CARR - AAON: Solid Long-Term Growth Prospects

2023-03-07 14:16:11 ET

Summary

• Net sales should benefit from price increases, healthy backlog, good end market demand, and improved production.
• Margins should benefit from easing supply chain challenges, price increases, and volume leverage due to an increase in revenue.
• While the stock has run up ~70% since we first covered it in September last year, its good long-term growth potential and secular market share gain prospects make it a buy.

Investment Thesis

AAON, Inc.'s ( AAON ) stock price has risen by over 20% since my last bullish article in December and has increased by over 70% since I began covering the company back in September last year. The company's revenue growth and margin improvement prospects continue to be strong. AAON's revenue growth is expected to be driven by price increases, a healthy backlog, and increased production capacity. Furthermore, the long-term growth drivers appear positive due to good end-market demand, driven by secular trends related to decarbonization, energy efficiency, and indoor air quality, which should support sales growth going forward.

Regarding margins, the company is likely to benefit from improving supply chain conditions, price increases, improving productivity, and volume leverage. I believe the company can achieve significant earnings growth over the long term and outperform the broader end-market growth. Therefore, I maintain a buy rating on the stock.

AAON Q4 2022 Earnings

In late February, AAON released its fourth-quarter 2022 results, which exceeded expectations on both the top and bottom lines. Net revenue increased by 86.8% YoY to $254.6 million, surpassing the consensus estimate of ~$240 million. EPS increased significantly by 545.5% YoY to $0.71, also exceeding the consensus estimate of $0.56. Gross margin rose by ~1130 basis points (bps) YoY to 30.8%, while operating margin increased by ~1430 bps to 18.3%. The revenue growth was driven by increased production, strong demand, and price increases. Margins were boosted by easing supply chain conditions, price increases, and easier comparisons from the previous year's quarter. EPS growth was a result of robust revenue and margin growth, as well as lower tax rates.

Revenue Analysis and Outlook

Since the start of the pandemic, AAON has experienced healthy demand across its end markets, driven by growing trends towards decarbonization, energy efficiency, and an increased emphasis on improving indoor air quality. Furthermore, the late 2021 acquisition of BasX also contributed to the company's growth.

In the fourth quarter of 2022, demand remained strong, and sales growth was further supported by a healthy backlog and volume growth due to increased production. This resulted in an 86.8% YoY increase in net sales to $254.6 million. The net sales growth reflects a 19.1 percentage point benefit from the BasX acquisition. Excluding the acquisition, net sales increased 67.7% organically, including a 26.7% benefit from price increases and a 41% benefit from volume growth.

Looking ahead, I anticipate that AAON will continue to experience robust revenue growth in the coming year, driven by healthy backlog levels, increasing production, price increases, easing supply chain challenges, and strong end-market demand.

The total backlog, which is a good indicator of future revenue growth, is currently at healthy levels. In the fourth quarter, the company reported a 110.6% YoY increase in the total backlog, which reached $548 million. The backlog growth was a result of strong demand and a solid order pipeline growth among data centers and semiconductor manufacturing end markets, as well as impressive win rates. I expect the strong backlog levels to continue to support top-line growth in the future.

Furthermore, as supply chain constraints ease and production capacity increases, AAON's backlog-to-sales conversion should also improve. The company is taking advantage of these conditions and increasing its capacity to reduce lead times for its customers. To this end, AAON has rapidly increased its headcount, with a 36.2% Y/Y increase in the fourth quarter and a sequential increase of 5.9% from the third quarter.

Moreover, the outlook for AAON's end markets remains healthy. The healthcare, data centers & semiconductors, education, and manufacturing end markets are experiencing strong demand for the company's products, which should more than offset weakness in office and lodging end markets. It is worth noting that AAON is currently only present in the non-residential market, so the slowdown in new residential construction should not impact the company's sales. Additionally, legislative drivers such as the CHIPS Act, which encourages reshoring, and the CARES Act, which has allocated funds for improving indoor air quality in schools, are expected to continue supporting demand. The company is also well-positioned to benefit from long-term secular growth drivers related to decarbonization, energy efficiency, and good indoor air quality, given its expertise in the customized commercial HVAC market.

Management is also focusing on increasing sales of replacement products, with the company currently deriving approximately 65% of its sales from this market. The company plans to increase its sales from the replacement market to around 75% over the long term. Given the increased emphasis on good indoor air quality and energy efficiency, AAON has significant potential to gain market share in this market.

In addition to strong volume growth prospects, the company should also benefit from price increases. Management has guided pricing to contribute low double-digits to sales growth in FY23. Overall, I am optimistic about AAON's revenue growth prospects.

Margin Analysis and Outlook

In 2021, AAON's margins were negatively affected by higher raw material costs and supply chain challenges. However, the company's pricing and productivity initiatives helped in margin recovery in the latter half of 2022. As a result, gross margin increased by 1130 bps Y/Y to 30.8% in the fourth quarter of 2022, and operating margin increased by 1430 bps Y/Y to 18.3%. Margins also benefited from easing supply chain conditions and easy comparisons versus Q4 2021, in addition to price increases and improving productivity savings.

Looking ahead, I believe that AAON is well-positioned to further expand its margins in the upcoming year. The company's margins are expected to benefit from its price increases. In recent quarters, management has implemented price increases of approximately 1% every month. Management expects this trend to continue in the near term. Additionally, due to the SEER2 mandate, the company's price differential with its peers has narrowed as its peers such as Carrier Global Corporation ( CARR ) have raised prices. This gives AAON some room to continue increasing prices. The ongoing price increases, as well as the carryover price increases from the previous year, are expected to drive margin growth in 2023. Furthermore, supply chain conditions have started to ease, which should lead to productivity improvements and support margin growth. As a result, I remain optimistic about the company's future margin prospects.

Valuation and Conclusion

AAON is trading at 35.34x FY23 consensus EPS estimate of $2.63 and 29.63x FY24 consensus EPS estimate of $3.14. While the stock is trading below its historical 5-year average forward P/E of 41.90x , it commands a significant premium over its peer group. However, given its faster growth compared to peers and potential for long-term secular growth and market share gains in the HVAC space, I remain optimistic about AAON's prospects.

Table: AAON's valuation and earnings growth versus peers based on consensus estimates

Prior to the Covid pandemic, the company was considered a niche player. However, increased awareness and requirements for good indoor air quality have resulted in the company transforming into a mainstream player that is well-positioned to benefit from this multiyear growth trend. We are already seeing this in the company's numbers, with its growth continuing at a healthy pace despite concerns of a macro slowdown. The stock has experienced a significant run-up since my previous coverage. At that time, my long thesis was based on the company's good growth prospects and low P/E multiple. While the P/E multiples have already re-rated, and I am not counting on them expanding further, the company has multiyear double-digit EPS growth potential, which could result in further upside for long-term investors. Therefore, I continue to maintain my buy rating on the stock.

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