time putting additional units in stock. And as I have mentioned those stock is up around 1700 units right now, which is real high precision for anybody in this industry, normally most people carry a very low stock, what are the reason their own reason. We have decided to carry a higher stock that we can benefit by having a bigger stock and leveling out our production and doing a number of things that we think will make money for us. So, it's not that we are getting what we announced early on was we were intending to go up to as much as 2300 units in stock, where we have got 1700 mark. Those are slowly but surely starting to materialize faster and we are not going to speed up line up any sooner, we really have to because it allows us to keep our cost down, when we do have one of these shutdowns because the software problem, we don't have too many people standing around when we fixed the software problem. So, it's working out quite well for us to bring it up into speed at a minimum cost. We are losing a little bit on the revenue line but we are saving in the bottom line at the same time. So, we are trying to trade that thing so that we get the revenue and bottom line performance working to the best part of the way.

Okay. And I know you were talking of that this first production line was -- the goal was in terms of low hanging fruit within the industry was to achieve $50 million of revenue give or take on this production line and then later in 2018, you are going to open up a new another second production line and that will sort of capacity wise will get you the same -- so, that gets you to sort of that $100 million that you have been sort of talking about or targeting. I'm just wondering where we are at in terms of that first production line and I know your goal was by the end of this year to get to an annualized run rate and exiting the year getting to that sort of $50 million, I think. Where are we that's the achievable or is that sort of -- that pushed into 2018 in terms of the first production line, any insight and in terms of those target numbers and timing wise would be helpful.

When we talk about the production line and turn the order input over to Gary. Gary is taking over that part of the dialog. One of the things we are concentrating on is internal ratios including production. We are going to have three production lines for water-source heat pump. They are all on what we call line six, the line six of AB&C. It's A that's running right now and that is as you say want to take us up to $50 million or little or actually a little more than that. But, one of the features the way we are doing this is quite - maybe a little different than anybody else's set-up line. A line is for small tonnage units. B line is going to be a different kind of a line, it's going to be a line for bigger tonnage units and for taking problem units off from line A -- go up from the A line. So, if we get a problem unit on the line we are not going to slow the production down, we are just going to left that problem unit slide off and on to the B line and let the B line fix it up, because the A line is a high volume line, the B lines are low volume lines, so you will get a more cost effective method of correcting whatever problem is in that particular unit which will lay the line out. So the A line runs from north to south, B line sits right on -- and the difference takes the unit directly off from the underlying rather than going to the test them and outside they go right on to the B line. The C line is going to run from south to north and also…

Okay. Thanks Norm. That's very informative and really great color in terms of that. Gary, could you comment just in terms of the -- so, we got a pretty good idea of what the daily sort of run rate this production line can do? Can you sort of give some color on the order in take that you are starting to bring in and how you are -- are you controlling the speed of that or the floodgates opened up at this point and it's how -- how that's going?

Okay. We have been controlling the speed. And still continue to control it to some extent by turning on only models and options that we have fully vetted out that we've had test runs up. So, that's really been the throttle. Approximately each month for the last three or four months about once a month, we open that valve just a bit more. Right now, I'm going to say that we still have some closure to the valve and it's because -- probably two or three different reasons, one of which, on a product of 2 tons through 5 tons, when you go for a project quote, it seems like there is always a handful of 6, 8, 10-10 units in there. Well, those are what we intend to build on 6b. So, we still don't have the ability to turn those on with a cost effective product. We have in our historic products we have some ability to build those, but it's not cost effective. So, I didn't want to turn that valve open too much, what we are doing is managing that on a kind of case-by-case basis. So, let's just say that a project has got a preponderance of 2 through 5, 10 units that we are prepared to build with 6a. Then that project has got a very small percentage handful of units that we intend to build on 6b to be ideal. But, we have another method building them in our historic product then we go ahead and open that up and look at that project. And we secured a couple of projects doing that. So, we are playing still project-by-project on those kind of opportunities. Then there are some options that are desirable options market want options that we are still vetting out in…

Okay. And regarding that sort of reps transitioning from competitors' line to your line at this point in time where the production line is and how much you are willing to sort of go out there and take orders. In terms of that transition of reps to your product line, are you -- is that sort of in line with your expectations, are you at all disappointed on the speed of that or is that sort of in line and you just need more time of production and getting the certification and you expect that will continue to progress?

I'm going to say the latter. I'm going to say, I'm disappointed in the timeline as it occurred because some of the restrictions that we have had with the approval from the agency approval and then getting our software vetted out. We had been probably a little more optimistic -- I certainly was a little more optimistic than what prove to be realistic as far -- how long it would take to get some of those preparations vetted out. So, the way I'm looking at is, as we probably versus the timeline that I had in my mind, we are probably just take everything that we have been saying and move it forward in the range of 90 days. But, it's all occurring as far as their endorsement -- our sales channels endorsement of our product, I could not be happier about that. I mean they are absolutely endorsing the product. And we've had delivery of a decent number of units and installations of them, and we have got some feedback from that. And by and large it's been very favorable feedback, of course, like any newer introduction, there has been a few little snags here and there that as given us an opportunity to work them out. But, that's also a good reason to say rather than having opened about too much too soon then it might not be so manageable. But this way, the small little -- I really call them inconveniences they have been about the same ripple in the water that the management change was. It's not tumultuous, but it's a little irritable. And so, we have managed to work those out in a very nice pace. So it's preparing us, in other words, to summarize it this way, we are building a very, very firm strong foundation under this business. It's very solid and we have got very solid support. So, I'm as optimistic as I've ever been and becoming more so every minute because we accomplished some things that -- some of them were a bit speculative as far as how we could automate some of the software, some of this has never been accomplished before. And so, while you are optimistic that you've got all of the right people in place to make this happen, it's been never been done before to some extent. And now we have accomplished quite a few of those things, they are now in the rear view mirror.

Okay, great. Thanks a lot. I appreciate that. Just one last question with WHP, at this point in time, would you say the overall operations with all the costs that are baked in whether there are production costs or any other sort of one-time like up -- start-up type cost. Is the business profitable or is it -- I would imagine it's probably a drain on the overall company at this point in time. But, can you comment on that at all?

At the present time our volumes are low and you are correct. It is not adding to our margins. We aren't quantifying the magnitude of that at this point but it is a drag on our profitability at the moment. But, not a major drag because we don't have a whole lot of investment we needed in the first place. It was a very low cost to get into it. It's mainly been intellectual, capital, time and resources relative to that.

One thing that should be said here, when we do start cranking up the volume, what's probably going to happen, is we are going to get to be a profitable entity before very long to where it's moving, there won't be room moving at the same percentage profitability that are historical product will be, so as it ramps up it will be a bigger and bigger chunk of volume at a lower margin and so we have [Technical Difficulty] margin for a little bit as it props up, whether it will have a positive effect on our bottom line total dollars of profitability.

But, long-term we do anticipate the margins will be comparable with our legacy product line.

We did a lot of studying earlier on and once we get there everything all the kings worked out of this and everything running full blast, we have every expectation that it will meet this previous profitabilities that we have experienced over the years. But, there will be a time in here when we are cranking it up, we are probably run the volume up, the revenue start increasing and we might suffer a little bit on the percentage of profit but the profitability will move up also. So, we were transferring dollars, real dollars on the bottom line but out of lower margin that we are getting some of them at a lower margin.

Great. Understandable. I just had two other questions, Scott, in terms of the SG&A, I may have missed this but is there a new way you can quantify sort of these one-time like warranty expenses, it seems like that is sort of behind us and going forward your SG&A should be sort of more normal as in compared to historical levels. Is there anyways you can quantify what sort of not normal in the second quarter?

Well, I mean we did have an increase in the reserve from the beginning of this year. So that's part of what you see within the first six months of this year is an increase in our reserve just do to the general cyclical nature of our sales because when you do have warranties it tend to be earlier in your shipments so as our sales are going up, the warranty reserve that's necessary is going to go up because you have more recent sales volume. So that will of course decline as your sales volume goes down generally towards the latter part of the year. The other part though is, the part that you are talking about the one-time portion which we think somewhere around about $1 million worth of that expenses around the one-time increase that we experienced and most of that is a timing issue people accelerating some claims, resolving some old outstanding issues and reviewing how we handle some prior situations and getting the assets through. And we believe that is all behind us at this point.

Okay. And how much did the reserve increase?

666,000, I believe it is since the beginning of this year.

Okay. And I mean that may trend down but that's not going to fully go away, right?

It follows with what your charges are against that reserve of course, and also with the volume. So, if our volume increases further going forward, then we are going to have the reserve going up accordingly.

And this is related to water-source heat pump or other new product?

Product in general -- it's rooftop.

The warranty incident of water-source heat pump in dollars is not even measurable at so low.

Okay. But, related to that though as that business ramps up, do you anticipate that will become some what of a substantial expense because it is a new product and you are not -- you are going to have to reserve for something, right?

It depends upon what you mean by substantial. Let us tell you this, because of the nature of the product being a high volume low cost product one of the things which we agree upon round here which is maybe a exaggeration of what we agreed. We are going to build perfect product. We weren't going to have, we weren't going to have anything but we are out just to warranty part would be things that worn out not for our failure and all those kinds of things. And so we're paying a lot of attention to the component that we selected. We did an enormous amount of work on the manufacturing methodologies. For instance when it gets to the end of the production line, we hook on refrigerant sensing devices, we hook on electrical sensing devices, we push a button and the computer run test. If the computer in its run test, which runs it through all the variations it should run through to check everything finds that it doesn't pass the big red sign comes up, we have some 50 screens big large several inch television screens around this manufacturing process, we use for communication and it comes [Technical Difficulty] failure. And when it comes up with that all of our product lines, if we don't allow the computer, the computer generates our name plate -- prints our name plate upon the completion of our check. And all the other things we have human beings doing this checks. In this case we have the computer doing the check. If the computer fails the unit, it will refuse to print the name plate, without a name plate we cannot ship units. So, human beings are taken out of the picture, they don't have the ability to override the machinery.…

Okay. Sounds like any warranty that was to be put to reserve, the customer should pay for it Norm, it sounds like you had such a good product there?

We think that once people realize what they are getting then we will be able to get at a very nice price for our product because I think there will be a lot of very satisfied customers. From the basic concept, the way it's been booked together [Technical Difficulty] looks.

It sounds so good. Just one last question for me and I appreciate you guys taking the time here today and bearing with me. The taxes Scott, they were little on the low side, I think you even mentioned in your prepared remarks about that going forward though the back half of the year going into 2018, what can we sort of think about in terms of a tax rate?

Well, we can't totally predict that nowadays because we do have to account for that beneficial impact when people exercise stock options. And we can't control who is going to exercise when and what the impact of that is going to be. So, we've had the lower tax rate because it's reflecting people who have been exercising equity compensation giving us a beneficial tax situation. And there is really no way for us to project that.

Outside of that is a normalized rate still around 36% or so.

Normalized is 36% and so far this year, we have had I believe it was $2 million versus $1.1 million last year.

Okay. All right. Well, again, I really appreciate it. Thanks for bearing with me and taking my questions guys.

Well, thank you, Joe. We hope we have answered your questions.

And there are no further questions at this time.

Okay. All right. Well, thank you ladies and gentlemen, we appreciate your time you taken to join us with our quarterly report. I hope that we have answered all your questions as you might have believed here, we have been in a little bumpy time here, but we are very optimistic about where we are going and feel very comfortable with what is going one. We don't see any big ripples in the economy yet even though there is -- as we all know a lot of the turmoil out there, but it doesn't seem to be slowing the economy much. So, we look pretty optimistic. Thank you.

That does now concludes today's call. And now you can disconnect your lines.