Generac Holdings' CEO Discusses Q2 2013 Results - Earnings Call Transcript

Jul.30.13 | About: Generac Holdings (GNRC)

Generac Holdings Incorporated (NYSE:GNRC)

Q2 2013 Earnings Conference Call

July 31, 2013, 09:00 AM, ET

Executives

York Ragen - Chief Financial Officer

Aaron Jagdfeld - Chief Executive Officer

Analysts

Christopher Glynn - Oppenheimer

John Quealy - Canaccord Genuity

Jeffrey Hammond - KeyBanc Capital

Ross Gilardi – Bank of America/Merrill Lynch

Stanley Elliott – Stifel Nicolaus

Operator

Good day, ladies and gentlemen and welcome to the Second Quarter 2013 Generac Holdings Incorporated Earnings Conference Call. My name is Katrina and I'll be your operator for today. At this time, all participants are in a listen-only mode. We will facilitate a Q&A session towards the end of the presentation. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. York Ragen, Chief Financial Officer. Please proceed.

York Ragen

Good morning and welcome to our second quarter 2013 earnings call. I'd like to thank everyone for joining us this morning. With me today is Aaron Jagdfeld, our President and Chief Executive Officer.

We will begin our call today by commenting on forward-looking statements. Certain statements made during this presentation as well as other information provided from time to time by Generac or its employees, may contain forward-looking statements and involve risks and uncertainties that could cause actual results to differ materially from those in these forward-looking statements. Please see our earnings release or our SEC filings for a list of words or expressions that identify such statements and the associated risk factors.

In addition, we'll make reference to certain non-GAAP measures during today's call. Additional information regarding these measures including reconciliation to comparable U.S. GAAP measures is available in our earnings release and SEC filings.

I'll now turn the call over to Aaron.

Aaron Jagdfeld

Thanks, York. Good morning everyone and thank you for joining us today. We are pleased to report our second quarter 2013 results this morning, which we believe continue to demonstrate the powerful macro growth drivers for our business as well as the ongoing progress we are making in executing our Powering Ahead strategic plan.

Our second quarter net sales increased 45% over the prior year to $347 million with very strong double-digit organic growth which remain broadly based across our product categories at all major regions in United States. We are particularly impressed with the organic growth that we have experienced when considering as follows the prior year second quarter in which net sales increased nearly 50% over the second quarter of 2011. We converted this robust revenue growth into even higher growth rates for adjusted EBITDA and adjusted earnings per share of 65% and 64% respectively, as we saw a 320 basis point improvement in EBITDA margin during the quarter versus prior year.

Growth in shipments of home standby generators were again very strong during the quarter as the market for these products continues to develop with more home owners becoming aware of the importance of having a backup power system. As home owners experience more frequent and longer duration power outages, they are increasingly seeking technology solutions which ensure their basic comfort, safety and expected standard of living. As a result, home standby generators are becoming more mainstream, given this increased need and awareness.

The accelerated adoption rates for these products has led to further expansion of our residential and light commercial distribution network, ending the second quarter with over 5100 dealers which is nearly a 1000 more since the end of 2011.

As we support the increased awareness with expanded distribution, we believe we are driving a new and higher baseline level of demand for home standby generators. As the clear leader in the home standby generator category over the last decade with approximately 70% market share, we believe it is incumbent upon us to continue to drive growth and increase the penetration rate of this emerging backup power solution in household across the United States.

We are supplementing the main growth drivers of an extended afterglow period and expanded distribution with some new and exciting sales and marketing initiatives to further increase the awareness of home standby generators. These initiatives include our AMP targeted marketing process, our power play in-home selling solution and our recently launched national advertising campaign.

The number of dealers using power play continue to grow during the second quarter as we are well on our way to achieving an approximate 20% adoption rate by our dealer base by the end of the year. We are very pleased with this rollout so far as we are still seeing a notable improvement in sales closure rates for dealers using this new and innovative sales tool.

In addition, our power you control direct response television advertising campaign was recently launched at the end of May, and we are selectively targeting certain national networks as well as specific local regions of the country. Although still early in the campaign, we are encouraged with the response rate relative to other forms of direct marketing.

The sales leads we are generating come directly into our lead management team here at Generac where they are qualified and directed to our dealers who are using power play thereby leveraging our investment and increasing the likely closure rate.

With penetration rates at only approximately 3% of single family unattached houses in the U.S. we believe there remains a substantial opportunity for us to continue to grow the market for home standby generators.

We also experienced a strong double-digit year-over-year increase in portable generator shipments during the second quarter of 2013 to the combination of inventory replenishment and overall expanded placement for these products at our retail customers. Shipments of portable generators during the first half of 2013 have significantly exceeded our expectations. Unlike previous major power outages where demand for portable generators increases rapidly and then settles back down to baseline relatively quickly, we are seeing a longer tail of demand following super storm Sandy. We believe this extended period of elevated demand as well as further market share gains have driven our outperformance of portable generator shipments so far in 2013.

Our ongoing success in portable generators after reentering this product category in 2008 has further solidified our leading position in providing a full range of backup power products to the residential market. In doing so, we have positioned the Generac brand as being the household name in backup power.

Also contributing to the year-over-year sales growth in residential products in the second quarter was an increase in revenues from power washers. We've developed the full line of washers since reentering the market in 2011, which includes the recently introduced OneWash the industry's only variable speed power washer.

OneWash is a premium priced product addition which serves as an important compliment to our existing broad product line which has price points in the entry level to the midpoint range. This new power washer product has met our initial expectations including positioning Generac as the leader in providing some much needed innovation to this market.

With the successful roll out of the new product as well as increased placement of our consumer and prosumer units and our retail channel partners, we believe we are making good progress in growing our market share in the power washer product category.

Demand for our commercial and industrial stationery generators continues to see very good momentum due to the increased awareness of the need for backup power in the part of businesses. In particular, we experienced strong revenue growth from our telecom national account customers during the second quarter as wireless providers look to further safeguard their network from future outages.

The need for reliable mobile voice and data has become increasingly more important and as a result wireless carriers are facing both increasing competitive and regulatory pressures to harden their networks. As the market leader in the telecommunication segment we believe providing backup power for this critical communications infrastructure represents the compelling secular growth opportunity for the Company.

Additionally, we continue to see attractive revenue growth from shipments of light commercial generators used in smaller footprint retail applications as market interest in cleaner burning more cost effective natural gas fuel backup generators continues to increase as a result of the exceptional value proposition of these products. As power outages are becoming more prevalent, business owners are also becoming keenly aware of the need for backup power to protect their revenue streams and perishable inventories.

Helping to increase the awareness in this optional standby market is a key corporate initiative for 2013. And recently we launched a concentrated direct marketing campaign, our largest such effort to-date targeted at several businesses in the light commercial category, including a particular focus on gas stations and convenience stores.

Our campaign is centered around driving awareness of the return on investments that these products have for particular businesses as well as educating business owners on the amount of hours on average that utility power is lost over the course of the year in their local area.

We are developing specific sales tool for both our national account sales team, and our independent dealer sales team to use in demonstrating the payback of standby generators. Given the relatively low penetration of light commercial backup generators, we believe there is a large growth opportunity that exists by focusing on improving the adoption rate with small businesses.

We attribute our success over the last several years to the development and execution of our Powering Ahead strategy. Since mid 2010, the strategic plan has served as a framework for the significant investments we have made to drive the baseline growth of Generac.

As a quick review, this strategy is organized around four key growth objectives. First, by growing the residential standby market. Secondly by gaining commercial and industrial market share; third by diversifying our end markets with expanded product offerings and services; and fourth by expanding into new geographies.

We've remained intensely focused on the first objective of Powering Ahead by making significant investments to roll the residential standby generator market through our numerous initiatives targeted at increasing the awareness, availability and affordability of these products. We have resourced this particular objective with a strong infrastructure and the investments we have made to-date have helped us capitalize on the powerful growth drivers within the residential products portion of our business.

At the same time, we have also been focused on better balancing the overall products and markets that we serve through our three remaining Powering Ahead strategic objective. Most of this diversification has been achieved over the last couple of years through several strategic acquisitions that have given us access to new products, new markets and new customers.

Our Magnum product acquisition has allowed us to enter the mobile power equipment market that predominantly serves the construction and energy sectors through rental channels. Our Ottomotores acquisition has given us access to larger output power generation equipment serving the Latin American market. In addition the launch of our power washer product line has allowed us to leverage our existing retail customer relationships, supply chain and manufacturing capacity.

We believe there are significant opportunities for growth in the global power generation and engine powered equipment markets. And we are committed to pursuing these through organic initiatives as well as maintaining an active M&A pipeline.

Another example of our efforts to become a more balanced company with improved global focus can be found in our announcement last week of the signing of an agreement to acquire Tower Light, a leading European developer and supplier of mobile light towers with headquarters outside Milan, Italy. With distribution in over 50 countries Tower Light is a great strategic fit for Generac's business, providing an expanded product offering of light tower generators to support additional geographic market from those we serve today.

When combined with our Magnum mobile product, this acquisition positions Generac as the global leader of light towers, allowing us to participate in the growing rental market outside the U.S. With over 100 employees and approximately EUR37 million in net sales in fiscal 2012 Tower Light customers and end-users buy their product not only on price but they also place a high level of importance on innovation, durability and sustainability.

The product line today includes the industry's widest range of LED based lighting towers as well as several hybrid lighting solutions that drive dramatic improvements in fuel efficiency. Tower light operates the flexible development and product environment which allows them to provide customized product design for specific applications where local market demands with relatively short lead times leading to premium margins for the company.

Although early in the process of exploring opportunities for revenue synergies, we have already identified several attractive cost saving opportunities that we are currently evaluating. With respect to cost synergies, we are estimating that over the next 18 months we can drive approximately $1 million in component related savings on an annualized run rate basis.

The execution of our Powering Ahead strategy has resulted in a more balanced company with improved global focus, and when combined with the powerful macro opportunities in the residential and light commercial backup power market, we believe we have the right strategy in place to drive future growth and ensure the value.

I would now like to turn the call over back to York to discuss second quarter results in more detail. York?

York Ragen

Thanks, Aaron. Net sales for the second quarter of 2013 was $346.7 million, a 45% increase as compared to $239.1 million in the second quarter of 2012. Looking at net sales by product class, residential product sales increased 59.3% to $196.6 million in the second quarter of 2013 relative to a prior year net sales comparison of $123.4 million, which saw year-over-year sales growth of 34% over the second quarter of 2011.

The growth in the current year was broad-based, primarily driven by very strong double-digit increases in shipments for both home standby and portable generators. With regards to home standby generators, the continued strength in shipments is due to a variety of factors including the continuing demand from recent major power outages driving further adoption of the category, expanded distribution broadening the availability of the product, increased sales and marketing initiatives extending the awareness of the category, overall strong operational execution to satisfy the increased demand and an improving environment for residential investment.

Portable generator shipments during the second quarter of 2013 were up strongly in comparison to the prior year quarter. Our broad relationships at retail provide us with an increase in portable generator shelf space over the last several years. As demand remained strong for backup power following the recent major power outages, we are also seeing increased pull through portable generators.

We believe our solid execution and working capital investments have allowed us to capture a leading share of the portable generator market. Also contributing to the revenue growth for residential products in the second quarter of 2013 was our growing presence in the market for engine driven power washers.

Looking at our commercial and industrial products, net sales increased 32% to $133.4 million in the second quarter of 2013 from $101.1 million in the second quarter of 2012. The increase in net sales was primarily driven by the Ottomotores acquisition. We also saw strong organic revenue growth for our C&I products due to robust shipments to telecom national account customers as well as increased sales of light commercial natural gas generators using small retail applications. These increases were slightly offset by difficult prior year comparison during the quarter for certain of our mobile products sold through national rental accounts.

Our other product sales category improved to $16.6 million in the second quarter of 2013, an increase of 13.7% from the prior year second quarter sales of $14.6 million. This growth is primarily due to increased sales of service parts as the installed base of our products continue to grow with the overall growth of the Company.

Gross margin as a percentage of sales for the current year second quarter was 37.8% compared to 36.6% in the prior year second quarter. This 120 basis point improvement was primarily the result of higher mix of home standby generators shipped in the current year quarter, improved pricing and a moderation in product cost due to lower commodities and the execution of cost reduction initiatives. These margin improvements were partially offset by the mix impact from the addition of Ottomotores sales.

Operating expenses for the second quarter of 2013 increased $4.2 million or 8.5% as compared to the second quarter of 2012. This increase was primarily driven by operating expenses associated with the Ottomotores business as well as increased sales, engineering and administrative infrastructure to support the strategic growth initiatives and higher baseline sales levels of the Company. Partially offsetting these increases were the $5.9 million decline in the amortization of intangibles.

In addition, we are also experiencing improved warranty rates resulting in reduced warranty reserves during the quarter. Excluding non-cash intangible amortization expense, operating expenses as a percentage of net sales during the second quarter of 2013 were 13.9%, representing a 200 basis point decline as compared to 15.9% in the prior year quarter. Favorable operating leverage and higher volumes and the improved warranty rates are the main drivers of this 200 basis points improvement.

Adjusted EBITDA increased 65% to $90.1 million or 26% of net sales in the second quarter of 2013 as compared to $54.6 million or 22.8% of net sales in the same period last year. Our attractive EBITDA margins improved by 320 basis points in the current year quarter, primarily as a result of the items just mentioned; improved product mix, improved price cost, warranty reserve improvements and leveraging our SG&A infrastructure on the higher organic shipment volumes.

Adjusted EBITDA over the last 12 months as of June 30, 2013 was $358.3 million or 25.8% of net sales during that period. GAAP net income for the second quarter of 2013 was $28.3 million as compared to $9.3 million for the second quarter of 2012. Adjusted net income as defined in our earnings release increased 67% to $66.6 million in the current year quarter versus $39.9 million in the prior year second quarter. This increase is attributable to improved operating earnings during the quarter resulting from a 45% increase in net sales and higher margins, partially offset by higher interest expense due to higher debt levels in interest rates compared to prior year as well as higher cash income taxes.

Diluted net income per share on a GAAP basis was $0.40 in the second quarter of 2013 compared to $0.14 per share in the second quarter of 2012. Adjusted diluted net income per share as reconciled in our earnings release was $0.95 for the current year quarter compared to $0.58 per share in the prior quarter, a 63.8% year-over-year increase.

As previously announced on May 31, 2013 the company completed refinancing of its senior secured credit facilities. Pursuant to which, it has incurred $1.2 billion of senior secured term loans to replace its prior term loan facilities. The new term loans will mature in 2020 and will initially bear interest at LIBOR plus 2.75% with a LIBOR floor of 0.75%. Beginning in the second quarter of 2014, the spread of LIBOR of the new term loan can be reduced to LIBOR plus 2.5% to the extent that the Company's net debt leverage ratio falls below 3.0 times.

Following the refinancing, the Company used a portion of the proceeds from the new term loans to fund a special cash dividend to its stockholders of $5 per share and to pay related financing fees and expenses. The special dividend constituted a declared amount of $342.1 million in the aggregate, of which $340.8 million was paid on June 21, 2013. As a result of the refinancing transaction and other debt prepayments, an extinguishment of debt charge of $13.5 million was recorded in the second quarter of 2013.

In summary, the current quarter debt refinancing transaction resulted in a 275 basis point reduction in interest rate as compared to the prior term loan facilities. Despite increasing our overall outstanding debt, this very attractive cost of debt allowed us to reduce our interest expense on an annualized run rate basis by approximately $7 million, resulting in an approximately $0.06 of accretion to adjusted EPS.

We are very pleased; we are able to return significant capital to shareholders while at the same time having a refinancing transaction being accretive to adjusted earnings. We were able to accomplish all of this while maintaining a comfortable leverage position at 3.4 times gross debt adjusted EBITDA as of June 30, 2013 and also maintaining flexibility to grow the business with regards to liquidity, covenants and access to additional capital.

Interest expense in the second quarter of 2013 increased to $14.3 million compared to $9.9 million in the same period last year. The increase was the result of higher debt levels and interest rates compared to the prior year period. Due to the reduction in interest rates from the current year refinancing transaction completed in May 2013, interest expense during the third quarter of 2013 is expected to be approximately $13 million which includes approximately $1.5 million of deferred financing costs and original issue discount amortization.

With regards to cash income taxes, the second quarter of 2013 includes the impact of a cash income tax expense of $2.7 million, as compared to only $272,000 in the prior year quarter. As we commented during recent conference calls, our cash income taxes for 2013 are expected to increase going forward due to a combination of our NOL carry forward being fully utilized during 2013 and higher overall profitability levels.

Cash income taxes for 2013 were previously estimated to be approximately $14 million to $15 million. Based on our increasing guidance for the full year 2013, partially offset by additional tax deductions relating to our recent debt refi, cash income tax expense is now projected to be $15.5 million to $16.5 million for the year, which translates into a cash income tax rate of 6.5% to 7.5%. Importantly, our favorable tax yield through our annual intangible asset amortization in our tax returns remains intact through 2021, resulting in approximately $49 million of cash tax savings per year for the next nine years.

As a result, our cash income tax rate is expected to be significantly lower than our current projected 36% to 38% GAAP income tax rate for the foreseeable future. As we drive higher profitability over time, any incremental pre-tax profit over this tax year will be taxed as we projected 36% to 38% tax rate going forward.

Free cash flow defined as net cash provided by operating activities less CapEx was $30.3 million in the second quarter of 2013, as compared to $17.8 million in the same period last year. Strong operating earnings were partially offset by increased working capital investment, driven primarily by seasonal finished goods inventory replenishment and to a lesser extent higher capital spending levels.

Free cash flow over the past 12 months remain strong at $223.3 million. As of June 30, 2013 we had a total of $1.21 billion of bank debt outstanding net of unamortized original issue discount, and $126.6 million of consolidated cash and cash equivalents on hand, resulting in a consolidated net debt of $1.084 billion.

Our consolidated net debt to the LTM adjusted EBITDA leverage ratio at the end of the second quarter was a comfortable 3.0 times compared to 3.5 times ratio at June 30, 2012.

With that, I now like to turn the call back over to Aaron to provide additional comments on our outlook for the remainder of 2013.

Aaron Jagdfeld

Thanks, York.

As a result of the continued strong demand for our products as well as the expected closing of the Tower Light acquisition earlier in the third quarter of 2013, we are again raising our sales guidance for full year 2013. Full year net sales are now expected to increase in the low 20% range over the prior year, which is an increase in the low to mid teens rate previously expected.

Specifically for the second half of 2013, net sales are forecasted to increase in the mid single-digit range as compared to the very strong prior year's second half period. Even after excluding the pending Tower Light acquisition, net sales are still forecasted to grow in the lower single-digit range during the second half of 2013 over the prior year period.

Importantly, the second half of 2012 had two major power outage events. The mid-Atlantic regions the Rachel early in Q3 and super storm Sandy in the fourth quarter. And our revised top line guidance for 2013 continues to assume no major power outage events for the remainder of this year. Additionally, our guidance also continues to assume no material changes in the current macroeconomic environment.

We expect the demand for home standby generators will continue to benefit from increasing awareness and adoption, as a result of the major power outage events that have occurred in recent years along with our expanded distribution which is resulting in the formation of a new and higher baseline level of sales for these products.

We also believe the ongoing improvement in the environmental residential investment and execution in our sales and marketing initiatives will further drive home standby penetration rates. As a result, total residential product sales are now expected to increase in the high single-digit range in full year 2013 over the prior year, which compares to the low single-digit growth previously expected.

As discussed, our guidance for the remainder of the year does not include any assumptions for major outage events, and prior second half include multiple major outage events. Therefore, as previously guided, we continue to expect a year-over-year decline in shipments of portable generators in the second half of this year. Despite this, we believe we are gaining share in the market for these products through additional retail placement.

Net sales for commercial and industrial products are now expected to increase in the low 40% range over the prior year, which is an increase in the low 30% range previously expected. This increasing guidance is primarily due to an improved organic outlook for C&I shipments along with the expected closing of the Tower Light acquisition earlier in the third quarter of 2013.

Excluding the Ottomotores and Tower Light acquisitions, organic revenue growth within the C&I product category is now expected to increase at a mid to high teens rate over the prior year, which compares to the high single-digit organic growth rate previously expected. The increased organic growth rate for C&I products is again mostly driven by increased spending from our telecom national account customers as they continue to make investments to improve the reliability of their wireless networks. Our outlook for C&I products continues to assume a modestly improved non-residential construction market in 2013 over the prior year.

Summarizing our sales growth assumptions for full year 2013, total Company organic year-over-year growth is now expected to be between 11% and 13%, which represents an increase from our previous guidance of between 5% to 7%. The acquisitions of Ottomotores and Tower Light are expected to contribute between 9% and 10% growth for a total expected year-over-year net sales increase in the low 20% range.

Consolidated gross margins for 2013 are still expected to be flat as compared to the prior year. This guidance implies the gross margins in the second half of the year will moderate as the benefit of product cost reduction is more than offset by an expected higher mix of C&I shipments. As a result of maintaining this outlook, we continue to expect full year gross margins of approximately 37% for the third year in a row while we continue to diversify and globalize our business.

Operating expenses as a percentage of net sales excluding amortization of intangibles are now expected to be flat for full year 2013 as compared to 2012 at approximately 14.5%, which is an improvement from previous expectation of slightly up compared to the prior year. This improved outlook is largely due to an improvement in our warranty rates resulting from our intense focus on improving overall product quality over the last several years.

As a result of the higher sales outlook and improved operating expense guidance, we now expect adjusted EBITDA for the full year 2013 to increase in the low 20% range, which is an increase in the low teens percentage range previously expected. We continue to expect cash flow conversion will remain strong during the year and to be consistent with the cumulative average during the past four years of free cash flow, representing between 90% to 95% of our adjusted net income.

In closing this morning, we believe our second quarter results further demonstrate the progress we are making in executing our Powering Ahead strategic plan. We delivered very strong organic revenue growth once again this quarter, which was broadly based across our major product categories and all significant regions in the United States.

The investments we've been making are driving performance that is exceeding our expectations. And with continued momentum entering the second half, we have raised our outlook accordingly. We believe the powerful macro drivers for our business which includes the under investment in the electrical grid and ageing population and an increasing reliance on uninterrupted power and data will continue to drive further awareness for the need for backup power.

Given the relatively low penetration for both home and light commercial standby generators, we believe there is substantial growth opportunity as a leader in this emerging product category. This concludes our prepared remarks and at this time we would like to open up the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you, ladies and gentlemen, (Operator instructions). Your first question comes from the line of Christopher Glynn representing Oppenheimer. Please proceed.

Christopher Glynn - Oppenheimer

If you can elaborate on the closure rate improvement seen from power play and what you are measuring against because I think previously, you know, you talked about the earlier adopters maybe having higher closure rates to begin with.

Aaron Jagdfeld

Hey, Chris, that's a great question and something we are watching very closely as we roll this out. We really like what we are seeing in closure rates. I think it is still too early, it was probably too early in the first quarter that we had it out and I counted on it, but we are pretty excited about what we are looking at.

We are digging deeper into that to understand, yeah those again we are targeting kind of about 20% of our dealers to be on power play. I think, yeah, that's 20% of the dealer count. I will say that these are the better dealers, they represent over half the sales that run though our dealer channels which represents the majority of sales in the residential standby category.

So we think that as we increase the adoption rate, what we are seeing in closure rate today I think it is another couple of quarters or so we are going to be comfortable that kind of maybe talk more deeply about those improvements. But I'll tell you just my experience having been around this and having watched closure rates for a while, we really like the uptick that we are seeing. The system is having an impact. We definitely know that it's having an impact. We are dialing it in, we've released a couple of different versions of it since the initial version, I think version 3 or 3.5 at this point.

We are expanding its functionality; we are expanding the training on it to make sure that you know, it is something that people understand how to fully use. We are now using it in conjunction with this new infomercial program that I've talked about this new campaign, the direct response television campaign that we launched called Power You Control, and that's something that is we are seeing some really interesting things in terms of the impact of both of those things in concert together. So I don't want to quote a specific closure rate, but I can tell you that they are materially higher than they were previous.

Christopher Glynn - Oppenheimer

Okay, thanks for that. And then on Tower Light wondering if you could comment on margins relative to Generac core and then the revenue geographic split and current growth?

York Ragen

Yeah, Chris this is York. I think with regards to margins, I think it's – Aaron made some comments about their approach to the market and how they approach different geographies around the world as Aaron mentioned, they have distribution that serves about 50 countries around the globe and they have products that service specific needs for each of those markets. And therefore they are able, with that approach they are able to go to the market with premium margin.

So I like in it, so I want to compare to say how do they compare to Magnum's margins which what we have commented in the past as more typical mobile equipment here in the North America sold through the national rental accounts. There are better margins in Magnum, probably in the high-teens range but that's pre-synergies. So as we talked about, there are some synergies we have identified. So we want to try to get those approaching 20% there, which are one of the reasons why we like this business was the margins that they are generating.

Christopher Glynn - Oppenheimer

Okay. And then just maybe the split of Europe and ex-Europe and if it's overall growing right now?

Aaron Jagdfeld

I think you are talking about Tower Light Chris?

Christopher Glynn - Oppenheimer

Yes please.

Aaron Jagdfeld

Yeah, so Tower Light is growing, it's growing from – we disclosed that it was EUR37 million in sales at the end of 2012, we can say that it's grown through the first half of this year. It's on plan definitely growing nicely. Their distribution, about two-thirds of the sales are in Europe and about one-third outside.

So, mainly the outside sales are going to the Middle East and Africa, couple of other parts of the world therein. They have distribution like a little bit in Latin America, they have distribution in 50 countries which is another kind of really nice thing we like about this business is with their customer base and with their breadth of their distribution, we think there is some pretty new things we can do with that.

In terms of adding additional products if you think about Magnum's product line, little bit fuller product lines there in terms of just outside the light tower, so is the rental market there are some other products that we think could possibly go into Tower Light as well and into those existing customers. So we are pretty excited about that.

Christopher Glynn - Oppenheimer

Great. Thank you.

Aaron Jagdfeld

You bet.

Operator

Your next question comes from the line of John Quealy representing Canaccord Genuity. Please proceed.

John Quealy - Canaccord Genuity

Good morning, guys. Nice quarter and looks good to get back to positive retained earnings for you guys. So a couple of questions. First, on the standby business, can you talk about relative growth rates I think you talked about for the whole business across the country growth, but can you kind of segment that for us in terms of Northeast, Southeast, Southwest, West? How is the growth trends looking for you folks at this point of the year?

Aaron Jagdfeld

Yeah I mean we don't obviously we don't disclose growth rates by regions. But what we can say is obviously as you would expect the growth rates in the northeast, mid-Atlantic and Southeast regions of the U.S. are beyond what they are in other parts of the country. But that being said, we continue to see John even the Midwest we haven't had any major events here in the Midwest to speak of, but yes just the frequency of events that we do get they are more localized in nature. They impact power, we are not talking about weeks on end, you're maybe talking about a day or two or maybe more.

But some of our best penetrated states remain here in the Midwest which Illinois, Michigan, parts of even parts of Pennsylvania in terms of Western Pennsylvania there is some great regions of the country here that for us anyway represent good business and good growth rates. And lower growth rates as you would are West where you don't get the severity of weather with the good, most it's underground, and so you've but still growth.

And that's the – it's up nicely I mean if you look at that we talk about what's driving that, and again it gets back to this under penetration story across the board that as we continue to drive awareness for the category, drive distribution points more points of lights. We think it's having that kind of an impact with our initiatives and with things that are driving awareness.

John Quealy - Canaccord Genuity

Okay, great. And then on the portable side it sounds like you guys have been positively surprised on the strengths there, obviously whether it was tough compares year-on-year decline in shipments in the back half of the year, is that channel still ahead of an expected somewhat storm season for the channel Aaron, or what do you think going on in the portable side for the back half?

Aaron Jagdfeld

Yeah there is definitely some inventory replenishment. There is no question in the front half that took place. The second half which we still see, even though there is a good everyday business on portable generators for the same reason that you know I mentioned with power outages that happen every day around the U.S. there is still 0.25 million people or more without power every day in this country.

And you know the typical solution for most people is coming out and get a portable generator with our expanded shelf position, retail partners and this has been a category that frankly you know has exceeded my expectations. When we made the decision to get back into it several years ago, you know it was more of a complementary product for us.

It really is you know for us it has become a way to strengthen our relationship with our retail partners, a way to really create a brand in Generac that speaks to backup power for the residential in consumer markets and I would say a lot of that come on the backs of our success in portable generator.

But a lot of it is you know with inventory replenishment here in the first half of the year and second half I think the replenishment is pretty well done. It's a cycle now, what you're going to see is normal sell through ahead of you know then normal weather patterns, there is seasonality in the category that happens typically late in the second quarter and throughout the third quarter with your active weather patterns around the U.S. just you know summer storm season.

John Quealy - Canaccord Genuity

Yeah. And then last two questions quickly. In terms of the national account business, was that surprising and what are your qualitative expectations for national accounts in the back half of the year?

Aaron Jagdfeld

Yeah, so I mean we're watching national accounts with a lot of interest. I mean it's a big piece of our business. We love that business because we think we do it very well, we think we have a good program setup with our national account sales team. You know a lot of it is coming as we said from the telecommunications vertical, we are seeing some traction in other verticals as well.

Financial services industry, we've got a couple of national account customers there that are new to us. But it's primarily the telecom space and as in our prepared remarks we said you know it's not only the competitive pressures in terms of uptime with the networks but also the regulatory pressures, the drumbeat there around you know is this going to be our cell towers is going to be regulated relative to meeting backup power.

We are watching that with great interest obviously, in terms of the impact it could have for us. But our customers our national account customers are by and large proactive on that already. So it's not like it's going to push them to do it faster. But they are already out there you know and we serve all the major telecom companies. We are the primary suppliers to all of them. It's kind of specialized space. Those products are a little bit niche, they are somewhat customized for each of the different networks and the network providers.

We like the future of that as we kind of indicated in our implied guidance here in the back half, a lot of that can be driven by national account business. Some of the other national accounts step on the rental space, are also starting to come alive. The CapEx spending by the larger national rental accounts which is mainly what we serve through our Magnum business, we are starting to see that pickup as well. So we continue to be bullish on national accounts barring any unforeseen pullback on a macro basis in the economy.

John Quealy - Canaccord Genuity

Great, thanks very much guys.

York Ragen

Thanks, John.

Operator

Your next question comes from the line of Charley Brady representing BMO Capital Markets. Please proceed.

Unidentified Analyst

Hi, good morning guys. This is Andrew joining on for Charley Brady.

York Ragen

Hi, Andrew.

Aaron Jagdfeld

Hi, Andrew.

Unidentified Analyst

I was just wondering with respect to rental companies, you guys seeing them just replacing what they have but also kind of expanding their fleets in terms of you know light towers and generators?

Aaron Jagdfeld

That's a great question Andrew. I mean the light tower category in particular has – is one of those categories that's expanding and there is lot of when you talk about the shift to more night time construction that's kind of new market if you will, you know there has always been some amount of night construction. But road construction at night is becoming much more prevalent around the U.S. as you know construction companies, municipality, state governments they try to avoid you know congestion issues that come from shutting down the roadways during the day.

The other part of the – the sector there that has obviously come out strong is the oil and gas sector, the energy sector. That has remained relatively soft in the first half this year, the energy sector. But road construction has remained pretty bullish. There is a lot of infrastructure rebuild to go on in this country, so I think there is an expansion of some fleets, certainly there is a replenishment cycle there you know these are products that go above four years in terms of their average life, four to five years that replacement cycle has been pretty heavy in 2011, and all the way into the first half of 2012. You know that started to slowdown but what we are seeing now is those companies are becoming more aggressive at spending CapEx dollars again as we indicated the back half of '13.

On the mobile generator side, just to kind of round out the discussion, we are taking share there. Magnum only has been in that market for about six or seven years, and so it takes time to build those relationships, to prove themselves the quality of the product and we continue to deepen our penetration of those products Magnum branded products at their rental customers that are currently buying light towers and that's been a success story for us.

Unidentified Analyst

Okay, great. That was helpful. And I was just wondering if you could quantify the gross margin impact the Ottomotores had in the quarter?

York Ragen

Yes, it's York. I mean it's probably if you are talking the margins were up 120 basis points that there was an offset to that with Ottomotores maybe a 1% to 1.5%.

Unidentified Analyst

Okay. And last question just is that $13 million in the $1.5 million of deferred financing, the run rate we should use going forward?

York Ragen

Yeah that was the Q3 2013 first full quarter with the new credit facility.

Aaron Jagdfeld

We would remind you that there is a function within that credit facility that if we get to net debt leverage of three times or less, we'll step down a quarter, quick quarter point the LIBOR plus 250 it still remains the 75 basis points more but –

York Ragen

If the Second quarter of 2014 if our net leverage is below three times, 3.0 times we'll step down to that 2.5 point. It will reduce 0.25%.

Aaron Jagdfeld

Yeah that can bring our run rate down obviously slightly.

Unidentified Analyst

Okay, great. Thanks, guys.

Aaron Jagdfeld

Thanks Andrew.

Operator

Your next question comes from the line of Jeffrey Hammond representing KeyBanc Capital. Please proceed.

Jeffrey Hammond - KeyBanc Capital

Hey good morning guys. I don't know if I missed this, but did you give an organic growth rate for the quarter in commercial, or can you give us the Ottomotores contribution?

York Ragen

Yeah, it was – we didn't specifically give it, but we still had about if we grew 32% for C&I all-in, we still had about 11% organic. So still very healthy organic growth on the C&I side for the quarter.

Jeffrey Hammond - KeyBanc Capital

Okay, great. And then you guys I mean clearly you've been talking about a robust demand period, share gains I am just wondering what all of this is within all this what you are seeing from a competitive landscape, are people investing more adding capacity, introducing new products at the rate you guys are, or is it pretty quiet?

Aaron Jagdfeld

No, Jeff I think the main competitors for us in the -- we just talk on standby for a second, the main competitors in that space have been they remain relatively unchanged for the last several years and they've always been aggressive. I think they compete with us in terms of trying to expand the market. But in terms of their level of investment, I think one of the things that benefits Generac is this is our focus, our primary focus whereas the primary focus of most of our competitors is something else first.

And so I think in terms of management resource, in terms of financial resource, in terms of focus, I think that benefits us in terms of why we've been able to maintain our share and grow the market on the same breadth here on all the initiatives and things that we are working on. But the competitive side is we are well aware of the opportunity here, it's just a question of focus and a question of resources and time allocation I think by those other companies.

Jeffrey Hammond - KeyBanc Capital

Okay. And then just longer term question about capital allocation, clearly private equities less involved, you had a couple of years of the special dividend. How should we think the same or differently about capital deployment in the out years as you continue to generate strong cash flows?

Aaron Jagdfeld

I think we've been pretty consistent in our message on how we're going to allocate capital and the deployment of capital going forward. I mean the first thing we want to put as much capital towards growth as we can in terms of growing the business organically. We've said that we want to pay down debt, I think more confirmable range for us in terms of leverage ratio be somewhere in that two to three times on a net debt basis.

So, we think that there is some room to continue to pay down debt. Both on M&A which we've been doing right along here, would kind of be the next priority for us and you see that evidence with another acquisition here we just announced with Tower Light which we really like in terms of broadening the company out both in product and in global scale.

And then after that we get through that progression, Jeff I think we'd evaluate what does make sense? Is it time to initiate a regular dividend for the Company for the shareholders, is it – would be another special dividend, share buyback I mean there is range of options there. I think the thing that we want to be our shareholders with the knowledge of it is that we are going to deploy capital in the way that's going to get them the best return and get us the best return.

We have lot of opportunities out there for us to grow this company organically and through M&A and I think we are going to be very judicious and we've always have been, it's kind of in our DNA, we are very judicious about how we spend capital there.

Jeffrey Hammond - KeyBanc Capital

Great, thanks guys.

Aaron Jagdfeld

Thanks a lot.

Operator

Your next question comes from the line of Ross Gilardi representing Bank of America/Merrill Lynch. Please proceed.

Ross Gilardi – Bank of America/Merrill Lynch

Yeah, thanks guys. Good morning.

Aaron Jagdfeld

Hey, Ross.

Ross Gilardi – Bank of America/Merrill Lynch

Yeah I just had a few questions. So your residential growth rate actually accelerated in the second quarter versus the first quarter on a year-on-year basis. Was that comp issue, so the comp just easier or is underlying demand actually accelerating as we get further from Sandy? And can you talk at all about what kind of demand you are seeing for standby kind of in the here now in July or any color you can provide sort of as the quarter progressed in terms of growth rates?

Aaron Jagdfeld

Yeah. So Ross I think your observation there is absolutely correct. I think there is a couple of things underlying that. I mean certainly the Q2 comp actually was a little bit easier than Q1. There was quite a bit of backlog demand we were fulfilling in the first quarter of '12 that made that quarter a little bit more difficult comp and that relaxed obviously we got to Q2 of 2012.

But I look at the new initiatives that we have got that we have just rolled out here at the end of the year, the end of 2012 and in the first quarter with power play, with our AMP direct targeted marketing, we have got our national ad campaign now in market that started in late May, around the Memorial Day holiday, I think all of those things everything that we see on our dashboards as we look at the company and the KPIs we watch are telling us that closure rates are improving, lead generation is up significantly, web hits are up significantly.

So interest level in the category home standby that is in particular which is the majority of that residential bucket is up significantly. We also had our power washers, that again this is our second full year in washers. So there is a little bit there in Q2 over the prior year Q2. So there is some pickup there which is good, we launched our OneWash product. So we are gaining share and there we are still small player, no question about it. But it continues to be a part of that overall growth for residential.

Here and now we don't want to make comments about the current quarter. I think as we've said that we really have been impressed with the tail on this home standby business from Sandy. We think that the echo effect of Sandy happening in the same region as Irene a year before, has had a more substantial impact on the length of that tail, whereas we have said in the past we would expect to normally see an elevated period of demand for about 6 to maybe 12 months after event. I think we are going to see all of 12 months maybe longer with this event. So it will remain to be seen what happens as the season shapes up this year, but at least right now we really like the trajectory of that business.

Ross Gilardi – Bank of America/Merrill Lynch

That's great guys. And then as you are seeing faster penetration or faster growth in portables, I mean what kind of opportunity do you see longer term for many of those consumers to upgrade to a standby product and are you seeing increasing incidence of that?

Aaron Jagdfeld

Yeah, that's the beauty of it. I mean we look at our own data, when you look at home standby sales data and we look at the registration data underlying that and underpinning that, about half of the people who have a home standby or buy a home standby generator either own or own portable.

So if we can give people a good experience, people kind of as a starter product if you will for backup power with a Generac branded portable generator, the upgrade path to a Generac branded home standby we believe is something that is an opportunity for us.

And so the ability to market directly to those people now that we have that data it becomes a readymade kind of upgrade path marketing project for us and something that we are playing with right now in terms of how we can do that after people who have owned a portable generator a couple of years and maybe used it a few times, they understand that it's not a fully automatic solution, you do have refuel it often times it's inconvenient points in the middle of the evening, you have to have extension cords, you know the lack of automation on it and you got to be home when the power is out, you've got to be in an area that isn't so where the power outages are so wide spread that you can't even get fuel.

So downside of using a portable generator are it works, but works in a pinch, and that's a great product. But the increased utility and value you get by spending little more money on a home standby is a great upgrade path and it's something we see as a great marketing opportunity for us as we have done very well in portable generators over the next few years, we think there could be good conversion rate opportunity there.

Ross Gilardi – Bank of America/Merrill Lynch

And then you talked about inventory replenishment in the first half by the mass merchants but what did the mass merchants do in preparation for hurricane season? Do they build lot more safety stock this year and if there isn't a major outage event this summer, are you concerned at all that we have – that you'll only go through a big destocking event later in the second quarter?

Aaron Jagdfeld

Yeah, it's a good question Ross, just kind of two parts of the question. The first part I think that it's natural for retailers as they did last year after Irene to probably go heavier the season after a major event right. So they did after Irene, they stocked up really heavy for Sandy because they did I think we benefited from that. I think the stocking levels were main elevators, Sandy may be even have gone up a little bit more. If we look at our in-channel inventory where our partners have talked about their inventory levels and where they want to be for the season, it is somewhere higher than the prior year.

Are we concerned about not getting storm? I think we put that into our guidance. Our guidance doesn't assume a major outage. It assumes there is no outage and as such would assume destocking would occur in the back half of the year as a result we built that into our guidance. The way we kind size ourselves around that and plan around that, it's pretty simple. We felt what's our everyday shop space in portable generators and then we kind of look at that, okay, if we didn't get in the event how long it will take us to burn that inventory off.

And so we calibrate our own inventory levels as well as looking at those in the field and in channel and we create, we have a decision to we make there, we make some decisions about what could happen if we don't get a storm and I think you are seeing that reflected in the second half guidance as it relates to what we've issued this morning here.

Ross Gilardi – Bank of America/Merrill Lynch

I got you, thanks. That’s helpful. And then your dealer network is clearly growing very rapidly and you're citing that as a source of strength in the standby category. But is dealer inventory an increasingly important issued to follow talking obviously more about local electricians; do you have dealers that are building speculative inventory of standby product in front of the hurricane season?

Aaron Jagdfeld

It's a good question I mean actually one that we have remarkable visibility to now given our activation data and things that we talk about on calls previously. There is no question that when you are look into certain regions of the countries, the Northeast, the Mid-Atlantic we're seeing some dealers that are carrying inventory. The thing we're noticing now is that the demand has remained so strong that really every time they get inventory position the demand kind of is set up and so it's sold already. And when you are small dealer, what we said traditionally and what we can see here is there are some outlier dealers. Some of the larger dealers I think do take stock and positions as it's clear based on the data we see that's the case.

And as dealers become bigger and we have more of them certainly field inventory becomes bigger every year as the category grows. But most dealers by and large of what we see these are small contractors, they don't have a lot of additional working capital and frankly not a lot of space to store 400 pound or 500 pound item, waiting betting on the come. And so what they do is often times they will not buy for mass until they've sold to a consumer. So they go and they do a consultation, an in-home consultation for a consumer or home owner. And then if the home owner chooses to accept their proposal, there is a permitting process.

These are products it has to be – building permits has to be issued for electrical inspection test to be conducted. There is a lot of – there is some initial work upfront. They generally will not order for the product from us until they have that permit in hand because for them there is no reason to be out of pocket that working capital until they absolutely know they need to be.

Operator

Your next question comes from the line of Stanley Elliott repressing Stifel. Please proceed.

Stanley Elliott – Stifel Nicolaus

Good morning guys, thanks for taking my question. Question, as we're thinking about the power washer product, I mean I know it's relatively new but is it not – to think you guys couldn't get a 10% market share, something of that magnitude in another about two years down?

Aaron Jagdfeld

I think Stanley think that's very reasonable goal for us. We're pushing people internally harder than that. I talked about we're calibrating that we want to be the number one provider in this space. I think it's an area where we have expertise based on our history we have expertise in terms of the manufacturing, in terms of the engineering, we have fantastic sourcing capabilities. These are engine-powered washers. So we're not in the electric washer space which would represent frankly about half of the market. So that's not a part of the market that we're going to address for the product line today.

But on the gas washer side it is something that I think when you talk about share there, I think it's very reasonable to say 10% is something that's achievable for us.

Stanley Elliott – Stifel Nicolaus

Then as far as the discussions with the national accounts and I guess the line reviews have been ongoing. You had a big win last year, are you seeing any other sorts of big wins this coming season, for next year I guess rather.

Aaron Jagdfeld

Yeah, we are still in the season right now in terms of line of years, we are getting some indications back and there is some puts and takes there. And what we have heard so far, I think you know, we remain optimistic that we are going to have more wins, and we will have losses obviously as we roll out the product line. But it is a tough market. It is a competitive market, you've got to bring innovation to these accounts every year, year in and year out. You've got to be sharp on your costs, you've got to be sharp on your execution in terms of being able to meet their timelines, their rapid development cycles.

Those are things that you know, we're developing competencies at the Company here. We've got elements of those competencies, we have more to develop but you know more to come as season kind of bears out here. And we have got more information in the months ahead.

Stanley Elliott – Stifel Nicolaus

Great. Then lastly, has there been any sort of improvement on regulatory environment, the FCC had they were some hearings I guess earlier this year, but is there any update of the status of that?

Aaron Jagdfeld

Yeah I mean from all indications that we kind of see things from the outside looking in a little bit, we've got some ears to the ground obviously pretty aggressively in Washington DC where this is taking place. But everything we see is that with the change in the chairperson of FCC you know, that has put everything a little bit on the backburner as far as things, our priorities are potentially, you know, re-ordered going forward. It remains to be seen whether this will continue to be priority as it looks early on for the FCC.

You know, I don't think there are anybody that can dispute there are more critical communications. You know, mobile voice and data communications that are going over wireless. That is the future of new LTE networks that are being rolled out very aggressively here by the carriers, you know, as well as the older networks that are vulnerable to power outages.

We believe most of our customers have been very pro-active in that regard in addressing the areas of the country where they certainly have power quality issues, they are more prevalent. A more widespread regulatory approach to this could you know, obviously accelerate that for us, our business honestly and I say dramatically as one of the largest providers. But everything we heard right now, it is kind of everything is a little bit of a holding pattern till the FCC kind of figures out with the new chairperson what are the priorities are going to be going forward.

Stanley Elliott – Stifel Nicolaus

That's great. Well, thank you very much for your time and thanks a lot guys, great quarter.

Aaron Jagdfeld

Okay, thanks Stanley.

York Ragen

Thanks Stanley.

Operator

Your next question comes from the line of [Tim Marooney] representing William Blair. Please proceed.

Unidentified Analyst

Good morning guys.

Aaron Jagdfeld

Good morning Tim.

York Ragen

Good morning Tim.

Unidentified Analyst

I've got a couple of just real quick ones. First of all going back to the geographic question you've got, you've got all power inventories, Tower Light, after the close of Tower Light, what percent of your sales will be outside of the U.S. and what would be an ideal target that you look out over the next several years.

Aaron Jagdfeld

Yeah, I think we were saying about 10% to 15% of our sales would be outside the U.S. and Canada going forward, if you perform a Tower Light into the operations there. And obviously with the expectations for growth beyond that and whether that growth is organically through the acquisitions we've made through the introduction of new products and new customers and being part of a more larger entity like the Generac, the benefit that we can give these entities like Ottomotores, Tower Light in particular, you know the benefit in scale which is we think is you know potentially significant when you look at some things like Tower Light in particular, as I said before, the ability to offer additional products to Tower Light customers that they don't have today.

We are very focused on a singular product line in light towers, but going forward you know right now about 10% to 15%, and we would expect to grow that even further, what is the comfortable position out there, you know, I don't think we quoted anything specific, but we like the opportunities that are ahead of us. There is a huge market worldwide for power generation for mobile equipment in particular. And so we think there is a lot of potential opportunity ahead of us.

Unidentified Analyst

Okay, thank you. And lastly statement in your outlook statement you discussed an improved outlook in C&I shipments. Is that driven at all by an improved outlook for commercial construction market or is it more your infrastructure and telecom?

Aaron Jagdfeld

I think it is more the infrastructure and telecom piece here, but there is a piece here. We said we expected a little bit of improvement in the non-res construction indices here going forward. But frankly all indications are that still remains fairly soft off of obviously a very low base of the last several years. You know the rental companies as well as part of our C&I growth, so the national accounts there. They build out their fleets, we replenish their fleets and add a new product like mobile generators like I said we are getting some better traction there with our mobile generator line in those accounts. That's also a part of that C&I object that we are expecting in the second half.

Unidentified Analyst

Great thanks, guys.

Aaron Jagdfeld

Thanks Tim.

York Ragen

Thanks Tim.

Operator

Ladies and gentlemen this does conclude the time we have for questions and answers. I would now like to turn the call back over to Aaron for any closing remarks.

Aaron Jagdfeld

Thank you. We really appreciate everybody's attention this morning for our second quarter call and we look forward to our third quarter call which should be sometime in the late October timeframe. Thanks again for your time this morning.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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Generac (GNRC): Q2 EPS of $0.95 beats by $0.18. Revenue of $346.7M (+45% Y/Y) beats by $18.29M. (PR)