Good day, and welcome to the AAON Incorporated Fourth Quarter 2022 Earnings Conference Call. Our host for today's call is Joseph Mondillo. At this time, all participants are in a listen-only mode. And later we will conduct a question-and-answer session. I would now like to turn the call over to your host. Joseph Mondillo, you may begin.

Thank you, operator, and good afternoon, everyone. The press release announcing our fourth quarter financial results was issued after market closed today and can be found on our website, aaon.com. The call today is accompanied with a presentation that you can also find on our website, as well as on the listen-only webcast. Please turn to slide two. We begin with our customary forward-looking statement policy. During the call, any statement presented dealing with information that is not historical is considered forward-looking and made pursuant to the Safe Harbor provisions of the Securities Litigation Reform Act of 1995, the Securities Act of 1933 and the Securities and Exchange Act of 1934, each as amended. As such, it is subject to the occurrence of many events outside of AAON's control that could cause AAON's results to differ materially from those anticipated. You are all aware of the inherent difficulties, risks and uncertainties in making predictive statements. Our press release and Form 10-K that we filed this afternoon detail some of the important risk factors that may cause our actual results to differ from those in our predictions. Please note that we do not have the duty to update our forward-looking statements. Joining me on today's call is Rebecca Thompson, CFO and Treasurer; and Matt Tobolski, President and Co-Founder of BasX. Unfortunately, Gary Fields, our President and CEO; is under the weather today, which is affecting his vocals a bit, that's why we have Matt here today. He will be filling in for him. We wish -- we all wish Gary a speedy recovery. Matt will provide some opening remarks to start the call. Rebecca will then walk through the financials, and then we'll finish with Matt for some commentary on the quarter and outlook for 2023. With that, I will turn over the call to Matt.

Thanks, Joe, and good afternoon. So, starting on slide number three. Overall, we are very pleased with our 2022 results and particularly with how we finished the year. We started the year faced with several challenges, which resulted in a slow start. However, we quickly assessed the issues, adapted and were able to overcome those issues by the second half of the year. We reported record results in the third quarter and followed that up with another record in the fourth quarter of 2022. Despite the slow start to the year, we finished 2022 with record sales and earnings for the year. In the fourth quarter, sales were up organically 67.7%, and earnings were up over 500%. Organic volumes in the quarter were up 41% and a two-year stack, volumes are up 46%. Compared to our previous record EPS in the third quarter, EPS was up 39%. Gross profit margins were the highest since 2020. At the same time, backlog has increased throughout the year, finishing 2022 at record levels. We've increased capacity and production output throughout the year and hope the orders continue to outpace production. Now, please turn to slide number four. This is a very interesting time for AAON. For decades, the company focused on a niche of the commercial HVAC market, centered around the design and manufacturing of premium quality, high-performing, high energy efficient equipment. Historically, two factors prevented this niche offering from becoming mainstream, the first factor being price. A historically has had equipment that carried at least a 15% to 20% price premium as compared to market pricing. This limited the size of our addressable market to specific applications and to our customers. The second factor is value. Up until recently, a vast majority of end users were not focused on total cost of…

Thank you, Matt. I'd like to begin by discussing the comparative results of the three months ended December 31, 2022, versus December 31, 2021. Please turn to slide five. Net sales were up 86.8% to $254.6 million from $136.3 million. The largest driving factor to the growth was organic volume, which contributed 41%. Volume growth reflected the company's strong backlog and the fourth straight quarter of record production. Improved productivity, along with approximate 36.2% increase in total headcount helped drive the increased production. In addition to volume, pricing contributed 26.7% and inorganic growth contributed 19.1%. Similar to the legacy business, BasX performed extremely well in the quarter. BasX realized record sales and EBITDA of any quarter in its history. Moving to slide six. Our gross profit increased 195.9% to $78.5 million from $26.5 million. As a percentage of sales, gross profit margin was 30.8% compared to 19.5% in 2021. Gross profit margin benefited significantly from multiple price increases initiated throughout the year, reduced impacts from supply chain issues and production efficiency improvements across all of our manufacturing locations. The year-over-year improvement in gross profit margin was also partially attributed to the abnormally low gross profit margin realized in the year ago quarter, a result of supply chain issues at the end of 2021, which constrained production and resulted in unabsorbed fixed costs. Please turn to slide seven. Selling, general and administrative expenses increased 51.3% to $31.9 million from $21.1 million in 2021. Adjusted SG&A expenses increased year-over-year at 85.9%. As a percentage of sales, adjusted SG&A decreased to 12.5% of total sales compared to 12.6% in the same period in 2021. In dollars, SG&A increased primarily due to our volume growth that created higher earnings, including higher profit sharing expenses, commissions and bonuses. Please turn to slide eight. Adjusted income…

Thanks Rebecca. I'll now turn to slide 11. As I said in my opening remarks, we are very pleased with how we finished the calendar year. Our operations continue to perform well in Q4 and I continue to command the team for their performance. All three of our locations are pushing more volume through their respective plants than we've ever seen before. Organic volume growth of 41% realized in the fourth quarter is pretty much unheard of in its industry and the comp was not easy. Volume in the fourth quarter of the year ago period was up 4% from the fourth quarter in 2020. On a two-year stack, volume was up 46%. This performance is a result of several factors. First, the headcount was up 36.2% from a year ago and up 6% from the third quarter. We continue to do a great job with our onboarding new employees and efficiently integrating them into our operations. Second, productivity continues to improve. Supply chain issues, while leaning a bit, still very much exist. Throughout the year, we learned to manage through supply chain constraints much better, leading to improved productivity. At the same time, we're ramping up headcount at an aggressive rate, which can result in inefficiencies, if not addable properly. Despite the challenges, our metrics on productivity tell us that our operations are continuing to become even more efficient. The team is fully adapted to the environment and has mitigated most of the financial impact, particularly when it comes to supply chain issues. We should see productivity improve even more as supply chain issues abate. Lastly, in addition to headcount and productivity improvements, the volume growth was also a reflection of our premier sales channel and the backlog of our partners have been able to generate for us. I'd…

Thank you. [Operator Instructions] Our first question today will come from Julio Romero with Sidoti & Company.

Thanks. Hey, good morning, Matt, Rebecca, Joe.

Good afternoon.

Good afternoon.

Maybe to start on the quarter, if you could just talk about what product lines drove the 41% volume growth you realized in the fourth quarter?

The overall growth in the fourth quarter was across the board. It was not isolated to one specific product or product line. We've seen consistent growth throughout all of our production facilities and across all of our production lines.

Okay. Got it. And thinking about price, I love the slide deck and love the guide. Does the pricing guide of low double-digits for 2023 assume the monthly 1% price increase kind of continues through the entire year or all the way through December of 2023?

Well, I think someone was going to ask that question, Julio. So right now, the -- well, so we have been continuing the 1% a month price increases. We have not determined if yet if we're going to stop those price increases. This is something that we've been looking at on a continuous basis. As Matt spoke to in his presentation, a lot has changed in the industry that caused us to begin managing our pricing to market, so we do still have the 1% a month in place. And right now, we've made no decisions to stop those increases. All that being said, we do expect to see improvement in 2023 in our gross margin, although it may not necessarily be linear. As we previously mentioned in our prior calls, we're using some of this pricing to benefit our employees, so some of these benefits are expected to have a one-time impact in our first quarter. So you should expect to see a stronger half of the year when it comes to the gross margin. And we're just constantly reevaluating rather than managing to our traditional guard wells of 28% to 32%, looking more at managing to the market and how to evaluate our gross margin. So at this time, that's where I'll leave you.

No, I appreciate the color, and that does make sense. I guess -- maybe just on the expected gross margin. I think, Matt, you might have mentioned in the first quarter, you expect some temporary expenses that might affect the first quarter's margin. I don't know if you can elaborate on that at all.

This is just a variety of one-time expenses as we put in place some new employee programs and better position the company to provide the employee experience that we expect. There are some one-time costs and adjustments that we’ve made in the first quarter, that's kind of driving some of that constraint on the overall margin in that quarter.

Okay. Really helpful. I’ll hop back into queue for now. Thanks so much.

And our next question will come from Brent Thielman with D.A. Davidson.

Hello. This is Jean Ramirez for Brent. How are you?

Good.

For my first question, regarding supply chain constraints, could you talk about the state of sourcing parts and materials and how AAON is positioning itself to fulfill the backlog orders?

Certainly. So….

Go ahead, Rebecca.

So I don't know if you've noticed, we have increased our inventory quite a bit. We said a few quarters ago, that we've been trying to maintain an inventory level of about 20% of our sales. So outside of that, we also will take advantage of opportunistic buys when we're able to. So if we get a good -- when we see a chance to buy certain quantities of steel or metals or component parts at a good price, we'll lock those in and purchase those to maintain a higher level than inventory than maybe we normally would, just to benefit from that price reduction. We also were keeping the larger quantity on hand that helps make sure production can continue seamlessly without interruption. But I would say supply chain and part shortages are still a daily challenge for the team. They're constantly having to find new vendors, find alternative parts, alternative sourcing, redesign products; it's just a part of our everyday life now in how we operate the business.

Just adding a little more context as well. The -- from a parts perspective, as Rebecca mentioned, there's continuing maintenance that goes on from a product engineering and manufacturing perspective as we kind of see these constraints coming ahead of us. The team is extremely nimble and continues to be extremely nimble in assessing the impacts of potential shortages. And proactively, basically, looking at the equipment design and configurations and alternate sourcing options and is in a continuous mode of basically redesign and modification to essentially address some of the supply chain constraints that we're experiencing. We also are very positively impacted by the fact that we are, as an organization, heavily integrated from a vertical perspective. And so, items such as the manufacturing of coil is a big example, but extending that further the production of fans and fan assemblies is a huge differentiator for us in the marketplace. And so, as we look at motor, motor constraints, motor technology constraints, electronic component constraints that are impacting a lot of our other competition. Our team has been very good at assessing alternate technologies or basically looking at ultimate vendors, coupled with the fact that we are manufacturing fans as an example, to really mitigate the overall impact in our deliverability and costing.

Thank you. And just regarding your 2023 model assumptions of gross profit margin, could you perhaps like talk about what leads us to improvement from Q4 of 2022. And circling back to, can you sustain this 28% to 32% gross margins through 2023? Thank you.

Go ahead, Matt.

Yes, so we finished off Q4 just in the 30% range. But as we look at the backlog and the strength of the backlog from a gross profit margin perspective, we have an understanding of kind of the improving gross profit profile that exists inside of there. Coupling that with the, I'll say, production and volatility in the supply chain side of things, obviously, not absolute reduction in volatility, but certainly waiting a bit, is providing some higher confidence as we continue monitoring overall cost inputs. With the continuing 1% price increases that Rebecca mentioned earlier, we have the ability to absorb some of the additional inflationary pressures without impacting margin on a high level. So, as we go forward, we see from a modeling perspective and from kind of the strength of our backlog and the inputs that we have a solid understanding of that we'll continue to see some increase in overall margin as we progress throughout the year.

Great. Thank you. I'll hop back into the queue. Appreciate it.

Thank you.

Your next question will come from Chris Moore with CJS Securities.

Good afternoon guys. Thanks for taking questions. So yes, maybe back to the guide for a second. Obviously, volume was very strong, Any thoughts in terms of volume growth for 2023 with those comps in mind kind of a range?

Yes, hey Chris, this is Joe. So, we're not giving volume guidance at this point in time. We gave you the price contribution to help you sort of narrow price out of the equation. And then where our backlog is and the trend of our volumes are, and you can sort of put two and two together, but at this point in time, we're not providing volume guidance.

Okay. And anything else that you could say on that front just in terms of maybe puts and takes. Why -- I'm just not sure where to head at this moment, why low single-digit would make -- wouldn't make sense why just any other color there that you might be able to provide?

Well, what I would say is that the backlog is very strong. The order trends have trended very positively as we have entered 2023. So, the first half of the year is positioned really good. As you get into the second quarter, the comps start to get very tough. And certainly, when you get into the back half of the year, the comps are -- become much tougher. So, you should see substantial volume growth early in the year just based on the comps and the strength in the backlog. And then the back half of the year should slow. I'm not going to -- we're not going to factual guidance on it, but hopefully, that helps.

That's helpful. I appreciate that. It was $16.2 million data center contract that you guys have been talking about for a while. Is that something that has started to ship at this point in time? Is that something that happens in Q1?

Yeah, that project is in production. It's overall shipping schedule and basically having a product out the door is basically imminent. So as we continue producing that product throughout the year, it will have an impact on the -- basically first half of the calendar year.

Got it. And, I guess most importantly from that is there's kind of a theme that you've talked about in terms of these bigger orders likely coming. That's still something that you're -- that you have some visibility on?

Yeah. So from an opportunity perspective and visibility perspective, the ability to leverage the Longview facility for BasX data center product remains extremely strong. And as you indicated, the overall sale of those projects continue to be of a highly attractive scale.

I just wanted to add one other thing regarding that t $16 million order that you're referring to. Like Matt said, it is on schedule to some extent. However, it has got pushed a little bit. So it will end up hitting some partially in the second half of the year as well. I just don't want you to fully think about modeling that fully shipped by the end of the second quarter.

Got it. And it’s helpful. I leave it there. Appreciate it guys.

Your next question will come from Jon Braatz with Kansas City Capital.

Good afternoon everyone.

Good afternoon.

Matt, sort of a strategic question. You talked about the pricing within the industry and your premium narrowing a little bit. How do you think about maybe as things continue to maybe returning to more of a premium price product and maybe giving up some volume? How do you think about -- strategically about going back to a higher premium price given what we're seeing in the industry at this time?

Yeah, sure. As we indicated on the call, so we're certainly evaluating pricing from a market based pricing perspective. And with that, obviously, continuing to focus on the value proposition that AAON provides. So we certainly expect there to be a continued value – or basically additional value provided by AAON product, and we'll price that accordingly. As we move forward, we certainly want to understand -- and really where we've always been successful as in the organization is selling the overall value of the product beyond just first cost. And so the AAON product, even given the pricing dynamics of the market, the AAON product continues to provide a superior overall total value to our end user, and we will continue to market and price accordingly for that consideration.

So would you characterize it as maybe being that there is some upside potential to pricing based on market dynamics?

There certainly is the opportunity for some upside in the overall pricing as we look at how AAON's product is positioned in the marketplace.

Okay. All right. Thank you. Rebecca, a second question, capital spending is pretty heavy this year, $135 million. I take it, there may be some timing differences between cash flow and so on that you might have to go to the bank and borrow some money and your debt balances may move up and down a little bit from the current levels?

Yes, certainly. So we do expect to see our operating cash flows resume their normal level. I can say, our CapEx spend is heavily weighted to the first half of the year. So we do have some negative free cash flow in Q1. But after Q1, we kind of start to see our free cash flow get back to its more normal level and about the 70% to 75% earnings free cash flow ratio by the second half of the year. And so I mean we don't anticipate needing to get any additional like liquidity under our credit agreement. In fact, we somewhat anticipate it could be paid off by the end of the year.

Okay. All right. Thank you very much.

[Operator Instructions] We'll take a follow-up question from Julio Romero with Sidoti & Company.

Thanks [Technical Difficulty]. I assume you realized all of the March increase by now. Where did you guys exit December in terms of realizing monthly price increases?

Well, so Julio, I think this will answer your question. I have in front of me, our January backlog. So like at the end of January, we have less than 1% of the backlog that's March or January price increase. So everything now that's pretty much left in our backlog is the various 1% price increases that will be flowing out over the next year.

Got you. Okay. Appreciate taking the follow-up.

[Operator Instructions] It appears there are no further questions at this time. Mr. Mondillo, I'll turn the call back to you for any closing remarks.

All right. I'd like to thank everyone for joining us on today's call. If anyone has any other questions over the coming days and weeks, please feel free to reach out to myself. As Matt mentioned at the closing of his remarks, we have Investor Day on May 17 and 18. We're attending the Sidoti conference on March 22, and we'll be at the Wells Fargo conference later in -- on June 13. So hope to see you at those events. And again, if you have any other questions over the next few days, feel free to reach out. Thanks, and have a great day.

This concludes today's conference call. Thank you for attending.