Company Quick10K Filing
Quick10K
AAON
Closing Price ($) Shares Out (MM) Market Cap ($MM)
$36.94 52 $1,920
10-Q 2018-09-30 Quarter: 2018-09-30
10-Q 2018-06-30 Quarter: 2018-06-30
10-Q 2018-03-31 Quarter: 2018-03-31
10-K 2017-12-31 Annual: 2017-12-31
10-Q 2017-09-30 Quarter: 2017-09-30
10-Q 2017-06-30 Quarter: 2017-06-30
10-Q 2017-03-31 Quarter: 2017-03-31
10-K 2016-12-31 Annual: 2016-12-31
10-Q 2016-09-30 Quarter: 2016-09-30
10-Q 2016-06-30 Quarter: 2016-06-30
10-Q 2016-03-31 Quarter: 2016-03-31
10-K 2015-12-31 Annual: 2015-12-31
8-K 2019-01-24 Officers, Exhibits
8-K 2018-11-08 Other Events, Exhibits
8-K 2018-11-01 Earnings, Regulation FD, Exhibits
8-K 2018-10-29 Other Events, Exhibits
8-K 2018-08-30 Other Events, Exhibits
8-K 2018-08-02 Earnings, Regulation FD, Exhibits
8-K 2018-07-30 Enter Agreement, Off-BS Arrangement, Exhibits
8-K 2018-05-15 Officers, Shareholder Vote, Other Events, Exhibits
8-K 2018-03-16 Officers, Exhibits
8-K 2018-03-01 Other Events, Exhibits
8-K 2018-01-03 Other Events, Exhibits
TRMB Trimble
WWD Woodward
NOVT Novanta
BE Bloom Energy
FARO Faro Technologies
KRNT Kornit Digital
BGG Briggs & Stratton
GHM Graham
RETO Reto Eco-Solutions
ISNS Image Sensing Systems
AAON 2018-09-30
Part I - Financial Information
Item 1. Financial Statements.
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Item 4. Controls and Procedures.
Part II - Other Information
Item 1. Legal Proceedings.
Item 1A. Risk Factors.
Item 2. Unregistered Sales of Equity and Securities and Use of Proceeds.
Item 3. Defaults Upon Senior Securities.
Item 4. Mine Safety Disclosures.
Item 4A. Submission of Matters To A Vote of Security Holders.
Item 5. Other Information.
Item 6. Exhibits.
EX-31.1 aaon_10q093018ex311.htm
EX-31.2 aaon_10q093018ex312.htm
EX-32.1 aaon_10q093018ex321.htm
EX-32.2 aaon_10q093018ex322.htm

AAON Earnings 2018-09-30

AAON 10Q Quarterly Report

Balance SheetIncome StatementCash Flow

10-Q 1 aaon10-qq32018.htm 10-Q Document


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

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

For the quarterly period ended September 30, 2018
or
[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ____________________ to ____________________
 
Commission file number:  0-18953

AAON, INC.
(Exact name of registrant as specified in its charter) 
Nevada
87-0448736
(State or other jurisdiction
(IRS Employer
of incorporation or organization)
Identification No.)
2425 South Yukon, Tulsa, Oklahoma  74107
(Address of principal executive offices)
(Zip Code)
 
(918) 583-2266
(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [ü]                                 No [ ]                               Not Applicable [ ]
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of "large accelerated filer", "accelerated filer", "small reporting company", and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ü]
Accelerated filer  [ ]
Non-accelerated filer  [ ] (Do not check if a smaller reporting company)
Smaller reporting company [ ]
 
Emerging growth company [ ]

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

As of October 30, 2018, registrant had outstanding a total of 52,094,537 shares of its $.004 par value Common Stock.




PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.
AAON, Inc. and Subsidiaries
Consolidated Balance Sheets
(Unaudited)
 
September 30, 2018
 
December 31, 2017
Assets
(in thousands, except share and per share data)
Current assets:
 
 
 
Cash and cash equivalents
$
7,265

 
$
21,457

Certificates of deposit
2,160

 
2,880

Investments held to maturity at amortized cost
1,252

 
6,077

Accounts receivable, net
51,207

 
50,338

Income tax receivable
2,292

 
1,643

Note receivable
28

 
28

Inventories, net
79,182

 
70,786

Prepaid expenses and other
1,310

 
518

Total current assets
144,696

 
153,727

Property, plant and equipment:
 

 
 

Land
3,029

 
2,233

Buildings
97,944

 
92,075

Machinery and equipment
210,182

 
184,316

Furniture and fixtures
16,035

 
13,714

Total property, plant and equipment
327,190

 
292,338

Less:  Accumulated depreciation
162,294

 
149,963

Property, plant and equipment, net
164,896

 
142,375

Intangible assets, net
564

 

Goodwill
3,229

 

Note receivable
639

 
678

Total assets
$
314,024

 
$
296,780

 
 
 
 
Liabilities and Stockholders' Equity
 

 
 

Current liabilities:
 

 
 

Revolving credit facility
$

 
$

Accounts payable
16,224

 
10,967

Accrued liabilities
37,492

 
39,098

Total current liabilities
53,716

 
50,065

Deferred revenue
1,638

 
1,512

Deferred tax liabilities
8,841

 
7,977

Donations
200

 

Commitments and contingencies


 


Stockholders' equity:
 

 
 

Preferred stock, $.001 par value, 5,000,000 shares authorized, no shares issued

 

Common stock, $.004 par value, 100,000,000 shares authorized, 52,209,643 and 52,422,801 issued and outstanding at September 30, 2018 and December 31, 2017, respectively
209

 
210

Additional paid-in capital

 

Retained earnings
249,420

 
237,016

Total stockholders' equity
249,629

 
237,226

Total liabilities and stockholders' equity
$
314,024

 
$
296,780

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

- 1 -




AAON, Inc. and Subsidiaries
Consolidated Statements of Income
(Unaudited)
 
Three Months Ended 
 September 30,
 
Nine Months Ended 
 September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands, except share and per share data)
Net sales
$
112,937

 
$
113,668

 
$
321,607

 
$
301,072

Cost of sales
80,174

 
78,010

 
245,869

 
208,750

Gross profit
32,763

 
35,658

 
75,738

 
92,322

Selling, general and administrative expenses
13,190

 
13,034

 
36,495

 
35,535

(Gain) loss on disposal of assets
2

 
(1
)
 
(9
)
 
46

Income from operations
19,571

 
22,625

 
39,252

 
56,741

Interest income, net
36

 
84

 
171

 
215

Other (expense) income, net
5

 
41

 
11

 
86

Income before taxes
19,612

 
22,750

 
39,434

 
57,042

Income tax provision
5,527

 
8,033

 
9,398

 
18,314

Net income
$
14,085

 
$
14,717

 
$
30,036

 
$
38,728

Earnings per share:
 

 
 

 
 
 
 
Basic
$
0.27

 
$
0.28

 
$
0.57

 
$
0.74

Diluted
$
0.27

 
$
0.28

 
$
0.57

 
$
0.73

Cash dividends declared per common share:
$

 
$

 
$
0.16

 
$
0.13

Weighted average shares outstanding:
 

 
 

 
 
 
 
Basic
52,238,796

 
52,566,619

 
52,315,719

 
52,586,429

Diluted
52,627,541

 
53,014,269

 
52,715,390

 
53,103,408

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

- 2 -



AAON, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity
(Unaudited)
 
 
 
 
 
 
 
 
 
Common Stock
 
Paid-in
 
Retained
 
 
 
Shares
 
Amount
 
Capital
 
Earnings
 
Total
 
(in thousands)
Balances at December 31, 2017
52,422

 
$
210

 
$

 
$
237,016

 
$
237,226

Net income

 

 

 
30,036

 
30,036

Stock options exercised and restricted
301

 
1

 
3,503

 

 
3,504

stock awards granted
 

 
 

 
 

 
 

 
 

Share-based compensation

 

 
5,614

 

 
5,614

Stock repurchased and retired
(513
)
 
(2
)
 
(9,117
)
 
(9,241
)
 
(18,360
)
Dividends

 

 

 
(8,391
)
 
(8,391
)
Balances at September 30, 2018
52,210

 
$
209

 
$

 
$
249,420

 
$
249,629


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

- 3 -



AAON, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(Unaudited)
 
Nine Months Ended 
 September 30,
 
2018
 
2017
Operating Activities
(in thousands)
Net income
$
30,036

 
$
38,728

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
12,865

 
11,025

Amortization of bond premiums
11

 
39

Provision for losses on accounts receivable, net of adjustments
67

 
180

Provision for excess and obsolete inventories
55

 
54

Share-based compensation
5,614

 
4,960

(Gain) loss on disposition of assets
(9
)
 
46

Foreign currency transaction gain
(20
)
 
(65
)
Interest income on note receivable
27

 
(18
)
Deferred income taxes
864

 
1,147

Changes in assets and liabilities:
 

 
 

Accounts receivable
146

 
(14,521
)
Income taxes
(649
)
 
6,239

Inventories
(7,071
)
 
(18,819
)
Prepaid expenses and other
(792
)
 
(141
)
Accounts payable
4,328

 
3,781

Deferred revenue
(1,644
)
 
416

Accrued liabilities and donations
364

 
8,814

Net cash provided by operating activities
44,192

 
41,865

Investing Activities
 

 
 

Capital expenditures
(34,328
)
 
(26,436
)
Cash paid in business combination
(6,377
)
 

Proceeds from sale of property, plant and equipment
11

 
8

Investment in certificates of deposits
(7,200
)
 
(5,280
)
Maturities of certificates of deposits
7,920

 
5,752

Purchases of investments held to maturity
(9,001
)
 
(13,241
)
Maturities of investments
13,320

 
15,443

Proceeds from called investments
495

 
500

Principal payments from note receivable
32

 
48

Net cash used in investing activities
(35,128
)
 
(23,206
)
Financing Activities
 

 
 

Stock options exercised
3,504

 
1,715

Repurchase of stock
(17,500
)
 
(12,991
)
Employee taxes paid by withholding shares
(860
)
 
(1,193
)
Cash dividends paid to stockholders
(8,400
)
 
(6,828
)
Net cash used in financing activities
(23,256
)
 
(19,297
)
Net decrease in cash and cash equivalents
(14,192
)
 
(638
)
Cash and cash equivalents, beginning of period
21,457

 
24,153

Cash and cash equivalents, end of period
$
7,265

 
$
23,515


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

- 4 -



AAON, Inc. and Subsidiaries
Notes to the Consolidated Financial Statements
(Unaudited)

1. General

Basis of Presentation
 
The accompanying unaudited consolidated financial statements of AAON, Inc., a Nevada corporation, and our operating subsidiaries, all of which are wholly-owned, (collectively, the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the rules and regulations of the Securities and Exchange Commission (“SEC”). These financial statements have not been audited by the Company's independent registered public accounting firm, except that the consolidated balance sheet at December 31, 2017 is derived from audited consolidated financial statements. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. The financial statements reflect all adjustments (all of which are of a normal recurring nature) which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. Interim results are not necessarily indicative of the results that may be expected for a full year. Certain disclosures have been condensed in or omitted from these consolidated financial statements. The accompanying unaudited financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. All intercompany balances and transactions have been eliminated in consolidation.
 
We are engaged in the engineering, manufacturing, marketing and sale of air conditioning and heating equipment consisting of standard, semi-custom and custom rooftop units, chillers, packaged outdoor mechanical rooms, air handling units, makeup air units, energy recovery units, condensing units, geothermal/water-source heat pumps and coils.
 
Use of Estimates
 
The preparation of financial statements in conformity with U.S. GAAP  requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Because these estimates and assumptions require significant judgment, actual results could differ from those estimates and could have a significant impact on our results of operations, financial position and cash flows. We reevaluate our estimates and assumptions as needed, but at a minimum on a quarterly basis. The most significant estimates include, but are not limited to, the fair-value of acquisitions, inventory reserves, warranty accrual, worker's compensation accrual, medical insurance accrual, income taxes and share-based compensation. Actual results could differ materially from those estimates.
 
Accounting Policies
 
A comprehensive discussion of our critical accounting policies and management estimates is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2017.

Business Combinations

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

Fair Value Measurements

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

Level 1: Quoted prices in active markets for identical assets and liabilities that we have the ability to access at the measurement date.

Level 2: Inputs (other than quoted prices included within Level 1) that are either directly or indirectly observable for the asset or liability, including (i) quoted prices for similar assets or liabilities in active markets, (ii) quoted prices for identical

- 5 -



or similar assets or liabilities in inactive markets, (iii) inputs other than quoted prices that are observable for the asset or liability, and (iv) inputs that are derived from observable market data by correlation or other means.

Level 3: Unobservable inputs for the asset or liability including situations where there is little, if any, market activity for the asset or liability. Items categorized in Level 3 include the estimated business combination fair values of property, plant and equipment, intangible assets and goodwill.

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

Intangible Assets

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

Goodwill

Goodwill represents the excess of the consideration paid for the acquired businesses over the fair value of the individual assets acquired, net of liabilities assumed.  Goodwill at September 30, 2018 is deductible for income tax purposes.

Goodwill is not amortized, but instead is evaluated for impairment at least annually. We perform our annual assessment of impairment during the fourth quarter of our fiscal year, and more frequently if circumstances warrant.

To perform this assessment, we first consider qualitative factors to determine whether it is more likely than not that the fair value of each reporting unit exceeds its carrying amount. If we conclude that it is more likely than not that the fair value of a reporting unit does not exceed its carrying amount, we calculate the fair value for the reporting unit and compare the amount to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired. If the carrying amount of a reporting unit exceeds its fair value, goodwill is considered to be impaired and the goodwill balance is reduced by the difference between the fair value and carrying amount of the reporting unit.

Estimates and assumptions used to perform the impairment evaluation are inherently uncertain and can significantly affect the outcome of the analysis. The estimates and assumptions we use in the annual goodwill impairment assessment included market participant considerations and future forecasted operating results. Changes in operating results and other assumptions could materially affect these estimates.

Recent Accounting Pronouncements

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

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

In February 2016, the FASB issued ASU 2016-02, Leases. The ASU will replace previous lease accounting guidance in U.S. GAAP. The ASU requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases. The ASU retains a distinction between finance leases and operating leases. The ASU is effective for the Company beginning January 1, 2019. The Company enters into lease agreements to support its manufacturing operations. The Company typically enters into leases agreements that are less than a year and for leases on assets such as warehouse vehicles and office equipment.  In addition, the Company also assumed an office space lease in the WattMaster business combination.  The Company has substantially completed the process of determining the contracts to which this new guidance applies. The Company is currently enhancing its accounting process in order to track and calculate additional information necessary for adoption of this standard.  The Company does not expect this new guidance will have a material impact on its consolidated financial statements due the non-material monetary amount of the total leased assets and due to the short-term nature of the current lease agreements that are not recognized under the new applicable guidance.

- 6 -




In July 2018, the FASB issued ASU 2018-11, Leases, which provides an optional method of adoption, the transition method.  The transition method allows entities to initially apply the new leases standard at the adoption date (January 1, 2019) and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The Company expects to elect the transition method, which becomes effective upon the date of adoption of ASU 2016-02 discussed above.   

In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other. The ASU simplifies how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. We will be required to perform our annual goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. In the event the carrying amount exceeds the reporting unit’s fair value, a goodwill impairment charge for the excess will be recorded (not exceeding the recorded amount of the reporting unit’s goodwill). The ASU is effective for the Company beginning April 1, 2020, and requires a prospective method of adoption, although early adoption is permitted for annual goodwill impairment tests performed on testing dates on or after January 1, 2017. We adopted this ASU effective January 1, 2018.  

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

Disaggregated net sales by major source:
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2018
 
2017
 
2018
 
2017
 
(in thousands)
 
 
 
 
Rooftop Units
$
86,498

 
$
88,012

 
$
244,978

 
$
235,676

Condensing Units
5,356

 
5,230

 
14,492

 
14,662

Air Handlers
5,686

 
5,339

 
17,479

 
16,728

Outdoor Mechanical Rooms
311

 
899

 
2,178

 
2,641

Water Source Heat Pumps
3,112

 
3,027

 
10,240

 
6,726

Other
11,974

 
11,161

 
32,240

 
24,639

Net Sales
$
112,937

 
$
113,668

 
$
321,607

 
$
301,072


Disaggregated units sold by major source:
 
Three months ended 
 September 30,
 
Nine months ended 
 September 30,
 
2018
 
2017
 
2018
 
2017
Rooftop Units
4,053

 
4,538

 
11,696

 
12,185

Condensing Units
611

 
496

 
1,647

 
1,715

Air Handlers
713

 
593

 
2,067

 
1,916

Outdoor Mechanical Rooms
8

 
17

 
35

 
56

Water Source Heat Pumps
1,162

 
614

 
3,780

 
1,510

Total Units
6,547

 
6,258

 
19,225

 
17,382


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

- 7 -



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

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

The Representatives’ fee and Third Party Products amounts (“Due to Representatives”) are paid only after all amounts associated with the order are collected from the customer. The amount of payments to our Representatives were $11.7 million and $12.6 million for the three months ended September 30, 2018 and 2017, respectively. The amount of payments to our Representatives were $36.6 million and $37.2 million for the nine months ended September 30, 2018 and 2017, respectively.

The Company also sells extended warranties on parts for various lengths of time ranging from 6 months to 10 years. Revenue for these separately priced warranties is deferred and recognized on a straight-line basis over the separately priced warranty period.
 
3. Acquisition

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

Inventories
1,380

Property, plant and equipment
340

Intellectual property
700

Goodwill
3,229

Assumed current liabilities
(354
)
     Consideration paid
$
6,377


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


4.  Investments
 
Certificates of Deposit – We held approximately $2.2 million and $2.9 million in certificates of deposit at September 30, 2018 and December 31, 2017, respectively. At September 30, 2018, the certificates of deposit bear interest ranging from 1.70% to 1.95% per annum and have various maturities ranging from less than one month to approximately 2 months.
 

- 8 -



Investments Held to Maturity – Our investments held to maturity are comprised of $1.3 million of corporate notes and bonds with original maturities ranging from less than one month to approximately 2 months. The investments have moderate risk with S&P ratings ranging from AAA to BBB-.
 
We record the amortized cost basis and accrued interest of the corporate notes and bonds in the Consolidated Balance Sheets. We record the interest and amortization of bond premium to interest income in the Consolidated Statements of Income.

The following summarizes the amortized cost and estimated fair value of our investments held to maturity as of September 30, 2018 and December 31, 2017:
 
 
Amortized
Cost
 
Gross
Unrealized
Gain
 
Gross
Unrealized
(Loss)
 
Fair
Value
 (Level 1)
September 30, 2018:
(in thousands)
Current assets:
 
 
 
 
 
 
 
 Investments held to maturity
$
1,252

 
$

 
$
(1
)
 
$
1,251

Non current assets:
 

 
 

 
 

 
 

Investments held to maturity

 

 

 

Total
$
1,252

 
$

 
$
(1
)
 
$
1,251

 
 
 
 
 
 
 
 
December 31, 2017:
 

 
 

 
 

 
 

Current assets:
 

 
 

 
 

 
 

Investments held to maturity
$
6,077

 
$

 
$
(6
)
 
$
6,071

Non current assets:
 

 
 

 
 

 
 

Investments held to maturity

 

 

 

Total
$
6,077

 
$

 
$
(6
)
 
$
6,071


5.  Accounts Receivable

Accounts receivable and the related allowance for doubtful accounts are as follows:
 
 
September 30,
2018
 
December 31, 2017
 
(in thousands)
Accounts receivable
$
51,384

 
$
50,457

Less:  Allowance for doubtful accounts
(177
)
 
(119
)
Total, net
$
51,207

 
$
50,338

 
 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
Allowance for doubtful accounts:
(in thousands)
Balance, beginning of period
$
208

 
$
81

 
$
119

 
$
90

Provisions for losses on accounts receivables, net of recoveries
(31
)
 
39

 
67

 
180

Accounts receivable written off

 

 
(9
)
 
(150
)
Balance, end of period
$
177

 
$
120

 
$
177

 
$
120

 

- 9 -



6.  Inventories

Inventories are valued at the lower of cost or net realizable value. Cost is determined by the first-in, first-out (“FIFO”) method. We establish an allowance for excess and obsolete inventories based on product line changes, the feasibility of substituting parts and the need for supply and replacement parts.
 
 
September 30,
2018
 
December 31, 2017
 
(in thousands)
Raw materials
$
65,694

 
$
57,784

Work in process
6,116

 
5,957

Finished goods
8,486

 
8,163

 
80,296

 
71,904

Less:  Allowance for excess and obsolete inventories
(1,114
)
 
(1,118
)
Total, net
$
79,182

 
$
70,786

 
The related changes in the allowance for excess and obsolete inventories account are as follows:

  
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
Allowance for excess and obsolete inventories:
(in thousands)
Balance, beginning of period
$
1,407

 
$
1,642

 
$
1,118

 
$
1,382

Provisions for excess and obsolete inventories
(263
)
 
(206
)
 
55

 
54

Inventories written off
(30
)
 
(243
)
 
(59
)
 
(243
)
Balance, end of period
$
1,114

 
$
1,193

 
$
1,114

 
$
1,193


7.  Intangible Assets

Our intangible assets consist of the following:

 
 
September 30,
2018
 
December 31, 2017
 
 
(in thousands)
Intellectual property
 
$
700

 
$

Less: Accumulated amortization
 
(136
)
 

       Total, net
 
$
564

 
$


Amortization expense recorded in cost of sales is as follows:

  
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
 
(in thousands)
Amortization expense
$
58

 
$

 
$
136

 
$



- 10 -




8.  Supplemental Cash Flow Information
 
 
Nine months ended
 
September 30,
2018

September 30,
2017
Supplemental disclosures:
(in thousands)
Interest paid
$
5


$

Income taxes paid
$
9,183


$
7,138







Non-cash investing and financing activities:





Non-cash capital expenditures
$
288


$
8,059

 
9.  Warranties

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

Changes in the warranty accrual are as follows:
 
 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
Warranty accrual:
(in thousands)
Balance, beginning of period
$
11,458

 
$
8,602

 
$
10,483

 
$
7,936

Payments made
(2,355
)
 
(2,281
)
 
(6,078
)
 
(5,935
)
Provisions
3,050

 
3,277

 
7,748

 
7,597

Balance, end of period
$
12,153

 
$
9,598

 
$
12,153

 
$
9,598

 
 
 
 
 
 
 
 
Warranty expense:
$
3,050

 
$
3,277

 
$
7,748

 
$
7,597

 
10.  Accrued Liabilities

Accrued liabilities are as follows:

 
September 30,
2018
 
December 31, 2017
 
(in thousands)
Warranty
$
12,153

 
$
10,483

Due to representatives
9,766

 
13,086

Payroll
3,162

 
4,456

Profit sharing
2,154

 
2,034

Worker's compensation
594

 
593

Medical self-insurance
744

 
725

Customer prepayments
2,300

 
2,838

Donations
850

 
588

Employee vacation time
3,086

 
2,688

Other
2,683

 
1,607

Total
$
37,492

 
$
39,098

 

- 11 -



11.  Revolving Credit Facility

Our revolving credit facility, which is provided by BOKF, NA dba Bank of Oklahoma, formerly known as Bank of Oklahoma, N.A. ("Bank of Oklahoma"), provides for maximum borrowings of $30.0 million. Under the line of credit, there is one standby letter of credit totaling $0.8 million. Borrowings available under the revolving credit facility at September 30, 2018 were $29.2 million. Interest on borrowings is payable monthly at LIBOR plus 2.0%. No fees are associated with the unused portion of the committed amount. We had no outstanding balance under the revolving credit facility at September 30, 2018 and December 31, 2017. The termination date of the revolving credit facility is July 26, 2021.

As of September 30, 2018, we were in compliance with our financial covenants. These covenants require that we meet certain parameters related to our tangible net worth and total liabilities to tangible net worth ratio. At September 30, 2018, our tangible net worth was $249.6 million and met the requirement of being at or above $175.0 million. Our total liabilities to tangible net worth ratio was 0.26 to 1, and met the requirement of not being above 2 to 1.

12.  Income Taxes

The provision (benefit) for income taxes consists of the following:

 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
 
(in thousands)
Current
$
5,101

 
$
7,250

 
$
8,534

 
$
17,167

Deferred
426

 
783

 
864

 
1,147

 
$
5,527

 
$
8,033

 
$
9,398

 
$
18,314


The reconciliation of the Federal statutory income tax rate to the effective income tax rate is as follows:

 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
Federal statutory rate
21.0
 %
 
35.0
 %
 
21.0
 %
 
35.0
 %
State income taxes, net of Federal benefit
5.0

 
5.3

 
5.9

 
4.5

Domestic manufacturing deduction

 
(3.1
)
 

 
(3.0
)
Excess tax benefits
(2.1
)
 
(0.9
)
 
(3.1
)
 
(3.8
)
Return to provision adjustments
4.2

 

 
0.5

 

Other
0.1

 
(1.0
)
 
(0.5
)
 
(0.6
)
Effective tax rate
28.2
 %
 
35.3
 %
 
23.8
 %
 
32.1
 %

The Tax Cuts and Jobs Act (the "Act") was enacted on December 22, 2017. Major changes under the Act include the following:
Reducing the corporate rate to 21 percent
Doubling bonus depreciation to 100 percent for five years
Further limitations on executive compensation deductions
Eliminating the domestic manufacturing deduction

As a result of these changes, the Company adjusted its deferred tax assets and liabilities in the forth quarter of 2017 using the newly enacted rates for the periods when they are expected to be realized.

In February 2018, the Bipartisan Budget Act of 2018 extended accelerated depreciation for business property on an Indian reservation. As a result, the Company estimated it had approximately $5.0 million in additional depreciation it can take as a tax deduction in 2017. Because the Company had remeasured its deferred tax liability related to property, plant and equipment to the new lower tax rate at December 31, 2017 and because this additional depreciation became a current tax expense with the passing of this bill in 2018, the Company recorded a benefit of approximately $0.6 million in the first quarter as the deduction was expected to be taken in 2017 at the higher federal tax rate of 35.0%. Upon completion of the Company's tax return, the Company recorded additional expense due to lower than expected R&D credit, lower than originally estimated bonus depreciation and changes in other temporary differences that offset the remeasurement benefit previously recorded of $0.6 million.

- 12 -




The Company's estimated annual 2018 effective tax rate, excluding discrete events, is approximately 26%. We file income tax returns in the U.S., state and foreign income tax returns jurisdictions. We are subject to U.S. examinations for tax years 2014 to present, and to non-U.S. income tax examinations for the tax years of 2013 to present. In addition, we are subject to state and local income tax examinations for the tax years 2013 to present. The Company continues to evaluate its need to file returns in various state jurisdictions. Any interest or penalties would be recognized as a component of income tax expense.

13. Share-Based Compensation

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

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

Options - The compensation cost related to unvested stock options not yet recognized as of September 30, 2018 is $15.8 million and is expected to be recognized over a weighted average period of 2.4 years.

The following weighted average assumptions were used to determine the fair value of the stock options granted on the original grant date for expense recognition purposes for options granted during the nine months ended September 30, 2018 and 2017 using a Black Scholes Model:
 
 
Nine months ended
 
September 30, 2018
 
September 30, 2017
Directors and Officers:
 
 
 
Expected dividend rate
$
0.26

 
$
0.26

Expected volatility
29.73
%
 
30.81
%
Risk-free interest rate
2.20
%
 
1.90
%
Expected life (in years)
5.0

 
5.0

 
 
 
 
Employees:
 

 
 

Expected dividend rate
$
0.26

 
$
0.26

Expected volatility
29.82
%
 
30.70
%
Risk-free interest rate
2.48
%
 
1.88
%
Expected life (in years)
5.0

 
5.0

 
The expected term of the options is based on evaluations of historical and expected future employee exercise behavior. The risk-free interest rate is based on the U.S. Treasury rates at the date of grant with maturity dates approximately equal to the expected life at the grant date. Volatility is based on historical volatility of our stock over time periods equal to the expected life at grant date.
 

- 13 -



The following is a summary of stock options vested and exercisable as of September 30, 2018:
 
Range of
Exercise
Prices
 
Number
of
Shares
 
Weighted
Average
Remaining
Contractual Life
(in years)
 
Weighted
Average
Exercise
Price
 
Intrinsic
Value
(in thousands)
$5.67 - $32.80
 
362,715

 
5.54
 
$
18.14

 
$
7,132

$32.85 - $33.80
 
5,484

 
4.08
 
33.18

 
25

$34.00 - $40.60
 
81,417

 
5.87
 
34.32

 
283

Total
 
449,616

 
5.58
 
$
21.25

 
$
7,440

 
The following is a summary of stock options vested and exercisable as of September 30, 2017:

Range of
Exercise
Prices
 
Number
of
Shares
 
Weighted
Average
Remaining
Contractual Life
(in years)
 
Weighted
Average
Exercise
Price
 
Intrinsic
Value
(in thousands)
$4.54 - $22.76
 
374,792

 
4.61

 
$
10.96

 
$
4,209

$23.57 - $32.80
 
41,490

 
7.86

 
25.61

 
18

$32.85 - $37.30
 

 

 

 

Total
 
416,282

 
4.93

 
$
12.42

 
$
4,227


A summary of option activity under the plans is as follows:

 
Shares
 
Weighted
Average
Exercise
Price
Outstanding at December 31, 2017
1,567,109

 
$
25.27

Granted
1,444,520

 
34.52

Exercised
(234,359
)
 
14.95

Forfeited or Expired
(229,244
)
 
32.84

Outstanding at September 30, 2018
2,548,026

 
$
30.80

Exercisable at September 30, 2018
449,616

 
$
21.25

 
The total intrinsic value of options exercised during the nine months ended September 30, 2018 and 2017 was $5.0 million and $4.2 million, respectively. The cash received from options exercised during the nine months ended September 30, 2018 and 2017 was $3.5 million and $1.7 million, respectively. The impact of these cash receipts is included in financing activities in the accompanying Consolidated Statements of Cash Flows.

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

These awards are recorded at their fair value on the date of grant and compensation cost is recorded using straight-line vesting over the service period. At September 30, 2018, unrecognized compensation cost related to unvested restricted stock awards was approximately $6.8 million, which is expected to be recognized over a weighted average period of 1.9 years.


- 14 -



A summary of the unvested restricted stock awards is as follows:
 
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Unvested at December 31, 2017
341,800

 
$
25.52

Granted
104,675

 
32.28

Vested
(102,333
)
 
24.68

Forfeited
(32,778
)
 
28.12

Unvested at September 30, 2018
311,364

 
$
27.80


A summary of share-based compensation is as follows:
 
 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
Grant date fair value of awards during the period:
(in thousands)
Options
$
53

 
$
121

 
$
12,633

 
$
3,628

Restricted stock
18

 

 
3,379

 
4,182

Total
$
71

 
$
121

 
$
16,012

 
$
7,810

Share-based compensation expense:
 
 
 
 
 
 
 
Options
$
1,076

 
$
620

 
$
3,202

 
$
2,050

Restricted stock
839

 
811

 
2,412

 
2,910

Total
$
1,915

 
$
1,431

 
$
5,614

 
$
4,960

Income tax benefit/(deficiency) related to share-based compensation:
 
 
 
 
 
 
Options
$
379

 
$
126

 
$
980

 
$
1,411

Restricted stock
26

 
131

 
245

 
836

Total
$
405

 
$
257

 
$
1,225

 
$
2,247

 


- 15 -



14.  Earnings Per Share

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

 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
 
(in thousands, except share and per share data)
Numerator:
 
 
 
 
 
 
 
Net income
$
14,085

 
$
14,717

 
$
30,036

 
$
38,728

Denominator:
 

 
 

 
 
 
 
Basic weighted average shares
52,238,796

 
52,566,619

 
52,315,719

 
52,586,429

Effect of dilutive stock options and restricted stock
388,745

 
447,650

 
399,671

 
516,979

Diluted weighted average shares
52,627,541

 
53,014,269

 
52,715,390

 
53,103,408

Earnings per share:
 

 
 

 
 
 
 
Basic
$
0.27

 
$
0.28

 
$
0.57

 
$
0.74

Diluted
$
0.27

 
$
0.28

 
$
0.57

 
$
0.73

Anti-dilutive shares:
 

 
 

 
 
 
 
Shares
1,950,343

 
842,631

 
1,929,453

 
795,678


15. Stockholders’ Equity

Stock Repurchase - The Board has authorized three stock repurchase programs for the Company. The Company may purchase shares on the open market from time to time, up to a total of 5.7 million shares. The Board must authorize the timing and amount of these purchases. Effective May 24, 2016, the Board authorized up to $25.0 million in open market repurchases and on June 2, 2016, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase an aggregate amount of $25.0 million or a total of approximately 2.0 million shares from the open market. The agreement expired on April 15, 2017. In May 2018, the Board authorized up to $15.0 million in open market repurchases and on May 18, 2018, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement expires on March 1, 2019. The Company also has a stock repurchase arrangement by which employee-participants in our 401(k) savings and investment plan are entitled to have shares in AAON, Inc. stock in their accounts sold to the Company. The maximum number of shares to be repurchased is contingent upon the number of shares sold by employee-participants. Lastly, the Company repurchases shares of AAON, Inc. stock from certain of its directors and employees for payment of statutory tax withholdings on stock transactions. Al1 other repurchases from directors or employees are contingent upon Board approval. All repurchases are done at current market prices.

Our repurchase activity is as follows:
 
Nine months ended 
 September 30,
 
Inception to date
 
2018
2017
 
Program
Shares
Total $
$ per share
Shares
Total $
$ per share
 
Shares
Total $
$ per share
Open market
116,289

$
3,839,766

$
33.02

8,676

$
283,654

$
32.69

 
3,959,784

$
65,071,881

$
16.43

401(k)
373,129

13,660,954

36.61

364,839

12,706,655

34.83

 
6,923,152

95,729,759

13.83

Directors and employees
24,457

859,696

35.15

33,845

1,193,337

35.26

 
1,943,967

18,137,729

9.33

Total
513,875

$
18,360,416

$
35.73

407,360

$
14,183,646

$
34.82

 
12,826,903

$
178,939,369

$
13.95


Subsequent to September 30, 2018 and through October 30, 2018, the Company repurchased 85,200 shares for $2.8 million from the open market and 30,618 shares for $1.0 million from our 401(k) savings and investment plan.

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


- 16 -



Our recent dividends are as follows:
Declaration Date
Record Date
Payment Date
Dividend per Share
May 16, 2017
June 9, 2017
July 7, 2017
$
0.13

November 7, 2017
November 30, 2017
December 21, 2017
$
0.13

May 18, 2018
June 8, 2018
July 6, 2018
$
0.16


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

17.  Related Parties

The Company purchases some supplies from an entity controlled by the Company's CEO. The Company sometimes makes sales to the CEO for parts. Additionally, the Company sells units to an entity owned by a member of the President's immediate family. This entity is also one of the Company's Representatives and as such, the Company makes payments to the entity for third party products. All related party transactions are made on standard Company terms. The following is a summary of transactions and balance with affiliates:
 
Three months ended
 
Nine months ended
 
September 30,
2018
 
September 30,
2017
 
September 30,
2018
 
September 30,
2017
 
(in thousands)
Sales to affiliates
$
298

 
$
76

 
$
890

 
$
1,226

Payments to affiliates
48

 
107

 
159

 
415

 
September 30,
2018
 
December 31, 2017
 
(in thousands)
Due from affiliates
$
144

 
$
9

Due to affiliates

 




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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the notes thereto, which are included in this report, and our audited consolidated financial statements and the notes thereto, which are included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. This discussion contains or incorporates by reference “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts, but rather are based on expectations, estimates, assumptions and projections about our industry, business and future financial results, based on information available at the time this report is filed with the SEC or, with respect to any document incorporated by reference, available at the time that such document was prepared. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those identified in the section entitled “Forward-Looking Statements” in this Item 2 of this Quarterly Report on Form 10-Q and in the section entitled “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2017. We do not assume any obligation to update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, new information or circumstances or otherwise, except as required by law.


- 17 -



Overview

We engineer, manufacture and market air conditioning and heating equipment consisting of standard, semi-custom and custom rooftop units, chillers, packaged outdoor mechanical rooms, air handling units, makeup air units, energy recovery units, condensing units, geothermal/water-source heat pumps and coils. These products are marketed and sold to retail, manufacturing, educational, lodging, supermarket, medical and other commercial industries. We market our products to all 50 states in the United States and certain provinces in Canada. Foreign sales were approximately $11.0 million of our total net sales for the nine months just ended and $11.4 million of our sales during the same period of 2017.

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

We sell our products to property owners and contractors through a network of manufacturers’ representatives and our internal sales force. The demand for our products is influenced by national and regional economic and demographic factors. The commercial and industrial new construction market is subject to cyclical fluctuations in that it is generally tied to housing starts, but has a lag factor of six to 18 months. Housing starts, in turn, are affected by such factors as interest rates, the state of the economy, population growth and the relative age of the population. When new construction is down, we emphasize the replacement market. The new construction market in 2017 through the third quarter of 2018 continued to be unpredictable and uneven. Thus, we continue to emphasize promotion of the benefits of AAON equipment to property owners in the replacement market.

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

The price levels of our raw materials have remained relatively consistent the past few years, but the market has become volatile and unpredictable as a result of the uncertainty related to the U.S. economy and a weakening global economy. For the nine months ended September 30, 2018, the price (twelve month trailing average) for copper, galvanized steel, stainless steel and aluminum increased by approximately 8.6%, 16.7%, 11.0% and 8.3%, respectively, as compared to the nine months ended September 30, 2017.

In 2015, AAON initiated the design of a new Water Source Heat Pump product line and its affiliated manufacturing facility. We have brought the product into the marketplace and are in the final stages of completing this introduction into a $500-$600 million new market.

We continued construction of our three-story 134,000 square foot laboratory building with ten testing cells contained within it. This unique laboratory will have capabilities beyond anything known to exist in the world and will elevate AAON's research and design capabilities accordingly. Completion of this lab in 2018 will therefore be quite significant.

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

Overall units sold increased approximately 10.6% for the nine months as compared to the same period last year.
We saw significant improvement in our gross margin during the third quarter.
We invested $34.3 million in capital expenditures in connection with the construction of our new research and development lab, water source heat pump line and other internal projects.
Our orders results in a record high backlog.
Completed the strategic acquisition of Wattmaster Controls, Inc.

Backlog

The following table shows our historical backlog levels:

- 18 -



9/30/2018
 
12/31/2017
 
9/30/2017
(in thousands)
$
126,843

 
$
81,226

 
$
73,813



Results of Operations

Three Months Ended September 30, 2018 vs. Three Months Ended September 30, 2017

Units Sold
 
Three Months Ended 
 September 30,
 
2018
 
2017
 
 
 
 
Rooftop Units
4,053

 
4,538

Condensing Units
611

 
496

Air Handlers
713

 
593

Outdoor Mechanical Rooms
8

 
17

Water Source Heat Pumps
1,162

 
614

Total Units
6,547

 
6,258


Net Sales
 
 
Three Months Ended 
 September 30,
 
 
 
 
 
2018
 
2017
 
Change
% Change
 
 
(in thousands, except unit data)
Net sales
 
$
112,937

 
$
113,668

 
$
(731
)
(0.6
)%
Total units
 
6,547

 
6,258

 
289

4.6
 %

Net sales for the quarter are down mainly due to the decrease in rooftop unit sales.

Cost of Sales
 
 
Three Months Ended 
 September 30,
 
Percent of Sales
 
 
2018
 
2017
 
2018
 
2017
 
 
(in thousands)
 
 
 
 
Cost of sales
 
$
80,174

 
$
78,010

 
71.0
%
 
68.6
%
Gross profit
 
32,763

 
35,658

 
29.0
%
 
31.4
%

The principal components of cost of sales are labor, raw materials, component costs, factory overhead, freight out and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper and aluminum, which are obtained from domestic suppliers. The Company saw improvement in its gross profit in the third quarter compared to previous quarters in 2018. The Company continues to experience increases in raw material costs due to tariffs and trade restrictions.


- 19 -



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

 
 
2018
 
2017
 
% Change
 
 
 
 
 
 
 
Copper
 
$
3.77

 
$
3.47

 
8.6
%
Galvanized Steel
 
$
0.49

 
$
0.42

 
16.7
%
Stainless Steel
 
$
1.31

 
$
1.18

 
11.0
%
Aluminum
 
$
1.82

 
$
1.68

 
8.3
%


Selling, General and Administrative Expenses
 
 
Three Months Ended 
 September 30,
 
Percent of Sales
 
 
2018
 
2017
 
2018
 
2017
 
 
(in thousands)
 
 
 
 
Warranty
 
$
3,050

 
$
3,277

 
2.7
 %
 
2.9
%
Profit Sharing
 
2,153

 
2,556

 
1.9
 %
 
2.2
%
Salaries & Benefits
 
3,071

 
2,982

 
2.7
 %
 
2.6
%
Stock Compensation
 
1,093

 
831

 
1.0
 %
 
0.7
%
Advertising
 
176

 
215

 
0.2
 %
 
0.2
%
Depreciation
 
223

 
184

 
0.2
 %
 
0.2
%
Insurance
 
281

 
274

 
0.2
 %
 
0.2
%
Professional Fees
 
448

 
371

 
0.4
 %
 
0.3
%
Donations
 
102

 
121

 
0.1
 %
 
0.1
%
Bad Debt Expense
 
(31
)
 
39

 
 %
 
%
Other
 
2,624

 
2,184

 
2.3
 %
 
1.9
%
Total SG&A
 
$
13,190

 
$
13,034

 
11.7
 %
 
11.5
%



Income Taxes
 
 
Three Months Ended 
 September 30,
 
Effective Tax Rate
 
 
2018
 
2017
 
2018
 
2017
 
 
(in thousands)
 
 
 
 
Income tax provision
 
$
5,527

 
$
8,033

 
28.2
%
 
35.3
%

The Company’s estimated annual 2018 effective tax rate, excluding discrete events, is expected to be approximately 26%. The decrease in our effective rate was due to the Act that was enacted on December 22, 2017 lowering the federal corporate tax rate to 21%. Additionally, the Company had additional expense during the quarter due to unfavorable return to provision adjustments with the filing of our 2017 tax return.











- 20 -




Results of Operations

Nine Months Ended September 30, 2018 vs. Nine Months Ended September 30, 2017

Units Sold

 
Nine Months Ended 
 September 30,
 
2018
 
2017
 
 
 
 
Rooftop Units
11,696

 
12,185

Condensing Units
1,647

 
1,715

Air Handlers
2,067

 
1,916

Outdoor Mechanical Rooms
35

 
56

Water Source Heat Pumps
3,780

 
1,510

Total Units
19,225

 
17,382


Net Sales

 
 
Nine Months Ended 
 September 30,
 
 
 
 
 
2018
 
2017
 
Change
% Change
 
 
(in thousands, except unit data)
Net sales
 
$
321,607

 
$
301,072

 
$
20,535

6.8
%
Total units
 
19,225

 
17,382

 
1,843

10.6
%

Net sales for the nine months ended are up mainly due to the increase in our water source heat pumps line which has a lower profit margin causing the percentage of net sales to not increase as proportionate to the percentage increase in total units.

Cost of Sales
 
 
Nine Months Ended 
 September 30,
 
Percent of Sales
 
 
2018
 
2017
 
2018
 
2017
 
 
(in thousands)
 
 
 
 
Cost of sales
 
$
245,869

 
$
208,750

 
76.5
%
 
69.3
%
Gross profit
 
75,738

 
92,322

 
23.5
%
 
30.7
%

The principal components of cost of sales are labor, raw materials, component costs, factory overhead, freight out and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper and aluminum, which are obtained from domestic suppliers. In January 2018, the Company paid all employees a one-time bonus of $1,000 per employee as a result of the Tax Cuts and Jobs Act (the "Act") which lowered the federal corporate tax rate from 35% to 21%. This bonus increased cost of sales by $1.9 million, excluding taxes and benefits. Additionally, the Company typically has seasonality in its sales and workforce with the fourth and first quarter being lower in production. The Company maintained a higher level of workforce through the end of 2017 and beginning of 2018 in anticipation of our growing business. While significant improvements have occurred in the second and third quarters of 2018, the Company's gross profit is still recovering from the events that occurred in the first quarter.


- 21 -



Twelve-month average raw material cost per pound as of September 30,:
 
 
2018
 
2017
 
% Change
 
 
 
 
 
 
 
Copper
 
$
3.77

 
$
3.47

 
8.6
%
Galvanized Steel
 
$
0.49

 
$
0.42

 
16.7
%
Stainless Steel
 
$
1.31

 
$
1.18

 
11.0
%
Aluminum
 
$
1.82

 
$
1.68

 
8.3
%

Selling, General and Administrative Expenses

 
 
Nine Months Ended 
 September 30,
 
Percent of Sales
 
 
2018
 
2017
 
2018
 
2017
 
 
(in thousands)
 
 
 
 
Warranty
 
$
7,748

 
$
7,597

 
2.4
%
 
2.5
%
Profit Sharing
 
4,382

 
6,366

 
1.4
%
 
2.1
%
Salaries & Benefits
 
9,513

 
8,410

 
3.0
%
 
2.8
%
Stock Compensation
 
3,161

 
3,276

 
1.0
%
 
1.1
%
Advertising
 
610

 
1,352

 
0.2
%
 
0.4
%
Depreciation
 
657

 
496

 
0.2
%
 
0.2
%
Insurance
 
886

 
723

 
0.3
%
 
0.2
%
Professional Fees
 
1,821

 
1,210

 
0.6
%
 
0.4
%
Donations
 
805

 
524

 
0.3
%
 
0.2
%
Bad Debt Expense
 
68

 
180

 
%
 
0.1
%
Other
 
6,844

 
5,401

 
2.1
%
 
1.8
%
Total SG&A
 
$
36,495

 
$
35,535

 
11.3
%
 
11.8
%

The overall decrease as a percentage of sales in SG&A was primarily due to the decrease in profit sharing which is the result of lower earnings for the year.

Income Taxes

 
 
Nine Months Ended 
 September 30,
 
Effective Tax Rate
 
 
2018
 
2017
 
2018
 
2017
 
 
(in thousands)
 
 
 
 
Income tax provision
 
$
9,398

 
$
18,314

 
23.8
%
 
32.1
%

The Company’s estimated annual 2018 effective tax rate, excluding discrete events, is expected to be approximately 26%. The decrease in our effective rate was due to the Act that was enacted on December 22, 2017 lowering the federal corporate tax rate to 21%.


Liquidity and Capital Resources

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

Our cash and investments decreased $19.7 million from December 31, 2017 to September 30, 2018 and totaled $10.7 million at September 30, 2018.


- 22 -



Under the line of credit, there was one standby letter of credit of $0.8 million as of September 30, 2018. At September 30, 2018, we have $29.2 million of borrowings available under the revolving credit facility. No fees are associated with the unused portion of the committed amount.

We had no outstanding balance under the revolving credit facility at September 30, 2018 and December 31, 2017. Interest on borrowings is payable monthly at LIBOR plus 2.0%. The termination date of the revolving credit facility is July 26, 2021.

At September 30, 2018, we were in compliance with all of the covenants under the revolving credit facility. We are obligated to comply with certain financial covenants under the revolving credit facility. These covenants require that we meet certain parameters related to our tangible net worth and total liabilities to tangible net worth ratio. At September 30, 2018, our tangible net worth was $249.6 million, which meets the requirement of being at or above $175.0 million. Our total liabilities to tangible net worth ratio was 0.26 to 1.0 which meets the requirement of not being above 2 to 1.

Authorizations - The Board has authorized three stock repurchase programs for the Company. The Company may purchase shares on the open market from time to time, up to a total of 5.7 million shares. The Board must authorize the timing and amount of these purchases. Effective May 24, 2016, the Board authorized up to $25.0 million in open market repurchases and on June 2, 2016, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase an aggregate amount of $25.0 million or a total of approximately 2.0 million shares from the open market. The agreement expired on April 15, 2017. In May 2018, the Board authorized up to $15.0 million in open market repurchases and on May 18, 2018, the Company executed a repurchase agreement in accordance with the rules and regulations of the SEC allowing the Company to repurchase shares from the open market. The agreement expires on March 1, 2019. The Company also has a stock repurchase arrangement by which employee-participants in our 401(k) savings and investment plan are entitled to have shares in AAON, Inc. stock in their accounts sold to the Company. The maximum number of shares to be repurchased is contingent upon the number of shares sold by employee-participants. Lastly, the Company repurchases shares of AAON, Inc. stock from certain of its directors and employees for payment of statutory tax withholdings on stock transactions. Any other repurchases from directors or employees are contingent upon Board approval. All repurchases are done at current market prices.

Repurchase Activity
 
Nine Months Ended 
 September 30,
 
Inception to date
 
2018
2017
 
Program
Shares
Total $
$ per share
Shares
Total $
$ per share
 
Shares
Total $
$ per share
Open market
116,289

$
3,839,766

$
33.02

8,676

$
283,654

$
32.69

 
3,959,784

$
65,071,881

$
16.43

401(k)
373,129

13,660,954

36.61

364,839

12,706,655

34.83

 
6,923,152

95,729,759

13.83

Directors and employees
24,457

859,696

35.15

33,845

1,193,337

35.26

 
1,943,967

18,137,729