Great. Good morning. Thanks for joining us. I'm Tim Wojs, and I cover building products here at Baird. We're delighted to have the AAON Group join us this year at our Global Industrial Conference. AAON's a leader in the HVAC market. They provide semi-custom rooftop units to the general market, and they also provide highly customizable data center cooling equipment. From the company, we have CEO Matt Tobolski, we have CFO Andy Cheung, and Joe Mondillo, who runs IR, is up here in the front. We're just going to do Q&A. Maybe just kind of start off, just kind of came off the third quarter. If you just kind of give us some of the highlights, and we'll go from there.
Yeah. Third quarter for us, I mean, it was definitely a kind of a proof point in a lot of the work we've been doing as a business. We look at where AAON as an organization has been five years ago to where it is today, and there's been a tremendous amount of growth, but more importantly, a lot of evolution. I've been in seat for about a year and a half now, and kind of coming in, obviously, really looking to capitalize on the opportunity to grow a much more robust, healthy business. We've done a tremendous amount of work in the last year and a half in terms of building not only capacity, but capability across the organization. Certainly not an easy task to be building a lot of that capability while growing dynamically in the space.
But really have put on a tremendous amount of new capacity across multiple sites inside the portfolio, but also really kind of changed and transformed the way that we operate as a business. We've added a ton of capacity in our supply chain organization, in our operations organization, our finance organization. Through all that, the work obviously has been kind of sitting there in the background, kind of gaining momentum. But really for us, Q3 was one of those proof point quarters, kind of showing that momentum catch from a flywheel perspective. We're really excited about kind of where we go from here. We saw the progression in margin. We saw some really solid supply chain performance in the midst of a lot of turbulence in the market.
We saw our operations execute consistently better and better, and with that, really catapulting stronger and stronger relationships with a lot of key customers. The fun part is it's not isolated to just one segment of the market. Both brands on the AAON and BASX side saw tremendous growth in the quarter, and really exciting to see the differentiation of our core commercial rooftop products, as well as a lot of really strong growth and differentiation in the data center product.
Maybe just, if you can step back just in terms of the differentiation, could you just talk about your business model versus maybe some others, just in terms of the customization of things and how you kind of think about going after certain pockets of business?
Yeah. No, it's great. Obviously two brands, but at the core, both brands are really focused on selling value to our customers. We're not a commodity product manufacturer. We're not a catalog-type product manufacturer. From a deployment perspective on the AAON brand, we do that through a highly configurable semi-custom rooftop product. The idea there is really trying to provide a ton of value to our customers by allowing us to really right-size the product for an application. But we do that with a ton of software automation and really allow that kind of platform-based semi-custom configuration. That allows our sales channel to really go out and engage with a tremendous amount of customers inside the market, and really select with our tools that we provide to them the right solution for the right application.
In doing that, yes, there's a price premium to it, but we're selling that kind of total cost of ownership conversation on the AAON side, and really a differentiated way of going to market and a really differentiated product. Really shown a lot of success. Year to date, we're up 30%. About 5% of that's price, so 25% volume on a commercial rooftop market that is flat from a volume standpoint across the industry. So, really good solid outperformance on that legacy AAON brand. On the BASX side, the BASX brand of the business, same logic goes into it. We're trying to sell value. We're trying to create solutions and really solve problems for customers.
The difference, I would say, when you think about the AAON brand versus the BASX brand, on the BASX side, a lot of it's really through what I call clean sheet customization. We have a ton of automation and tools that our team uses to be able to do that efficiently, effectively, and repeatedly. But at the end of the day, we're going into large hyperscale customers and really taking a seek to understand mindset. Really understand the pain points they have, not just from an efficiency standpoint, life cycle, maintainability, kind of understanding that full need they have, and then really taking that back to the office and providing really robust solutions that meet all those needs.
It's a real differentiation to be able to develop custom products, but to be able to do it and then execute that at scale and pace at a cost-effective price point is something we're incredibly proud of.
How does the process work in terms of Because you can't be everything to everybody.
Nor do you want to be.
Right, nor do you want to be. But how do you look at the market of kind of available supply and say, "I want to work with this customer," or, "I want to do this product for them"?
How many of those kind of like greenfield opportunities are there in your pipeline?
Data center specific or?
Data center specific, yeah.
Yeah, so from a data center standpoint, obviously there's a breadth of customer types inside the market. I always start off by saying we tend to spend a lot of energy working with larger and larger customers. That tends to be the focus area. The reason being the level of sophistication, the level of engineering wherewithal, and really kind of desire to optimize and then deploy across large footprints. Really, we can sell that value at scale and really showcase the impact that can have in their portfolio. So, large hyperscale customers are the type of customers we love because we're embedded with their engineering teams, we're embedded with their operations teams, and we're solving the problems that they're actually facing on a day-to-day basis. So, those tend to be where we focus, on that larger and more sophisticated customer base.
As you kind of think of the overall opportunity landscape in the data center space, there's certainly, as we kind of go down that value chain, there's other data center developers that aren't quite as sophisticated. They're not spending the time and energy kind of optimizing what they build, how they build. They're looking for speed, they're looking to just kind of deploy, and don't have the same capabilities in-house to really think optimized, how do we make the best data center possible? We tend to not focus on those. What I would say, though, is in the grand scheme of things, we also have a very strong sales channel in the data center space, that does allow us to kind of get a little bit more exposure into the market.
Our engineering teams are going to spend a ton of time with the hyperscale and large co-location customers, but we also have a sales channel that's engaged with some of that more kind of middle ground kind of data center developers, and really go after those opportunities as well.
Okay. Then I guess, I mean, as the chips get more powerful, they project more heat.
As you kind of look at the technology roadmap over the next three to five years, like, where are you kind of focused and where are your customers focused?
versus kind of what they're focused on today? What's going to change, I guess?
Yeah, it's kind of funny because when we think about the market and the sort of the race to build data centers, if you ask me, I'd tell you, over the last 12 months, I would say some of the basics of efficiency and how to optimize data centers, has to a certain extent from the industry perspective, sort of been overshadowed by just the desire for speed. We definitely saw that in the industry. I mean, the biggest conversation at a certain point in time was just lead time and understanding how fast can I get things. That was definitely in that neocloud -type market. It was all speed conversation. Through all that, obviously, we remain very disciplined on the engineering strength and capabilities that we have.
Why we think that's critically important is, as you think into the future and we think power density increases in the chipsets, we think power availability becomes more and more constrained. Environmental considerations become more and more important as we talk about developing responsibly data centers of the future. Efficiency is going to matter more and more. The value and the differentiation and the ability to optimize solutions is going to become stronger and stronger differentiation from a portfolio standpoint. For us, I mean, that's core to how we started the business over 10 years ago on the BASX side. That was kind of foundational. It's about driving value and efficiency, and really using that engineering at scale to really deploy great products.
As we go forward and that density increases and that power becomes more constrained, this is just continuing to reinforce the differentiation of the portfolio and the go-to-market strategy.
Do you feel like it insulates you from technology changes in a way?
What I'd say-
I imagine, like, over time, like, how you reject heat's going to change.
Yeah, it'll evolve. I mean, we've seen it evolve over the last five years.
Right.
What I would say is, from a differentiation, from an insulation standpoint, core to us is being as close to the customer as possible. Understand the problem, help solve their problems. With that, we're not talking about, "Hey, what's your current problem today?" It's about where you're going in the future. We look at some of the solutions we've deployed and developed with customers over the years, and you kind of were sitting there having the conversation for two years until it became a product. That's a very strong relationship, it's a very strong bond to break, and it's really a good insulator from an innovation standpoint. We love the conversations that we're already having with our customers about data centers of the future and modularization. How do we continue to reduce on-site construction time and put more in the factory?
Which, again, it adds more content, more dollar content for us, because the more we modularize, the more we take into the manufacturing work scope, the more we combine to deploy faster, obviously the more we're building. A lot of interesting things happening and a lot of really good conversations.
Okay. I know it's just been a week, but it's a top of mind topic with investors. Just any kind of early comments or reads on the election and kind of how that might kind of change demand for data centers?
Yeah, I think when we First perspective, obviously, is we've had no change in the sentiment from our customers. We've had no movement in projects. We actually have had acceleration in conversations on long duration kind of portfolio conversations. From that standpoint, I'd say the immediate kind of reaction on data centers, certainly it's not showing up in the conversations we're having. What I would say is fundamentally, as we think about kind of the pace of data center development over the last couple years versus sort of this, the shift from a political standpoint, I mean, I can say nobody. Certain people are saying, "Hey, we don't want data centers." But the vast majority of conversations in politics, it's not about no data centers, it's about responsible development of data centers. It's around the cost sharing of power. It's about the environmental impacts.
There's fundamentally going to be data center building. It's not going to stop the data center build. It's going to create some more conversation about regulation and responsible construction. But again, I take all that back to that's going to drive more and more conversation and focus on efficiency. That's going to take more energy for all of us in the industry to ensure we are developing responsibly and we're developing with the least impact possible to the communities and to the environment.
Maybe just, when you think about kind of near-term trends, I mean, you guys have stood up Memphis. You're kind of ahead of schedule. What does that mean from like an order activity? From our perspective, it seems like you may have more capacity to sell than maybe you thought six to nine months ago. Maybe just could put that in context for us.
Yeah, certainly incredibly proud of what our team has done in terms of building out capacity. I mean, we look at where Memphis started to where we are today, and I mean, it's been an awesome journey. It's certainly been with plenty of bumps and bruises, but the amount of capacity that's online and what we're building, the level of complexity of product, the quality of product, it's been awesome. Through all of that, we've been ramping Memphis, we've been ramping our Longview site and some really complex products, and our team continues to perform better and better and get better every day. Through all of that, we do recognize there's more capacity sitting inside the four walls than maybe historically we all thought. And when we look at it's not just a BASX brand conversation. It's an AAON brand conversation.
We think of Tulsa, it's our legacy rooftop manufacturing site, and when I joined AAON five years ago, I remember sitting in an investor meeting, where my predecessor, Gary, was saying, "Yeah, we've got about 30%-40% capacity headroom inside Tulsa." And why I laugh is we've grown Tulsa 30%-40%, and I would tell you that we have at least 30%-40% headroom capacity in Tulsa. And it's not like we're mysteriously finding capacity. It's very deliberate. What we're seeing from the operations team, and again, we've completely revamped and reimagined our ops way of thinking over the last 18 months, but we've driven incredible efficiency programs throughout the entire factory. We've really strong lean initiatives across the portfolio, and when you see that, what we're seeing is continued capture of more and more capacity in existing investments.
Really exciting to see the capacity that sits there, but I think the more exciting part from my seat is growth is incredibly fun, and it's fun to talk about top-line growth, but the opportunity for us, and really where we look to 2027 and beyond, is there's a lot of opportunity to grow the bottom line a heck of a lot faster than the top line. When we look at a growth from a value creation standpoint, with all the work we've done, the heavy lift has been over the last year and a half, but as we look at a go-forward basis, there is so much opportunity in the cost structure. There's so much opportunity from a pricing power perspective in our supply channel.
A lot of good SG&A leverage, a lot of good technology impact to the business, and through all of that, great working capital and cash flow trends. What's really exciting is growth is exciting, and it's going to be a continued story for us, but beyond just top line, the bottom line story is going to be incredibly exciting over the next couple years.
Has the focus internally shifted too? Was it like go growth for nine months and just get these products out, ship them out, get to the customer, and now it's, okay, we've delivered on that, and so now let's go focus on margins, or is that too simplistic?
There's some level of kind of validity there. What I would say, though, is as we built out the operating model, and as we built out the supply chain strength, and we built out the finance team strength, it takes a little bit of time for all that to kind of catch and start creating the discipline in how we operate. If you go to an AAON factory today versus 18 months ago, they look completely different. The how we operate, the manner in which leadership teams behave on the shop floor is completely different than what it was 18 months ago. With that, it's all about urgency to solve problems and urgency to transparently see where the issues are and tackle them.
Andy and I have spent a ton of energy down at our Longview site, helping that team and guiding that team through the operating discipline to get ourselves the sort of progression in margin. You see obviously that showing up in the financials, but what's exciting is, I mean, we're just scratching the surface on that work in Longview, let alone all the other factories. It's not that the team was not focused on margin. The tools and the discipline weren't in place. During that growth cycle, we consciously said to ourselves, "In the midst of all this growth, what is most important?" At the end of the day, customers are most important.
We can sit here and I can sit up here and talk about a little bit of short-term pressure on the margin, knowing if we take care of our customers, the durability of this business is going to be way better off in the long term. Cementing ourselves with some of these customer relationships, especially in times like this where supply chain is disrupting all sorts of things for customers, to sit out there and look at the world's largest hyperscaler and have them come into our factory two weeks ago and said, "You are the only manufacturer that's reliably delivering every single time you say you will." I mean, that's what our team has been focused on. The kind of fun part is, the margin's almost the easier part of the conversation. We can clearly look at the opportunity and start tackling that.
For us, we're excited about where we're at.
Okay, great. Andy, you joined as CFO six months ago?
Yeah.
Yeah.
Yeah, about six months.
I guess, where are you kind of spending your time and kind of what's your kind of initial assessment of the opportunity?
Yeah, it's a great question. When I first joined, everybody asked me, "Hey, Andy, what's your priority?" I said three things. I said, "I come in to build a finance function that can run this company and run this company like a mature company." The second thing I said, "I'll focus on margin." The third thing I said, "I focus on cash flow." I would say that now starting to see the outcome showing up, and I'm really happy with the team, what they've been doing the last six months, and not only supporting the customer, but turning that customer satisfaction into the bottom line, right? Think about when Matt talk about these proof points of what we do, think about ability of getting the price-cost equation right, getting our pricing right in our backlog.
This is not done just by going out and trying to do it without the customer satisfaction. There's a proof point about how we serve our customer. That's why they give us more business, their top line growing. At the same time, we got our fair share of the economics, right? Beyond the proof point, I think the other thing that I would describe it is the turning point from a cash flow standpoint. Q3 marked the first time that we became free cash flow positive for more than two years, in the recent history. There's also, again, another great evidence that with the growth, with the profitability, now we are able to really turn those into cash, full working capital, full managing CapEx better. Yeah, I think we're seeing a lot of success over the last six months, so really happy about it.
And could you just provide like a couple examples of Because you've talked about kind of beefing up supply chain and beefing up kind of finance and internal visibility and things like that over the last, call it probably 12 months.
Could you talk about a few things of like what it was and kind of what it is today?
Yeah, I mean, and again, I think it's not a knock on how AAON used to operate.
Yeah
I mean, I think there was a level of scale and sort of intimacy in the way they operated that allowed it to kind of live the way it lived. But, from a completely blunt perspective, when I took this over 18 months ago, we didn't actually have supply chain. Like, we had a purchasing department, and that's a very distinctly different thing. So, we had a purchasing department historically in AAON that basically just said, "The MRP sent me a demand, I go out there and I buy whatever part shows up in the MRP." That was the level of sophistication that existed inside the supply chain organization. Today we have category management, we have quarterly business reviews with key suppliers. We have way more insight into supplier performance. With that, we went from having, I think, 3% of our spend under contract a year and a half ago to well over 50.
We've got long-term purchasing agreements with all the critical suppliers. We have price lock programs in place that help provide stability in the price/cost perspective. We have a lot more strategic supply chain that's able to really unlock value inside, not just the price side of it, but the reliability side of it. That's been a huge piece of just really allowing us to execute incredibly well from a customer delivery standpoint through all this. Are we perfect? By no means.
No.
The supply chain work is never done, especially in this environment. But where we sit today is markedly different than where we were a year and a half ago. On the finance side, and Andy Cheung can certainly provide some more color, but we didn't really have a finance organization. Joe Mondillo was, I guess, the only person, quote unquote, "in finance" a year and a half ago. How we operate today, we've built out a robust organization of finance capability in the plant that's providing our operators way more insights into the business. We have way more strength in the business units in terms of understanding the health of their business and the opportunities. Certainly, Andy, more color you want to throw in there.
Yeah. So, definitely those are the opportunity that, as Matt Tobolski mentioned, I came from automotive background, right? So about lean, about driving waste away. The only way to see it is through a very focused measuring of all our activities inside the four wall of the factories, and on the pricing side and then supply side, making sure we kind of balance the equations. So, I think the finance function clearly enabled the rest of the other function do a much, I'll call it robust job in terms of capturing the economics of the business.
Okay. Has the margin profile of the data center business, kind of the, I guess, the optimal margin performance of the data center business, has that kind of changed at all in terms of the targets?
No, I mean, we've talked obviously getting the BASX brand into the 30% range. Obviously part of that is just getting absorption in a lot of this investment to kind of get it to a sweet spot and kind of its performance point. We saw in the quarter obviously a good movement in margin in the Coil Products segment, which is primarily BASX branded product. Taking that up to just below 27%, there's still a lot of opportunity in just operational efficiency to drive that further, as well as absorption. So, we look at getting to that 30. We have line of sight on how to get there, and there's a lot of stuff we're doing to get there.
I think it's exciting to look at something like the ACP margin movement, because what you see kind of in a progression perspective, price/cost obviously is a lever in there, but there's also operational kind of momentum in terms of how we operate that's also making an impact. So, you saw a good amount of the movement in Q3 on a price/cost conversation, which I just like to kind of pause and point out, it kind of showcases the pricing power of the brand and kind of how we go to market.
If you think about, we have a lot of backlog that's there with the customer, that that customer could tell us, "You have a contract, this is the price, this is what you're going to build it for." We've talked openly about, "Hey, we're actively repricing that backlog." Tim reminded me, we had a lot of folks that kind of shook their head and say, "Yeah, right." But the kind of the evidence and the reason we were confident in doing that is the execution. It is the relationship with that customer, how we execute, the value we provide them. There is a level of intimacy with that customer in terms of how we operate that is a shared success perspective. The value we provide in the innovation, in the product, the quality and delivery reliability, from that relationship standpoint, it wasn't easy.
We had to go through and provide a lot of reason, rationale for why the price had to be what it was. But that customer was incredibly open to that conversation, and we worked through it together to reprice the entire backlog with that customer. So, a huge kind of proof point of the power of the brand. Then we think about, that was just step one, and then obviously all the future orders are repriced or priced at a much different level. So, a lot of good momentum and also a lot of good kind of strength in the products.
Yeah. On the Oklahoma side, I mean, you're talking about 30% growth
in a market that's not really growing.
What are the one or two kind of key drivers of that, and I guess as you go into 2027, is there any sort of like hangover or do you feel like that you're actually building momentum and that's not going to be an issue?
Yeah, it's actually interesting to look at the growth we have. Our lead times have not been where we wanted to be, and so all that growth is coming while also from a, if you will, competitiveness, we were actually not as in the sweet spot we wanted to be. We had long lead times. So to be able to see that growth and continue booking at strength showcases kind of the value proposition. I kind of put it into the two big buckets. I think, first off, to call out the strength of our sales channel, incredibly strong sales channel at positioning the products, really able to identify opportunities and really working with our sales team, create a lot of focused energy on where the value proposition sells best. So you see that gain a lot of good strength in the market.
The other side of it is really on that national account focus. A lot of growth we've seen is in national accounts. All of that supported, whether it's the transactional type in-market work or national accounts, by a really good product portfolio. The Alpha Class heat pumps showing great strength, the innovation of the product, the value proposition, all showing good strength. Specifically to the national accounts, we've seen that flywheel really catch and really get a lot of momentum in terms of our teams creating a lot of opportunity and our sales channel collaboratively closing a lot of that opportunity. It's not something that happened by accident. It's not something we stumbled upon. About two years ago, we had laid out a plan to basically strengthen the national account strategy. The reason was we were looking at why does AAON win?
We kind of were having a meeting talking about the value proposition and the reasons we win, and it's all about selling total cost of ownership. If you look at 10 years ago and you asked, "Hey, who does AAON sell to?" I'd tell you that 25%, 30% of our business is K-12 schools. We can sell reliably to K-12 because not only is it, "Hey, how much does it cost to buy the equipment?" but maintainability, efficiency, that total cost of ownership conversation is incredibly important. We're sitting there saying to ourselves, "Where else does that matter?" We started talking, and I'm like, "We have zero focus. We have zero intentional focus on national accounts inside AAON." We took the operating model from BASX in terms of how we support large data center customers.
We took that same exact model, and then we basically adapted it into the commercial HVAC market. We built out a ton of capability in terms of program management, dedicated technical support, dedicated service technicians, warranty support, customer service, and built out a robust and dedicated internal national account team inside AAON. The reason that's important is in national accounts, we don't sell projects, we sell programs. If we mess up a project in a multi-site program, the ripple effects are really big. When you look at how you want to service those customers that are geographically diverse, touching multiple of your reps' locations, you got to invest in-house in that level of service.
We built from scratch about two years ago that process to build out that capability, and then our sales and marketing team created very intentional kind of value-selling, vertical market selling tools to our sales channel and helped them focus on where to put energy to sell the value proposition best. All of that's allowed national accounts to basically go from a nothing portion of our conversation over a two-year period to represent a 33%-35% of our sales and bookings inside the business. It's really been a good growth driver in the midst of a down market.
How do you When I think about national accounts too, I mean, that kind of does play into your sweet spot of total cost of ownership and things like that. Like, how does the heat pump, your Alpha Class kind of play into that? Because I know you have kind of a well-established kind of heat pump in the market relative to the competition, and it seems like the market eventually is going to move that way.
Yeah, I mean, heat pumps have been a great portion of the conversation, and I always start off by reminding everyone that when we say Alpha Class heat pump, it's actually three different model lines inside the Alpha Class. From a branding perspective, we have the Alpha Class Eco, Pro, and Extreme. Sorry, I forgot the low end there. Eco basically is your everyday heat pump. It's going to operate down to 37 , 40 degrees Fahrenheit in a fully electric mode, and then below that needs some level of supplemental heat via gas or electric. So that's kind of your baseline heat pump. But then the Eco will operate down to 0 degrees Fahrenheit, and then it can actually operate below that with a blended heating source.
Then we go all the way down to the Extreme, and Extreme will actually operate in heat pump mode down to negative 20 degrees Fahrenheit. So incredibly strong performance. The kind of importance of that portfolio is when you go to a national account customer and you talk heat pumps, you're not talking a single product. You're able to sit there and look at that portfolio and say, "If electrified heating is important to you, from a portfolio standpoint, let's look at the geographies." All right, you've got some locations in Florida. Okay, we're going to talk about the Eco down there. We're going to optimize the price point down there. But as we move to the middle states and the northern states, we kind of progress from the Eco to the Pro to the Extreme.
You're having a very strong, robust product portfolio that you're able to really right-size to the geography depending on where their sites are at.
And then maybe last one, just on, there is obviously a lot of kind of margin noise in that segment just because of some of the BASX ramp-up costs and things, but you are making progress on kind of margins. Like, what is the target for gross margins in Oklahoma, and do you have visibility to it in 2027?
Yeah, I mean, our target from a gross margin standpoint, so we are sitting 32.8% in Q3, and there is more price in the backlog, so there is more momentum to kind of come off of that. And we continue to be very disciplined on price and also disciplined on operations. So getting ourselves back to that mid-30s range kind of in next year is really where the target is.
Okay, great. We are out of time, so please join me in thanking AAON for being here.