AAON: This HVAC Manufacturer’s Valuation Needs To Cool Down (NASDAQ:AAON)

Introduction

AAON, Inc. (NASDAQ:AAON) is a manufacturer for HVAC equipment in the United States. Last week, the company released its Q4 2023 results and while the company reported a beat on both revenue and EBITDA, there are indications that the company’s growth rate is slowing and that its shares are likely undeserving of the current trading multiples. In this article, I’ll discuss the recent results, my outlook, the company’s valuation, and my thoughts on the risks to the investment thesis.

Company Overview

AAON is a manufacturer of HVAC equipment. HVAC stands heating, ventilation, and air conditioning, so its products include everything from heat pumps, air handling systems, cleanroom systems, chillers, condensing units, and related parts to service these types of equipment. AAON sells to a wide range of customers in the retail, commercial, manufacturing, healthcare, and government sectors making it well diversified amongst both its product offering and customer base.

AAON is a fascinating company. If you aren’t familiar with the company’s history, I highly recommend reading up on the company’s founder Norm Asbjornson. Norm founded the company over 30 years ago making semi-custom equipment for the HVAC space. With semi-custom equipment being very expensive during the 1980s and 1990s, the company’s founder sought to create a more efficient manufacturing process that brought the cost down and lowered the barrier to entry for customers. With cost effective solutions, the company began to take market share and cement itself as a leader in the industry. Today, the company is less of a niche player and more of a mainstream operator that’s still very price competitive.

Background

When looking at the historical share price performance of AAON, the company’s shares have significantly outperformed the index. Over the last decade, shares of AAON have delivered a total return of 540% to shareholders compared to the S&P500’s return of just 231%. With an annualized return of 20.4% over this time period, investors who’ve been able to hold on for the long run have been rewarded with above average returns.

Along with a reduction in share count of 19%, with a revenue CAGR of 10.9% and an EBITDA CAGR of 12.6% over the last twenty years, the fantastic share price performance is almost as a direct result of consistent growth in the company’s financials and share repurchases. As the ten year CAGRs for revenue and EBITDA are higher at 13.8% and 15.3% compared to the last two decades, this shows that the company’s growth rate has accelerated in recent years. Later on, I’ll discuss why I don’t expect this to continue.

Recent Results

In analyzing the full year 2023 and Q4 results for AAON, the company surpassed analysts’ expectations with a beat of $0.04 in EPS for the quarter and a beat of $12.29 million in revenue. Revenue for the quarter came in at $306.6 million which was up 20.4% year over year. For the full year, revenues were $1.17 billion, an increase of 31.5% against last year.

Overall, AAON’s growth for 2023 was rather unprecedented and unusual when we compare it to its historical growth rate. For a company that generally grows about 10-12% a year, I would say this growth was impressive, especially off of a tough comp for 2022 when revenues were up 66.3%.

Importantly, most of this growth was organic growth, and not growth that’s been funded via acquisitions, highlighting organic growth of 14.5% in 2023. About half of the growth can be attributed to volume gains and the other half to pricing gains.

Moving down the income statement, the growth in profitability didn’t disappoint either with gross margin expansion of 560 basis points for the quarter against last year and quarterly EPS of $0.56 which was 19.1% higher than last year.

In terms of what’s been driving the growth at AAON, the company has been executing well on integrating departments amongst its three locations. With the new Parksville, Missouri location, AAON has been migrating some production to the Longview, Texas location.

With an expansion project underway, I think the company will be better positioned to have more capacity and meet future demand. The Longview Texas facility is expected to add about 50% more capacity and an expansion project at the Redmond, Oregon location is likely to add 15% to the existing capacity.

AAON has also been investing beyond its facilities into SG&A. While product innovation is still core to AAON, the company has been focusing a lot more on training new representatives and marketing. With a new training facility in Tulsa, the company will be able to deliver better customer service and help sell the value proposition of the company’s products and services. Additional marketing will also help build the company’s brand in the marketplace. As a smaller player in the industry, the company’s market efforts should help to build trust among potential customers. Historically, AAON hasn’t spent a lot in marketing so it will be interesting to watch how this investment plays out over time.

Finally, with respect to the balance sheet, AAON had just $9 million of cash on its balance sheet. This may seem abnormally low but it’s typically been the case for AAON that the company has held less than 10 million of cash at any given time, given its cash cycle for receivables and payables. Working capital is strong at $282.2 million and AAON had just $38.3 million of debt on the company’s revolver at quarter end, having paid down over $40 million of debt during the quarter. Nearly debt free, the company’s balance sheet looks to be in very good shape.

Outlook

As for my outlook for the company, AAON’s investments in new facilities as well as marketing look like they can position the company for future growth. However, I have some concerns about the growth rate not being sustainable. When looking at the company’s backlog, it’s actually down 6.9% year over year. That’s not to say revenue will be lower, but it certainly suggests that the growth rate here is slowing down. AAON services a lot of great verticals that are doing well, like data centers and manufacturing, but I’m personally concerned about the company’s office exposure.

According to a report from McKinsey Global Institute, office demand could fall as much as 13% by 2030 driven by lower office attendance as more people opt to live in less urban areas and work from home. According to the report, office attendance has held steady at 30 percent below pre-pandemic norms and it doesn’t seem likely that’s going to return. That could have a negative effect on the replacement cycle for HVAC in office towers.

More broadly, the construction industry has been weak. With flattish to down growth expected, it’s not obvious to me that non-residential construction is going to rebound any time soon. And that could have an impact on the demand for new HVAC equipment. AAON’s result speak for themselves but this is certainly a risk factor to monitor.

Finally, even with higher capex in 2024 expected around $125 million, guidance for the company suggests only moderate sales growth in 2024 with pricing growth contributing mid-single digits and volume growth contributing low-single digits. So if we extrapolate out 10-12% growth for 2024, it would seem that there is a deceleration in growth, especially with management expecting both sales and earnings in the Q1 to be lower compared to Q4 2023. As I’ll discuss in the next section, with a decelerating growth rate, I think the company is undeserving of its sky-high multiple.

Valuation and Wrap Up

To my knowledge, there is only one analyst covering AAON’s stock, from D.A. Davidson. The analyst there has a target price of $105.00 a share which implies about 29% upside from the current price, excluding the company’s dividend yield of 0.4%, implying that shares are undervalued at the current price (source: TD Securities).

However, in my view, shares of AAON don’t represent good value today. When we look at the historical valuation range to see at what valuations the company has previously traded at, we can see that the company’s current EV/EBITDA multiple is almost two times higher than the historical average. Keep in mind as well that D&A (or capex if you want to use actual figures) in this business is a real expense and with an average of $75 million in capex annually in the last five years, this would reduce EBITDA by about 30%, increasing the multiple to 30x before interest expenses and taxes.

When comparing AAON to its peer group, AAON trades at twice the multiple of its peer group. With a better balance sheet, higher ROE, and above-average growth, I think it’s deserving of a premium multiple. But at 22.0x forward EBITDA and 36.0x earnings, it just seems a little rich for my preference.

I’m not arguing that AAON is not a high quality business, but it seems to me that the EBITDA multiple of 24.2x is far too expensive of a multiple to be paying for a company that can grow in the low teens at best. Why? Pre-pandemic, from 2010 to 2018, the company’s revenue CAGR was about 7.4%. So even with a bit of margin expansion and some share repurchases, it’s hard to justify why an investor would pay 38.0x earnings for this business. With all the aforementioned risks outlined earlier, at the current price, I’d recommend investors stay clear of the company’s shares.