Aaon Inc (NASDAQ:AAON)’s management would like investors to believe that the company’s new data center cooling projects, the ones driving all its revenue growth, have gross margins in line with its corporate average. Based on our analysis, these projects have a far lower gross margin than that. Yet the Street is forecasting both rapid revenue growth in this area, and massive gross margin expansion at the total company level. Even if AAON were to meet its revenue growth expectations, it will miss on gross margins due to this mix shift alone.
But there’s a more immediate problem: those revenue expectations. The data center (BASX) business has been borrowing revenues from the future with creative revenue accounting. We believe BASX revenue is currently overstated by ~30-40% thanks to such accounting games. At best, this implies that would-be-future revenues have already been booked, creating a near-term shortfall in the part of the business obviously responsible for AAON’s lofty price multiple. At worst, we may be looking at a revenue restatement at the upcoming year-end audit.
All this shortsighted nonsense – the bad data center projects, the worse accounting games – began under the prior CEO and Chief Accounting Officer. Both men left these positions in recent months. Both sold a ton of shares on the way out.
We believe BASX is doing essentially contract manufacturing to win data center contracts, at far lower gross margins than investors are used to. This would explain the ongoing gross margin “challenges” that just keep popping up since taking on the liquid cooling business.
And since management is compensated on sales growth, and the stock story requires a data center growth story, then by God they’re going to “win” big data center contracts any way they can get them.
We are short AAON and see >30% downside to earnings versus consensus, as the revenue and margin catalysts play out. We further see a potential accounting restatement that should reset inflated revenues to something more accurate.
Creative Accounting Is Exaggerating BASX Current Revenues by 30-40%
“Now [AAON’s] margin and profitability, when I go by the numbers they are publishing…If you ask me if I believe these numbers, that’s a very different story…I see [AAON] side by side with us working in projects where we are both in the same project…You have your own numbers, you see what it costs to do certain things…We sometimes struggle to believe what they put out there.” – Interview with competitor on AlphaSense Expert Insights
Accounting games getting more desperate but also more hilarious
We believe AAON has been using an increasingly aggressive series of accounting and reporting games to cover up the problems in its BASX business. BASX is the main driver of this stock’s valuation, so there’s a lot of bang for the buck if management can flatter the numbers there. BASX also has more subjective accounting methods than the legacy AAON business, so it is more available for tinkering should financial managers get the urge.
All this tinkering is shortsighted, though. These accounting gimmicks have done the job until now, but they have a natural time limit built into them. But there is good news: some of the tinkering is really funny.
Before we get into the more entertaining accounting games being played, most of which appear to have started recently and are tied to the “crown jewel” BASX segment, let’s examine what the simple balance sheet numbers tell us about revenue recognition the past couple of years.
Some basic contract asset DSO analysis first will help frame the problems.
2023: BASX order growth is slowing, why don’t we borrow some revenues from the future?
The measurement and recognition of revenue requires us to make judgments and estimates, including the determination of whether we should recognize revenue as we perform or upon the completion of our performance obligation, as these determinations impact the timing and amount of our reported revenue. – AAON 10-K (emphasis added)
Fellow accounting nerds will be familiar with how contract accounting works, along with its accompanying creation of contract assets when revenue is recognized ahead of the right to get paid. This is different from an account receivable, which arises from the unconditional right to get paid, where it’s only a matter of time before payment is due (or it may already be due). PWC explains all this and more in this endnote.
As PWC says, “[t]he distinction between a contract asset and a receivable is important because it provides relevant information about the risks related to the reporting entity’s rights in a contract, such as whether the reporting entity only has credit risk or if there are other risks, such as performance risk, remaining.” (You may have noticed that short sellers love situations in which contract assets are piling up surprisingly fast.)
In the case of AAON, we have every reason to believe that its contract assets are exclusively associated with its BASX business. Before AAON bought BASX in Q421, AAON’s contract asset balances were consistently zero:
(BASX also had contract assets on its own balance sheet before AAON bought it.)
For this reason, we conclude that the many contract asset dollars now on AAON’s balance sheet are the result of revenues recognized in its BASX business. One problem, then, is that AAON has $233m of contract assets on its balance sheet as of Q225, but BASX-branded revenues in the quarter were only $109m.
This leads to the appropriate way to conduct a “contract asset Days Sales Outstanding (DSO)” analysis: compare total AAON contract assets to quarterly BASX revenues only, and then multiply by 90. Incredibly, at Q225, BASX’s contract asset DSO was 192 days. It appears that BASX has been recognizing so much revenue on its contracts, and so early, that it is over six months ahead of even sending the bill out for all this work it’s supposedly doing. No HVAC peer we could find, whether focused on data centers or not, is recognizing revenue at a rate anything like this as we will see shortly.
When we do that DSO math for each quarter, we can see an alarming trend dating back over two years: BASX contract asset days started going up quickly in 2023, have kept going up since, and started going up really quickly in recent quarters. What could account for this snowball of unbilled revenue on the balance sheet, piling up so quickly without invoices or unconditional rights to payment attached to it? This analysis is the backdrop for the rest of this section on AAON’s aggressive contract accounting:
Source: AAON 10-Ks and 10-Qs and Jehoshaphat Research analysis. See endnote for calculation.
And since BASX is in the business of making cooling products for data centers, it can be compared to companies ranging from Carrier (CARR) to Modine (MOD) to Vertiv (VRT) who have various degrees (no pun intended) of traditional HVAC work, data center HVAC work, or supplying other products to data centers alongside cooling. The pace of revenue recognition that’s been happening at BASX for the past few years is even more concerning when you do such a comparison:
It’s just you. Source: 10-Ks/Qs of companies and JR analysis. See endnote for calculation.
For those investors who would feel more comfortable staying high-level, you could compare total AAON contract asset DSOs to peers too. We don’t prefer this method, due to the revenue mix shifting toward the BASX business with its contract assets. We present it here mainly to dispel a misguided rebuttal that might be based on similar analyses (that rebuttal being, “the contract asset DSO expansion is driven by mix shift”):
Source: Company filings and Jehoshaphat Research analysis. See endnote for calculation.
The rapid growth of BASX, which is driving a mix shift toward the very part of the business with more contract assets, should be driving AAON’s overall contract asset DSO up over time to a modest extent without any funny business needing to occur. Fine, right?
But there’s a problem with this justification. The data center cooling business is growing as a percentage of revenues for all these HVAC peers.ix Why haven’t these peers' overall contract asset DSOs also been going up for years? Our guess is that it’s because they aren’t taking the revenue recognition liberties AAON is taking.
Analyzing AAON’s contract asset DSOs on a BASX-only basis solves this problem and neutralizes this would-be excuse for contract asset accruals getting miles ahead of revenue growth or billings.
Read the full report here by Jehoshaphat Research
