July 26, 2018 - 3:56pm EST by
2018 2019
Price: 36.70 EPS .95 0
Shares Out. (in M): 53 P/E 38.6 0
Market Cap (in $M): 1,941 P/FCF 0 0
Net Debt (in $M): -10 EBIT 69 0
TEV (in $M): 1,931 TEV/EBIT 28 0
Borrow Cost: General Collateral

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Short Thesis

â–  AAON is over-earning due to cyclically strong non-residential construction activity. Despite current earnings being above mid-cycle levels shares trade at 38.6x 2018 estimates


â–  AAON is losing market share


â–  Fair value is about 50% below the current price. Shares are not cheap even in a best-case scenario


Business Overview

AAON, Inc. manufactures and sells air-conditioning and heating equipment (HVAC) for the North American commercial and industrial new construction and replacement markets. The company’s largest end markets are education (23% of sales), manufacturing (16% of sales), commercial (21% of sales), and office (17% of sales). Approximately 55% of sales are replacements and 45% is new construction. The market is highly competitive with large and powerful players such as United Technologies, Johnson Controls and Ingersoll-Rand fighting for sales. AAON’s overall market share is about 7%.  The company’s products are compatible with control systems from most suppliers are more customizable than many competitors. This makes AAON’s offerings well suited for complex retrofits or buildings that require unique performance capabilities. People I spoke with in the industry noted that AAON high-quality products and good service but is also generally more expensive than larger competitors.


AAON is Over-Earing

As one would expect, AAON’s market is highly cyclical. To illustrate this, after the 2008 peak non-residential construction spending fell 35% in only two years.  


Figure 1: AAON’s Market Is Cyclical

On a nominal basis AAON’s end markets are now only 4% below the 2008 all-time highs.  On an inflation adjusted basis, construction activity is also above average levels. Even though 55% of revenues are from replacement sales much of this is planned replacement and remodeling work which is cyclical in nature and will at least partially track the new construction market.  Despite current earnings that are well above mid-cycle levels, AAON trades at 38x 2018E P/E. When construction activity eventually normalizes AAON’s sales and profits will fall.


Exactly how much AAON is over-earning is tough to say. If you assume that the 2006 -2016 average is a good proxy for normalized construction activity than the current market is about 20% above normalized levels.  A 20% decrease in AAON’s end-markets should translate to at least a 15% decrease in sales and an approximately 25% decrease in operating profit or about $70mm annually assuming full maturity of the water-source heat pump business. However, to be conservative we assume a significantly higher level of normalized EBIT in our valuation.


AAON is Losing Market Share

AAON was one of the first to offer “semi-custom” HVAC units. Semi-custom systems provide customers the ability to modify certain aspects of the product without the time and expense of a fully built-to-order unit.  According to people I spoke with in the industry, for many years AAON was the leader in the semi-custom space. This allowed AAON to grow sales much faster than the overall HVAC market as semi-custom products gained acceptance.


However, these same industry contacts indicated that competitors have now caught up to AAON and now there are several providers of high-quality semi-custom units. After gaining share for many years the company’s market share (as they report it annually) began to fall in 2014. Simply comparing AAON’s sales to the overall market shows sales growth has been lagging the market for a couple years. This data appears to conform what industry contacts were saying and suggests that AAON is indeed losing share.


Figure 2: AAON Sales vs. Total End Market


New Market Entry

AAON recently expanded into the water-source heat pump market. Management believes that in 2-3yrs they will capture 20% of the market at margins similar to the overall business.  As show below this would imply annual cash flow of about $15mm per year which is what our valuation assumes. Management has also talked about expanding production of air handlers.  Air handlers are a large, mature market that is served by large and power competitors such as United Technologies and Ingersoll-Rand. This expansion would cost at least $75mm and take 3 years. Our analysis assumes any investment in the air handler business is value-neutral. Our research indicated that these new markets are fairly mature with well established relationships. As such, AAON will likely be able to gain some share but is unlikely to materially surpass expectations.


Figure 3: Water-Source Heat Pump Business


Fair Value is 50% Below the Current Price

In 2017, AAON’s total adjusted operating profit was about $80mm. For a cyclical business such as this it would be generous to assume that this is a “mid-cycle” earnings level. We then assume a 2% long-term growth rate due to slow growth in the overall market. At an 9% cost of capital this yields a fair value of $19/share or about 50% below the current price.


Figure 4: Valuation

Shares Are Over-Valued Even in a Best Case Scenario

For a ‘best-case’ scenario, we assume non-residential construction is no longer cyclical and rather will continue to grow at 5% per year for the foreseeable future. We also assume that AAON is not losing share, but rather will grows sales 4% faster than the market. As shown below, even in this best-case scenario shares are slightly over-valued.


Figure 5: Best Case Scenario Valuation




Key Risks

Infrastructure Spending – AAON could benefit from an increase in federal spending on infrastructure. While most of AAON’s business is related to private construction, approximately 33% of sales are from healthcare and education. Its important to note that the infrastructure spending proposed by the current administration does not appear to be focused on healthcare or education. However even if healthcare and education construction increased 20% from government stimulus this would imply AAON sales would increase 7% and thus wouldn’t invalidate the thesis. Furthermore, during the prior period of government infrastructure spending (2008 and 2009) AAON’s sales did not outperform the market. Given the stock’s valuation, we are comfortable with this risk.  


Better Performance of New Products – It is possible that either the recent expansion into water-source heat pumps or possible future expansions of air handlers performs better than we are expecting. We’ve assumed AAON captures 20% share in pumps in 2-3yrs which seems fairly conservative. Both markets are also mature and have strong incumbent competitors.  These segments are also small relative to the core HVAC business and as such even if performance is in fact better than expected it would not invalidate the thesis.




To anticipate some questions / pushback: I’m not really sure why AAON trades at this valuation (although earning should rise and thus the multiple should fall as the pump business matures). There is also no great catalyst except from lower future earnings from lower market share and weaker end markets.  That said, you’re shorting an easy to understand business with limited upside that has some competitve issues at pretty crazy valuation where earnings are cyclical and likely to fall in the future.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


lower future earnings from lower market share and weaker end markets

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