Overview

We engineer, manufacture and market air-conditioning and heating equipment consisting of standardized and custom rooftop units, chillers, air-handling units, make-up units, heat recovery units, condensing units, coils and boilers. Custom units are marketed and sold to retail, manufacturing, educational, medical and other commercial industries. We market units to all 50 states in the United States and certain provinces in Canada. Foreign sales are less than 5% of our 2008 sales as the majority of all sales are domestic.

We sell our products to property owners and contractors through a network of manufacturers' representatives and our internal sales force. Demand for our products is influenced by national and regional economic and demographic factors. The commercial and industrial new construction market is subject to cyclical fluctuations in that it is generally tied to housing starts, but has a lag factor of 6-18 months. Housing starts, in turn, are affected by such factors as interest rates, the state of the economy, population growth and the relative age of the population. When new construction is down, we emphasize the replacement market.

The principal components of cost of goods sold are labor, raw materials, component costs, factory overhead, freight out and engineering expense. The principal high volume raw materials used in our manufacturing processes are steel, copper and aluminum, which are obtained from domestic suppliers. The raw materials market was volatile during 2008 due to the economic environment. Raw materials pricing had steadily increased from the beginning of 2006 until the second half of 2008 when pricing sharply decreased. We experienced raw materials price increases of approximately 70% for steel, 18% for aluminum and 19% for copper from 2006 through the second quarter of 2008. Prices decreased by approximately 40% for steel, 76% for aluminum and 62% for copper from June 30, 2008 to December 31, 2008. We attempt to limit the impact of price increases on these materials by entering cancelable and noncancelable fixed price contracts with our major suppliers for periods of 6 -12 months.

Selling, general, and administrative ("SG&A") costs include our internal sales force, warranty costs, profit sharing and administrative expense. Warranty expense is estimated based on historical trends and other factors. Our product warranty policy is: the earlier of one year from the date of first use or 18 months from date of shipment for parts only; an additional four years on compressors (if applicable); 15 years on gas-fired heat exchangers (if applicable); and 25 years on stainless steel heat exchangers (if applicable). Warranty charges on heat exchangers do not occur frequently.

Our office facilities consist of a 337,000 square foot building (322,000 sq. ft. of manufacturing/warehouse space and 15,000 sq. ft. of office space) located at 2425 S. Yukon Avenue, Tulsa, Oklahoma (the "original facility"), and a 563,000 square foot manufacturing/warehouse building and a 22,000 square foot office building (the "expansion facility") located across the street from the original facility at 2440 S. Yukon Avenue. We utilize 39% of the expansion facility and the remaining 61% is leased to a third party. The third party lease expires May 31, 2009, at which time the facility will be remodeled to give us increased manufacturing capacity. The 2009 capital expenditures budget reflects the projected outlay to remodel the facility.

We conduct other operations in a plant/office building at 203-207 Gum Springs Road in Longview, Texas, containing 258,000 square feet (251,000 sq. ft. of manufacturing/warehouse and 7,000 sq. ft. of office space). An additional 15 acres of land was purchased for future expansion in 2004 and 2005 in Longview, Texas.

Our operations in Burlington, Ontario, Canada, are located at 279 Sumach Drive, consisting of an 82,000 sq. ft. office/manufacturing facility on a 5.6 acre tract of land.

Set forth below is income statement information and as a percentage of sales for years 2008, 2007 and 2006:

                                                                          Year Ended December 31,
                                                                          -----------------------
                                                  2008                             2007                             2006
                                                  ----                             ----                             ----
                                                                              (in thousands)
Net sales                             $ 279,725         100.0%         $ 262,517         100.0%         $ 231,460         100.0%
Cost of sales                           212,549          76.0%           205,148          78.1%           187,570          81.0%
                                   ---------------    ----------    ---------------    ----------    ---------------    ----------
Gross profit                             67,176          24.0%            57,369          21.9%            43,890          19.0%
Selling, general and
  administrative expenses                23,788           8.5%            21,703           8.3%            18,059           7.8%
                                   ---------------    ----------    ---------------    ----------    ---------------    ----------
Income from operations                   43,388          15.5%            35,666          13.6%            25,831          11.2%
Interest expense                            (71)          0.0%               (10)          0.0%               (81)          0.0%
Interest income                              27           0.0%                 8           0.0%                24           0.0%
Other income (expense), net                 724           0.3%              (321)         (0.1%)              424           0.1%
                                   ---------------    ----------    ---------------    ----------    ---------------    ----------
Income before income taxes               44,068          15.8%            35,343          13.5%            26,198          11.3%
Income tax provision                     15,479           5.6%            12,187           4.7%             9,065           3.9%
                                   ---------------    ----------    ---------------    ----------    ---------------    ----------
Net income                            $  28,589          10.2%         $  23,156           8.8%         $  17,133           7.4%
                                   ===============    ==========    ===============    ==========    ===============    ==========

Results of Operations

Key events impacting our cash balance, financial condition, and results of operations in 2008 include the following:

o An increase in the volume of sales on all product lines due to market share gains and effective moderation of commodity costs with purchase agreements and pricing strategies affecting gross margin, resulted in significantly higher revenues and net income. The large volume of sales also lowered the effect of major fixed costs in general and administrative expenses and occupancy expenses.
o We remained the leader in the industry for environmentally-friendly, energy efficient and quality innovations, utilizing R410A refrigerant and phasing out pollutant causing R22 refrigerant. The phase out of R22 began at the beginning of 2004. We also utilize a high performance composite foam panel to eliminate over half of the heat transfer from typical fiberglass insulated panels. We continue to utilize sloped condenser coils, and access compartments to filters, motor, and fans. All of these innovations increase the demand for our products thus increasing market share.
o In February 2006, our Board of Directors initiated a program of semi-annual cash dividend payments. Cash payments of $5.8 million were made in 2008 ($2.9 million paid in January and July 2008, respectively), and $2.8 million was accrued as a liability for payment in January 2009.
o Stock repurchases of our stock from employee's 401(k) savings and investments plan was authorized in 2005. Stock repurchases of our stock from directors was authorized in 2006. Stock repurchases of our stock from the open market was authorized and initiated in November 2007. Total repurchases resulted in cash payments of $24.8 million. This cash outlay is partially offset by cash received from options exercised by employees as a part of an incentive bonus program. The cash received in 2008 from options exercised was $1.7 million.
o Borrowings under the line of credit were $46.9 million and approximately $71,000 in interest expense was paid in 2008. Borrowings under the line of credit where interest is accrued are relatively short and generally paid off within the month incurred or the following month. At the end of 2008 there was $2.9 million outstanding on the line of credit.
o Purchases of equipment and renovations to manufacturing facilities remained a priority. AAON's capital expenditures were $9.6 million. Equipment purchases create significant efficiencies, lower production costs and allow continued growth in production. We currently estimate dedicating $7.0 million to $8.0 million to capital expenditures in 2009 for continued growth.

Net Sales

Net sales were $279.7 million, $262.5 million and $231.5 million in 2008, 2007 and 2006, respectively. Sales increased $17.2 million or 6.6% which was attributable to an increase in volume of product sold related to our new and redesigned products being favorably received by our customers, the diversified customer mix of products, active marketing by sales representatives and pricing strategies implemented in order to keep up with increasing raw material costs. The increase in sales in 2007 of $31.0 million or 13.4% was attributable to an increase in volume of product sold related to our new and redesigned products being favorably received by our customers, active marketing by sales representatives and pricing strategies implemented on 90% of our product lines in the second quarter in order to keep up with increasing raw material costs. New commercial construction steadily improved throughout 2007 and 2006, contributing to growth of the market.

Gross Profit

Gross margins in 2008, 2007 and 2006 were $67.2 million, $57.4 million and $43.9 million, respectively. As a percentage of sales, gross margins were 24.0%, 21.9% and 19.0% for the years ended 2008, 2007 and 2006. The increase in gross profit for 2008, resulted from pricing strategies implemented and production and labor efficiencies, as sales volume increased. We saw a decrease in raw material costs in the second half of the year, which also contributed to higher gross profits. Management anticipates the moderation of commodity costs through relationships with suppliers and price decreases in certain commodity costs, if realized, should enhance gross margins. Due to an increase in the volume of sales, actual gross profit for 2008 increased by $9.8 million from 2007, and by $13.5 million from 2006 to 2007.

The principal high volume raw materials used in our manufacturing processes are steel, copper and aluminum, which are obtained from domestic suppliers. The raw materials market was volatile during 2008 due to the economic environment. Raw materials pricing had steadily increased from the beginning of 2006 until the second half of 2008 when pricing sharply decreased. We experienced raw materials price increases of approximately 70% for steel, 18% for aluminum and 19% for copper from 2006 through the second quarter of 2008. Prices decreased by approximately 40% for steel, 76% for aluminum and 62% for copper from June 30, 2008 to December 31, 2008. We attempt to limit the impact of price increases on these materials by entering cancelable and noncancelable fixed price contracts with our major suppliers for periods of 6 -12 months.

We also purchase from other domestic manufacturers certain components, including compressors, electric motors and electrical controls used in our products. The suppliers of these components are significantly affected by the raw material costs as steel, copper and aluminum are used in the manufacturing of their products. While raw material costs decreased in the last half of the year, increases in component parts were experienced throughout 2008. We instituted several price increases to customers from 2006 to 2008 in an attempt to offset the continued increases in steel, copper, aluminum, and component parts. We attempt to limit the impact of price fluctuations on these materials by entering into cancelable and noncancelable fixed price contracts with our major suppliers for periods of 6-12 months.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $23.8 million, $21.7 million and $18.1 million for the years ended 2008, 2007 and 2006. The increase in selling, general and administrative expenses is due primarily to an increase in selling related expenses, warranty expense caused by increased sales, increase in profit sharing resulting from an increase in net income, and an overall increase in general and administrative expenses. In 2007, the increase in selling, general and administrative expenses was primarily caused by an increase in sales expenditures for an increased sales force and active marketing, increases in salaries for selling, general and administrative personnel and an increase in profit sharing. There were additional non-cash compensation costs for the fair value of stock options granted to employees in accordance with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 123R, Share-Based Payment ("SFAS 123R").

Interest Expense

Interest expense was approximately $71,000, $10,000 and $81,000 for the years ended 2008, 2007 and 2006. The increase in interest expense of approximately $61,000 in 2008 was due to higher average borrowings under the revolving credit facility as a result of a decrease in net cash provided by operations related to the stock repurchases. The decrease in interest expense of approximately $71,000 from 2006 to 2007 was due to a decrease in average borrowings under the revolving credit facility and interest rates. Interest on borrowings is payable monthly at the Wall Street Journal prime rate less 0.5% or LIBOR plus 1.6%, at our election (3.50% at December 31, 2008). Average borrowings under the revolving credit facility are typically paid in full within the month of borrowing or the following month.

Interest Income

Interest income was approximately $27,000, $8,000 and $24,000 in 2008, 2007 and 2006 respectively. The increase in interest income is due to interest paid for repurchased stock shares that were held in transit by the transfer agent in early 2008.

Other Income (Expense)

Other income was approximately $724,000 in 2008. Other expense was approximately $321,000 in 2007. The change in other income (expense) was primarily related to foreign currency losses that result from operations in Canada in 2008 and 2007. Other income was approximately $424,000 in 2006. Other income is attributable primarily to rental income from our expansion facility. All expenses associated with the facility that are allocated to the rental portion of the building are included in other income. We plan to continue to rent the expansion facility until the lease term expires on May 31, 2009.

Impact of Current Economic Conditions

Our business is affected by a number of economic factors, including the level of economic activity in the markets in which we operate. The current state of the United States economy has negatively impacted the commercial and industrial new construction markets. The current decline in economic activity in the United States could materially affect our financial condition and results of operations. Sales in the commercial and industrial new construction markets correlate closely to the number of new homes and buildings that are built, which in turn is influenced by cyclical factors such as interest rates, inflation, consumer spending habits, employment rates and other macroeconomic factors over which we have no control. In the Heating, Ventilation, and Air Conditioning ("HVAC") business, a decline in economic activity as a result of these cyclical or other factors typically results in a decline in new construction and replacement purchases, which could result in a decrease in our sales volume and profitability. Although the volatile economic conditions did not significantly affect our business in 2008, the impact the economy will have on us in 2009 is still unknown.

Analysis of Liquidity and Capital Resources

Our working capital and capital expenditure requirements are generally met through net cash provided by operations and the occasional use of the revolving bank line of credit based on our current liquidity at the time.

Cash Provided by Operating Activities. Net cash provided from operating activities has fluctuated from year to year. Net cash provided by operating activities was $33.4 million, $31.2 million and $19.4 million in fiscal years 2008, 2007 and 2006, respectively. The year-to-year variances are primarily from results of changes in net income, accounts receivable, inventories, accounts payable and accrued liabilities.

Net income for fiscal year 2008 was $28.6 million, an increase of $5.4 million from 2007. The increase in net income during fiscal years 2008 and 2007 compared to fiscal years 2007 and 2006 was primarily due to increased volume of sales, adjusted pricing strategies, fluctuations in raw materials costs, innovative and efficient products, and improved production efficiencies.

Depreciation expense was $9.4 million, $9.7 million and $9.1 million for the years ended December 31, 2008, 2007 and 2006, respectively. The decrease in depreciation is due to the realization of full depreciation of certain capital assets. We adopted SFAS 123R in 2006. Share-based compensation was $0.8 million, $0.6 million and $0.5 million in 2008, 2007 and 2006, respectively. Both depreciation expense and share-based compensation expense decreased net income but had no effect on operating cash.

Accounts receivable balances did not significantly fluctuate in 2008 even though sales increased. Accounts receivable increased during 2007 and 2006 from the increase in sales. Accounts receivable increased by $0.9 million at December 31, 2008 compared to December 31, 2007. The increase at December 31, 2007 from December 31, 2006 was $1.8 million.

Inventories increased by $4.8 million, $2.1 million and $5.8 million at December 31, 2008, 2007 and 2006, respectively. The increase in 2008 was attributable to procurement of inventory to accommodate an increase of sales. The leading factor in the increase in 2007 and 2006 is primarily related to the valuation of inventories due to higher raw material and component parts costs.

Accounts payable and accrued liabilities decreased by $1.3 million at December 31, 2008 and increased by $4.9 million and $4.3 million at December 31, 2007 and 2006. The decrease in 2008 is primarily due to timing of payments to vendors and a decrease in workers' compensation expense. The increase in 2007 is due to an increase in commissions payable related to the increase in sales, timing of commissions payable and payments to vendors.

Cash Flows Used in Investing Activities. Cash flows used in investing activities were $9.6 million, $10.8 million and $16.8 million in 2008, 2007 and 2006, respectively. The decrease in cash flows used in investing activities in 2008 and 2007 was $1.2 million and $6.0 million, respectively, and primarily related to a decrease in capital expenditures. Management utilizes cash flows provided from operating activities to fund capital expenditures that are expected to increase growth and create efficiencies. Due to anticipated production demands, we expect to expend approximately $7.0 million to $8.0 million in 2009 for a building expansion, a building renovation of the leased facility and equipment. We expect the cash requirements to be provided from cash flows from operations. We did not invest in any certificates of deposits in 2008 and 2007, respectively. A previously invested certificate of deposit matured in the first quarter of 2006.

Cash Flows Used in Financing Activities. Cash flows used in financing activities were $24.5 million, $20.0 million and $3.3 million in 2008, 2007 and 2006, respectively. The increase of cash used in financing activities primarily relates to cash dividends declared and paid and the continued repurchase of our stock.

We occasionally utilize the revolving line of credit as described below in "General" to meet certain short-term cash demands based on our current liquidity at the time. We have $2.9 million of borrowings outstanding under the line of credit at December 31, 2008. We had no net borrowings under the revolving line of credit at December 31, 2007. We accessed $46.9 million and $12.1 million of borrowings under the line of credit during 2008 and 2007, respectively. We utilized the revolving line of credit in 2006 for short-term demands in the amount of $53.7 million.

We received cash from stock options exercised of $1.7 million and $2.4 million and classified the excess tax benefit of stock options exercised and restricted stock awards vested of $1.6 million and $3.0 million in financing activities in 2008 and 2007, respectively. We received cash from stock options exercised for the year ended 2006 of approximately $1.3 million and classified the excess tax benefit of stock options exercised of $1.9 million.

We repurchased shares of stock under the Board of Directors authorized stock buyback programs in 2008, 2007 and 2006. We repurchased shares of stock from employees' 401(k) savings and investment plan, Directors, and the open market in 2008 in the amount of $24.8 million for 1,211,538 shares of stock. We repurchased shares of stock from employees' 401(k) savings and investment plan, Directors, and the open market in 2007 in the amount of $20.8 million for 1,082,736 shares of stock and in 2006 in the amount of $3.9 million for 250,500 shares of stock.

On February 14, 2006, the Board of Directors voted to initiate a semi-annual cash dividend. We initially paid Board of Director approved semi-annual dividends of $0.20 per share. The Board of Directors approved future dividend payments of $0.16 per share related to the stock split effective August 21, 2007.

Cash dividend payments of $5.8 million were made in 2008, and $2.8 million in dividends were declared and accrued as a liability in December 2008 for payment in January 2009. Cash dividend payments of $5.0 million were made in 2007, and $2.9 million in dividends were declared and accrued as a liability in December 2007 for payment in January 2008. Cash dividend payments of $2.5 million were made in 2006, and $2.5 million in dividends were declared and accrued as a liability in December 2006 for payment in January 2007. Board of Director approval is required to determine the date of declaration for each semi-annual payment.

General

Our revolving credit facility provides for maximum borrowings of $15.2 million which is provided by the Bank of Oklahoma, National Association. Under the line of credit, there is one standby letter of credit totaling $1.0 million. The letter of credit is a requirement of our workers compensation insurance and was extended in 2008 and will expire on December 31, 2009. Interest on borrowings is payable monthly at the Wall Street Journal prime rate less 0.5% or LIBOR plus 1.6%, at our election (3.50% at December 31, 2008). No fees are associated with the unused portion of the committed amount.

At December 31, 2008, we had $2.9 million outstanding under the revolving credit facility. At December 31, 2007, we had no borrowings outstanding under the revolving credit facility. Borrowings available under the revolving credit facility at December 31, 2008, were $11.3 million. At December 31, 2008 and 2007, we were in compliance with our financial ratio covenants. The covenants are related to our tangible net worth, total liabilities to tangible net worth ratio and working capital. At December 31, 2008 our tangible net worth was $96.5 million. Our total liabilities to tangible net worth ratio was 2.2. Our working capital was $40.6 million. On July 30, 2008, we renewed the line of credit with a maturity date of July 30, 2009. We expect to renew our revolving credit agreement in July 2009. We do not anticipate that the current situation in the credit market will impact our renewal.

On July 12, 2007, our Board of Directors approved a three-for-two stock split of our outstanding stock for shareholders of record as of August 3, 2007. The stock split was treated as a 50% stock dividend which was distributed on August 21, 2007. As a result of the stock split, our Board of Directors adjusted the dividend paid per share to $0.16. The applicable share and per share data for 2007 and 2006 included herein has been restated to reflect the stock split

Management believes projected cash flows from operations and our bank revolving credit facility (or comparable financing) will provide us the necessary liquidity and capital resources for fiscal year 2009 and the foreseeable future. The belief that we will have the necessary liquidity and capital resources is based upon management's knowledge of the HVAC industry and our place in that industry, our ability to limit our growth if necessary, our ability to authorize dividend cash payments, and our relationship with our existing bank lender. For information concerning our revolving credit facility at December 31, 2008, see Note 3 to the Consolidated Financial Statements, Revolving Credit Facility.

Commitments and Contractual Agreements

The following table summarizes our long-term debt and other contractual
agreements as of December 31, 2008:

                                                                    Payments Due By Period
                                                                        (in thousands)
  Contractual Financial Obligations                      Less Than 1                                          After 5
                                           Total             Year          1-3 Years        4-5 Years          years
                                      ---------------  ---------------  -------------------------------------------------
Long-term debt and capital leases         $     163        $      91        $      72        $       -        $       -
Purchase commitments(1)                       4,738            4,738                -                -                -
                                      -----------------------------------------------------------------------------------
Total contractual obligations             $   4,901        $   4,829        $      72        $       -        $       -
                                      ===================================================================================

(1) Purchase commitments consist primarily of copper commitments. In the normal course of business we expect to purchase approximately $4.7 million of raw materials in the form of legally binding commitments.

The fixed rate interest on long-term debt includes the amount of interest due on our fixed rate long-term debt. These amounts do not include interest on our variable rate obligation related to the revolving credit facility.

We are a party to several short-term, cancelable and noncancelable, fixed price contracts with major suppliers for the purchase of raw material and component parts.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Because these estimates and assumptions require significant judgment, future actual results could differ from those estimates and could have . . .