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Tennant Company (NYSE:TNC)

Q4 2013 Earnings Conference Call

February 25, 2014 11:00 AM ET

Executives

Thomas Paulson – Senior Vice President and Chief Financial Officer

H. Chris Killingstad – President and Chief Executive Officer

Analysts

Jason M. Ursaner – CJS Securities, Inc.

Joe Maxa – Dougherty & Company, LLC

Daniel D. Rizzo – Sidoti and Company, LLC

R. Scott Graham – Jefferies LLC

Kevin S. Sonnett – RK Capital Management LLC

Operator

Good morning. My name is Davetta, I will be your conference operator today. At this time, I would like to welcome everyone to the Tennant Company's Fourth Quarter and Full Year Earnings Conference Call. This call is being recorded. (Operator Instructions) There will be time for Q&A at the end of the call. All parties please stay on the line after Q&A for closing remarks from management. Thank you for participating in Tennant Company's fourth quarter and full year earnings conference call.

Beginning today's meeting is Mr. Tom Paulson, Senior Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin.

Thomas Paulson

Thanks, Davetta. Good morning, everyone, and welcome to Tennant Company's fourth quarter 2013 earnings conference call. I am Tom Paulson, Senior Vice President and Chief Financial Officer of Tennant Company. With me on the call today are Chris Killingstad, Tennant's President and CEO; Pat O'Neill our Treasurer; and Karen Durant our Vice President and Controller.

Our agenda today is to review Tennant's performance during the 2013 fourth quarter and full year and our outlook for 2014. First, Chris will brief you on our operations, and then I'll cover the financials. After that we'll open up the call for your questions.

Before we begin, please be advised that our remarks this morning and our answers to questions may contain forward-looking statements regarding the company's expectations of future performance. Such statements are subject to risks and uncertainties and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today's news release and the documents we file with the Securities and Exchange Commission. We encourage you to review those documents, particularly our Safe Harbor statement for a description of the risks and uncertainties that may affect our results.

Additionally on this conference call, we will discuss non-GAAP measures that include or exclude special or non-recurring items. For each non-GAAP measure, we'll also provide the most directly comparable GAAP measure. There were special non-GAAP items in the third and fourth quarter of the 2012 and the first and fourth quarters of 2013.

Our 2013 fourth quarter earnings release includes a reconciliation of these non-GAAP measures to our GAAP results for the fourth quarter and full year. Our earnings release was issued this morning via Business Wire and is also posted on the Investor Section of our website at tennantco.com

At this point, I'll turn the call over to Chris.

H. Chris Killingstad

Thank you, Tom, and thanks to all of you for joining us this morning. Today I’d like to briefly review our performance and then tell you about our strategic plans going forward. Tom will give you greater detail on our financial results for the quarter and full year.

First, let’s take a look at Tennant’s fourth quarter. The company had solid top line revenue growth. Our 2013 fourth quarter consolidated net sales of $195.1 million rose 5% organically compared to the prior year quarter on higher volume across all of Tennant’s product categories. Contributing to sales was demand for new products, especially the T12 rider scrubber, which is the first new product in our redesigned modular large equipment portfolio. It has been a great success for us. We also saw strong sales of industrial equipment as well as sales to strategic accounts. Additionally sales of scrubbers equipped with ec-H2O technology rose in the fourth quarter to post their strongest quarterly gains for the year.

We had record sales for our fourth quarter, although they were slightly below our expectations. This impacted our bottom line as we intentionally ramped up key strategic investments during the quarter in order to accelerate long-term growth. We were simply not able to pull back spending in time to pace with the lower sales level in the quarter. Going forward we expect our growth initiatives to produce clear benefits in 2014 and beyond. I’ll say more about our strategic plans in a moment.

Turning to a few fourth quarter highlights across our geographic regions. Contributing to Tennant’s revenue in the America were sales of industrial products, sales through distribution and continued strong growth in Latin America. As I mentioned last quarter, we are building on our momentum with strategic accounts by duplicating in Brazil, the approach that’s been successful in North America.

Sales in Europe, the Middle East and Africa or EMEA, continued to be somewhat constrained due to challenging economic conditions. Despite this, sales to strategic accounts increased in the quarter by 18% and grew 12% for the full year.

Further sales of our environmentally, friendly Green Machines outdoor sweepers were up for the first time since the 2012 first quarter. Along with the steady stream of new products we are introducing, we have made significant progress over the last two years in rightsizing our EMEA cost structure and improving our sales and service organization. We believe we are well positioned to take advantage of growth opportunities as the macro environment continues to improve in EMEA.

In the Asia-Pacific region, organic sales increased due to strong performance in China, which posted about 45% organic sales growth. During the quarter we began manufacturing our first industrial product in China, the T12 rider scrubber. We also made further progress on our initiative to expand into the western part of that country, where we expect to open a sales office within the next six months.

Additionally, we plan to rollout our successful North American strategic accounts structure and strategy in China this year. We are confident about our continued growth prospects and expect double-digit sales growth again in China in 2014.

Now for a deeper look at our new products. We continue to execute against one of the most robust new product and technology pipelines in the company’s history. As you know, innovative products and technologies are a significant driver of Tennant’s revenues.

To illustrate our new product ramp, in 2012 Tennant introduced 17 new products. In 2013 we launched 20. In the 2013 fourth quarter specifically Tennant introduced a new canister carpet extractor and grout cleaners with high heat functionality. And Tennant is on track to rollout more than 63 additional new industrial and commercial products by 2016.

In 2014, we plan to launch 16 new products. These include a new line of walk-behind burnishers in the 2014 first quarter as well as the second product in our redesigned modular large equipment portfolio in our second quarter. The majority of Tennant’s new products will be manufactured on modular equipment platforms. Modularity allows us to offer a wider ranger of possible machine features, more efficiently and cost effectively.

To demonstrate the growing momentum of new product sales as we complete our launches and demand accelerates, sales of new products unveiled in late 2012 and 2013 rose steadily from 2% of total equipment sales in the 2013 first quarter to 8% in the fourth quarter.

In addition, our Orbio Technologies Group is developing an exciting new product with Split Stream Technology that will deliver an anti-microbial solution, as well as an effective multi-surface cleaner, for use in a wide variety of customer segments. We expect to introduce this new Orbio product in the first half of 2014.

Now, I’d like to tell you about our strategic growth plans. As you saw in today’s new release, we are shifting our focus to growth with the goal of reaching $1 billion in revenue by 2017. Why growth? Over the past five years, we have built a scalable business model capable of delivering improved efficiency and profitability. To take full advantage of that effort, we’re shifting our focus to organic revenue growth, in order to increase market share and enhanced Tennant’s ability to reach a 12% or above operating profit margin.

We have many existing growth levers. Additionally, through a deep analysis of our markets, we have identified and validated exciting ways to expand our global market coverage and win over new customers. As a result, we see significant opportunities to grow in key existing global vertical markets, such as the industrial, retail, education and healthcare sectors, were Tennant’s value proposition is a strong one.

Why now? Tennant has the right people, strategies and business model in place to take on an ambitious revenue target. The marketing investments that we’ve made over the last four years are paying off, especially in the area of analytics. We can now identify by geography, vertical market, and customer where we’re well represented, under represented and not represented at all.

This allows us to better and cost effectively target our customer aquisition investments. Add sales, service and channel resources against the biggest opportunities and arm our sales group with detailed information about active opportunities in order to maximize their effectiveness and boost to sales. We begin ramping up some of these investments in the 2013 second half.

Why target a $1 billion in revenues? This goal is a significant and compelling milestone. And our modeling shows that it’s achievable. We plan to meet this goal through strong and sustained new product growth in our core business and in the Orbio Technologies Group. Continued significant sales gains in emerging markets, growth in Europe, ongoing focus on strategic accounts, and an enhanced go-to-market strategy designed to meaningfully expand Tennant’s global market coverage and customer base.

Our plan to reach the $1 billion revenue goal by 2017 includes an assumption of approximately 2% global GDP growth. We anticipate Tennant’s targeted 7% compounded annual growth rate to be broken down approximately as follows; up to 3% from new products including Orbio; up to 3% from our enhanced go-to-market strategy including Europe and strategic accounts; and up to 2% from emerging markets.

Why 2017? We continue to operate in an uncertain economic environment. We recognized that it takes time to ramp our go-to-market initiatives. We will carefully monitor our progress and seek to accelerate our timeline wherever possible.

We are excited about our prospects in 2014 and beyond, as we work to reach our $1 billion revenue growth goal. We will continue to manage our business with a focus on operational excellence and strong cost controls, while investing in direct sales, distribution and marketing capabilities, and maintaining a strong pipeline of new products in order to deliver long-term growth and improved profitability.

Now, I’ll ask Tom to take you through Tennant’s fourth quarter financial results. Tom?

Thomas Paulson

Thanks, Chris. In my comments today, all references to earnings per share are on a fully diluted basis. For the fourth quarter ended December 31, 2013, Tennant reported net sales of $195.1 million compared to $187.5 million in the prior year quarter. Organic sales grew approximately 5.1%, excluding an unfavorable foreign currency exchange impact of about 1%.

As you may recall, Tennant's organic sales grew approximately 6.8% in the 2013 third quarter, excluding an unfavorable foreign currency exchange impact of about 1%. We are encouraged by the solid level of organic sales growth in the last two quarters.

For the 2013 full year, Tennant reported net sales of $752 million compared to $739 million in the prior year. Organic sales grew approximately 2.8% excluding an unfavorable foreign currency exchange impact of about 1%.

Fourth quarter 2000 net earnings as adjusted were $12.2 million or $0.65 per share. These numbers exclude the restructuring charge of $1.6 million pretax or $0.10 per share. In the year ago quarter, Tennant reported adjusted net earnings of $11.8 million or $0.62 per share.

For the 2013 full year net earning as adjusted were $42.6 million up 7.3% compared to net earnings as adjusted of $39.7 million in the prior year. 2013 earnings per share as adjusted were $2.26 up 8.7% compared to earnings per share as adjusted of $2.08 in 2012.

Turning now to a more detailed review of the 2013 fourth quarter. Our sales are categorized into three geographic regions which are the Americas, which encompasses all of North America and Latin America; EMEA which covers Europe, the Middle-East and Africa; and lastly Asia-Pacific which includes China and other Asian markets, Japan and Australia.

In the Americas, 2013 fourth quarter organic sales increased approximately 5.6% excluding about 1% of unfavorable foreign currency exchange impact. Record sales for the fourth quarter in North America were due to strong sales of industrial sweepers, continued high demand for new products and sales of scrubbers equipped with ec-H2O technology. Sales in the emerging market of Latin America remained robust with organic sales growth of approximately 20%.

In EMEA, organic sales were down about 3.2%, excluding a favorable foreign currency impact of approximately 3.5%. Although EMEA sales in the 2013 fourth quarter continue to be somewhat constrained due to challenging economic conditions, sales through strategic accounts increased in the quarter as did sales of our industrial sweepers.

As you may recall we recorded a $1.4 million restructuring charge in the 2013 first quarter that was primarily focused on reducing the size of our European sales and service organization. We also recorded a $1.6 million restructuring charge in the 2013 fourth quarter to right size our cost structure and enhance our go-to-market approach primarily in Europe.

Going forward, we anticipate the EMEA sales growth and profit margins will improve as a result of process improvement projects as well as benefits from the restructurings.

In Tennant’s Asia-Pacific region organic sales grew approximately 15.1%, excluding an unfavorable foreign currency impact of about 6.5%. Organic sales grew for the third consecutive quarter in this region. Growth in the 2013 fourth quarter was due primarily to strong sales performance in China, which had organic sales growth of approximately 45%.

Tennant’s gross margin for the 2013 fourth quarter was 42.9% compared to an exceptionally high gross margin of 44.5% in the prior year quarter. Gross margin in the 2013 fourth quarter was adversely affected by selling channel mix with strong sales through distribution and sales to strategic accounts and also product mix.

Sales through distribution and strategic accounts tend to have slightly lower gross margins which are typically more than offset by the lower cost of a more efficient selling process. The 2013 full year gross margin of 43.3% was within our target range of 43% to 44%.

Research and development expense in the 2013 fourth quarter totaled $7.2 million or 3.7% of sales compared to $7.7 million or 4.1% of sales in the prior year quarter. We continue to invest in both our core business, and Orbio, which is focused on advancing the platform of chemical free and other sustainable water-based cleaning technologies.

Selling and administrative expense as adjusted in the 2013 fourth quarter totaled $57.3 million or 29.4% of sales, this compares to S&A in the fourth quarter of last year of $56.8 million or 30.3% of sales. S&A expense was down 90 basis points as a percent of sales due to continued operating leverage efficiencies.

As Chris mentioned, to accelerate future growth we are making strategic investments in this area that include additional direct sales, distribution and marketing capabilities. Absent these investments, we would have achieved even greater operating leverage in the 2013 fourth quarter.

Our 2013 fourth quarter operating profit as adjusted totaled $19.2 million or 9.9% of sales, compared to the 2012 fourth quarter operating profit of $19 million or 10.1% of sales. Improved S&A leverage and lower R&D spending in the 2013 fourth quarter was offset by lower gross margins through selling channel and product mix.

We remain committed to our goal of a 12% operating profit margin by successfully executing our strategic priorities and assuming that global economy improves. However, as we previously stated, achieving this milestone requires a return to organic revenue growth in the mid-to-high-single digits.

As we work towards this target, we are keenly focused on driving organic revenue growth in the mid-to-high single digits, holding fixed cost essentially flat in our manufacturing areas as volume rises, striving for zero net inflation at the gross profit line and standardizing and simplifying processes globally to improve the scalability of our business model while minimizing any increases in our operating expenses.

Thus far we have made significant process of building a scalable business model capable of delivering improved operational efficiency and profitability. We are now placing a renewed focus on accelerating organic revenue growth. We are encouraged that we achieved our target organic revenue growth in the range of mid-to-high single digits in both the third and fourth quarters of 2013. These past two quarters represented the highest organic sales growth achieved in two years.

We continue to successfully execute our tax strategies. Tennant's overall effective tax rate for the 2013 full year was 32.8%. This includes the $0.6 million tax benefit related to the 2012 R&D tax credit recorded in the 2013 first quarter and the taxes related to the 2013 first quarter and fourth quarter restructuring charges.

Excluding these special items, the 2013 full year overall effective tax rate would have been 32.3%. This is higher than the 2013 first nine months overall as adjusted effective tax rate of 30.8% due to lower earnings in Europe in the fourth quarter of 2013 than we originally estimated.

The unfavorable impact on the fourth quarter to bring the first nine months up to the higher tax rate was approximately $0.03 of earnings per share. The base tax rate of approximately 33.2%, which excludes the restructuring charge and discrete tax items was at the high end of our targeted range of 31% to 33%. Variability in the base tax rate is primarily due to the mix of full year taxable earnings by country.

Turning now to the balance sheet. Again we continue to have a very strong balance sheet. Net receivables for the end of the 2013 fourth quarter were $140.2 million versus $138.1 million a year earlier. Quarterly average accounts receivables days outstanding were 61 days for the fourth quarter compared to 60 days in the 2012 fourth quarter.

Tennant's inventories at the end of the 2013 fourth quarter were $66.9 million versus $58.1 million a year earlier. Quarterly average LIFO days inventory in hand were 81 days for the 2013 fourth quarter up three days compared to 78 days in the year ago quarter.

Capital expenditures of $14.8 million in the 2013 full year were comparable to the $15.6 million in the prior year period with planned investments in tooling related new product development, manufacturing equipment and process improvement projects.

Tennant's cash from operations was $59.8 million in the 2013 full year, an increase of $12.2 million versus cash from operations of $47.6 million in the prior year. This was primarily due to cash contributions to the U.S. pension plan in 2012 as compared to no cash contributions in 2013.

As you may recall, in 2012 Tennant made cash contributions of $16.7 million to our U.S. pension plan of which $15 million was discretionary. This was an economically efficient use of cash as we have previously not made a cash contribution to that pension plan since 1987. We do not expect any additional cash contributions to this plan will be necessary. Note that this pension plan was closed since the new participants back in 2000.

Cash and cash equivalents totaled $81 million up $27 million from $53.9 million a year ago. The company's total debt of $31.8 million declined $0.5 million from $32.3 million a year ago. Our debt-to-capital ratio was 10.8% at the end of 2013 versus 12.1% a year ago.

Regarding other aspects of our capital structure, Tennant is currently paying a quarterly dividend of $0.18 per share. We paid cash dividends of $13.2 million in the 2013 full year and $12.8 million in the prior year. Reflecting our commitment to shareholder value, Tennant has increased our annual cash dividend payout for 42 consecutive years.

During the 2013 full year, we purchased 434,118 shares of Tennant stock in the open market at an average price of $51.04 per share for a total cash outlay of $22.2 million. As of December 31, 2013 we had approximately 631,000 shares remaining under our repurchase program.

Moving now to our outlook for 2014. Based on our 2013 full year results and expectations of future performance, we estimate 2014 full year net sales in the range of $780 million to $800 million up 4% to 6%. And our earnings in the range of $2.50 to $2.80 per diluted share, an increase of 11% to 24% compared to 2013 as adjusted. For the full year 2013, adjusted earnings per share were $2.26 and sales of $752 million.

Our current 2014 annual financial outlook includes the following expectations: modest economic improvement in North America and Europe and steady growth in emerging markets; unfavorable foreign currency impact on sales for the full year of about approximately 1%; gross margin performance in the range of 43% to 44%; research and development expense of approximately 4% of sales and capital expenditures in the range of $20 million to $22 million.

We anticipate a base tax rate excluding any special items in the range of 31% to 33% depending primarily upon the mix of full year taxable earnings by country. Note that our 2014 base tax rate does include the 2014 benefit for the federal R&D tax credit. However, the Federal R&D tax credit program has not yet been reenacted for 2014. So we are not allowed to include that favorable impact on the 2014 tax rate we record until it is inactive.

While we do not provide quarterly guidance, we do expect our 2014 sales will be stronger in the second half of the year as our investments for growth begin to generate incremental revenues. During the initial ramp up of strategic investments to accelerate future revenue growth, we anticipate our selling and administrative expense will grow at approximately the same rate as our sales.

Importantly, we expect to increase our operating profit margin in 2014 with the majority of the improvement expected in the second half.

Now, we'd like to open up the call to any questions. Davetta?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jason Ursaner with CJS Securities.

Jason M. Ursaner – CJS Securities, Inc.

Good morning. Congrats on a very strong finish to the year.

H. Chris Killingstad

Thanks.

Jason M. Ursaner – CJS Securities, Inc.

The gross margin was down, 1.5% year-to-year despite higher sales with the lowest total of any quarter. I just didn’t catch what this will primarily attribute to obviously not a longer term issue given the guidance on grow margin?

H. Chris Killingstad

Yes, the two biggest pieces of it were channel mix and product mix. The biggest of those two is the channel mix as we had a particularly strong growth in our strategic accounts and through the distribution channel and both of those channels tend to have modestly lower gross margins and we do make it up through the efficiency and the selling expense side. So it’s additive to our operating margins, but it is with the mix we had it was dilutive to our gross margin. But it’s fair to say we think we will be back within our targeted range for next years as we just kept on guiding.

Jason M. Ursaner – CJS Securities, Inc.

Okay. And when you think about the strategic account, obviously it’s becoming a bigger factor, the overall growth strategy, when you think about that on the operating margin leverage, I guess just overall how do you view it and what was the commentary on SG&A inflation relative to sales.

H. Chris Killingstad

What you’ll see is on an absolute basis, we’ll expect our operating expenses to grow inline with our sales revenue. So it will be depended upon where our revenue ends up and that we’ll monitor our spending at that level. A predominant amount of the investment will be around sales coverage, service coverage and also investments in marketing. And then to your first question around strategic accounts and distributions through also, we do make lower gross margins, but through the efficiencies incrementally where it’s additive to our operating margin structure. We try to negotiate the best prices we can at the gross margin line but we’re even more focused on the fact that we’ve got to incrementally drive our operating margins above 12% or will be in dilutive to our operating model once – where we want to take it too.

Jason M. Ursaner – CJS Securities, Inc.

Okay. And the SG&A increase with sales, that’s I guess due the actual sales growth in the year or that’s reflective of the future growth with investment coming ahead of revenue on the longer term in 2017 $1 billion target?

H. Chris Killingstad

Yes, a reflective of investments ahead of the curve a bit Jason. I mean one of the comments I will make there is, we did say that we made some of those investments in the back half of the year. I mean we haven’t published our K yet, but you’ll see that our headcount from the end of the year 2012 to the end of the year 2013 will be up somewhere in north of 100 heads and a vast majority of that is going to be increases that were sales people, service people and end to end marketing folks. And that’s an investment that’s in our cost base and we think that it is a critical part of driving accelerated revenue growth in the next year. But when you come into Q1 at the higher level of investment against our lowest revenue typically in the year and that puts pressure on the profit margins. But we are very comfortable in improving operating margins for the full year.

Jason M. Ursaner – CJS Securities, Inc.

Okay. And just last question from me, and then I’ll jump back in the queue. Outside of the cost base from a capitalized investment point of view, the gross strategy is not particularly capital intensive. So just overall I mean you’re generating very strong cash, what’s kind of the view on capital structure sitting here today?

H. Chris Killingstad

Well, we’ll continue to – we’ll explore dividend increase as we have said that, that’s under way and we’ve typically taken our dividend up. It sits under exploration at this point, so we will continue to return money to shareholders through dividends also. We expect to remain aggressive in our buyback of shares. We’ve been that way for the last three years. We’ll continue to be aggressive. Assuming the right economic circumstances we’ll be going to the market and buy shares on the open market. We’ll fund our working capital. We are taking our capital spending up a bit in the upcoming year and we will continue to look at M&A activity but it is unlikely to be a major investment. Our predominant focus is on organic growth.

Jason M. Ursaner – CJS Securities, Inc.

Okay, I appreciate it. Thanks guys.

H. Chris Killingstad

You bet, thanks Jason.

Operator

Your next question comes from the line of Joe Maxa with Dougherty & Company.

Joe Maxa – Dougherty & Company, LLC

Hi, good morning thank you.

Thomas Paulson

Good morning Joe.

H. Chris Killingstad

Good morning Joe.

Joe Maxa – Dougherty & Company, LLC

So a couple of questions. So back on the gross margin, the channel mix being a bit of an issue in Q3 for the margin. I understand the sales benefit or lower expenses. How does that look going forward? Are you still focusing on strategic accounts? Are we going to see this gross margin be at the lower end of that range because of it or what is your expectations for 2014? Can you get back to that higher end?

Thomas Paulson

I sure hope so. That’s certainly what we’re going to strive for Joe, but we don’t want to be that precise. We are comfortable, it will be about 43% or certainly I’m not willing to say we can go about 44% that’s the current point. But we are going to continue to focus on gross margin improvement. I mean we’re working on our discounting. We are going to take price increases. We are managing the heck out of our supply chain.

But if we can continue to accelerate growth in strategic accounts, and we can earn operating margins above 12%, we are okay with that. And it has been an important part of our growth and will continue to be an important part. I can’t say some of the investments we are making are outside of the world of strategic accounts and then in our direct sales organization and with our distribution partners also.

Joe Maxa – Dougherty & Company, LLC

Right. On the guidance, second half appears to be a little more back-end loaded than a typical year based on what I’m hearing? Is that driven by…

H. Chris Killingstad

A couple of comments on that Joe. One is if you’ve looked at our revenue over the last few years we’ve been returning to a more normalized skew, if you went back to 2012, we had more revenue in the front half than the back half. That’s abnormal. It used to about 48% of revenues in the front half. We got closer to that norm in 2013. I think it will be closer to history in the upcoming years, so higher percent of total revenue in the back half. And then we have made investments and we feel really good about them.

The other commentary, I’d make on Q1 specifically as we kind of have the opposite effect in our tax rate last year in Q1. We had an abnormally low tax rate in Q1 of last year and an abnormally high in Q4 and that makes for some tough comps. We don’t expect for that very low, I think it was around at 28% tax rate in Q1. We don’t expect that to repeat itself. So put some pressure on profitability in the first quarter and we are focused on again – we care about the quarters a lot more focusing on the full year and really accelerating our growth profile for the future.

Joe Maxa – Dougherty & Company, LLC

Regarding the tax rate, if you’re not taking the R&D credit, what would be that base rate without it?

H. Chris Killingstad

It’s about 50 basis points overall in the R&D tax credit. So we’re not saying…

Joe Maxa – Dougherty & Company, LLC

[indiscernible] is going to come in.

H. Chris Killingstad

Yes, we are not saying we can’t be within range without it, but it’s going to negatively affect our tax rate in the quarter by 50 basis points until it gets inactive.

Joe Maxa – Dougherty & Company, LLC

And then, last from me is, regarding the Orbio launch coming up this spring. Can you give us little color on how initial beta tests are going and what the initial outlook maybe?

H. Chris Killingstad

Yes, we’re really excited about this product. It’s call the OS3 system. Remember it’s a machine that’s half the size and half the cost of our 5000-Sc which is out there right now. It provides both an anti-microbial solution, as well as a multi-purpose cleaning solution. The other thing that’s real benefit is that it produces a concentrate that is a diluted kind of on site and that concentrate we can then store in containers and move about the facilities to other dilution stations, something we could not do with the 5000-Sc, which gives it a lot more flexibility and allows our customers to that way cost effectively clean the entire facility.

The other issue we have with the 5000-Sc was a lot of our customer said it’s great, but it only solves part of our cleaning problem. We still have the sanitizing and disinfecting part and if we’re going to change our cleaning protocol, we want to do it across the board. They can now do that because we can help them disinfect, sanitize and clean. What I would say is that, we’ve had prototypes in test for a while now with extremely strong positive reaction from everyone. The goal is to get this product out in the market commercially in the second quarter of this year.

It’s the product. We always talked from the beginning that this is the product that had the potential of truly making Orbio a force within the cleaning industry.

Thomas Paulson

And we’re taking orders as we speak?

Joe Maxa – Dougherty & Company, LLC

Sounds good, thanks a lot.

Thomas Paulson

We won’t call that [indiscernible].

Joe Maxa – Dougherty & Company, LLC

Great guys, thank you.

H. Chris Killingstad

Thank you.

Operator

Your next question comes from Dan Rizzo with Sidoti and Company.

Daniel D. Rizzo – Sidoti and Company, LLC

Hi guys.

H. Chris Killingstad

Hi, Dan.

Daniel D. Rizzo – Sidoti and Company, LLC

In addition to the new product you just described, I think you said you have 63 new products that you plan on launching over the next couple of years. Is that can be like somewhat evenly distributed or something when you look more of those new products coming in the back half of the year into 2015 or I mean just a little color on the timing on that?

H. Chris Killingstad

I think it would be fair to say they will be relatively evenly distributed across the three years, 2014, 2015 and 2016. And we’re not ready to get a specific as front half or back half, but if you looked at for each of the three full years that will relatively evenly distributed across the three years.

Thomas Paulson

And we said 20 products, no sorry 16 products in 2014, so that gives you an indication that’s the cadence then it is pretty evenly distributed.

Daniel D. Rizzo – Sidoti and Company, LLC

Then with the product you just describing this, its sounds kind of revolutionary the way you’re describing it. So could it be as big as where it was a couple of years ago where it’s just really changes everything?

H. Chris Killingstad

Well, it’s very different from ec-H2O, remember when we reported ec-H2O results, it was the ec-H2O module on our scrubbers, right. So we were reporting the scrubber sales with ec-H2O not just the sales of the technology module that produces the ec-H2O. So I don’t think you’re going to see in the short-term that we can get to those levels, which are in the vicinity of $140 million annual sales right now.

But we do think it’s revolutionary, I mean, what this does it allows our customers to produce on site and on demand sanitizing, disinfecting and cleaning solutions that can replace just about everything if not everything they currently use. It is cost effective. It simplifies the cleaning process for their operators dramatically and it’s environmentally friendly and that the on site on demand generation eliminates the very long and significant environmental supply chain of producing or striking the raw materials, producing the chemicals, packaging the chemicals, transporting them to the facility.

So, we think and the feedback we are getting from the beta test is that this could be transformative.

Daniel D. Rizzo – Sidoti and Company, LLC

Would that mean that, that you could – I mean, I think you said emphasis half the cost, give the way, how it could be – that would mean that you can charge more for it and still enjoy higher margins. Am I looking at it the right way?

H. Chris Killingstad

I think the only comment we could really make there Dan is, we certainly expect it to be additive to our margin structure at both the gross margin line and the operating margin line. So we can pass on value to the end-user and they can improve the economics of there cleaning process and we can make nice margins at the same time. So it’s exactly a kind of innovative products we want to bring out.

Daniel D. Rizzo – Sidoti and Company, LLC

All right, thank you guys.

H. Chris Killingstad

You are welcome.

Operator

Your next question comes from line of Scott Graham with Jefferies.

R. Scott Graham – Jefferies LLC

Hi good morning.

H. Chris Killingstad

Good morning Scott.

Thomas Paulson

Good morning Scott.

R. Scott Graham – Jefferies LLC

Couple of questions for you guys. Tom, the first one is, it sounds to me as you went through the 12% operating margin that there is a bit less confidence in getting there in the fourth quarter of this year. In fact I don’t even think you’ve said that you will. And I’m just wondering if that is traceable to this mixed issue and if so, why this 43% to 44% gross margin guidance.

Thomas Paulson

The guidance in the 43% to 44% as we really believe will be there, I mean we wouldn’t give a guidance range if we didn’t believe in that and it could be at the lower end, it could be at the higher-end. We are comfortable that it will be within the range. The biggest reason for us not definitively committing to that 12% by the fourth quarter, we’re not saying, we’re not going to get there.

But we’ve given a pretty broad range in our revenue and it’s a $20 million range. And the dependences on what revenue level you get and what quarter it falls in, could dictate that you are not able to get to that 12% by the fourth quarter and we are – we’ll knowledge we are a bit more focused on the long-term here and accelerating and making the investments to take our growth profile to a different level. And we are not going to manage to a quarter to get the 12%. We’re looking at to get to a sustainable 12% as quickly as we possibly can while achieving better than the historical revenue growth rates that we’ve had over the last period of time.

H. Chris Killingstad

And the beauty with the new growth strategy it actually enhances our ability to get the 12% and go beyond, right, because if you look back over the last two years, our struggle has been organic growth. I mean we’ve kept our R&D spending within the range that we have promised, we actually took our gross margin range up a 100 basis points. So it exceeded expectations there and we made great progress in terms of reducing our operating expenses.

So growth has been the culprit in terms of postponing our ability to get the 12%. Now that we are focused on the organic growth while maintaining the discipline against the three other metrics, it should allow us to get to the 12% and beyond to a much greater extend than before. So we view it as a net positive for both our ability to grow market share, get to a $1 billion and to enhance our operating profit margins.

R. Scott Graham – Jefferies LLC

Okay that’s actually down the path of my third question, which if you don’t mind.

Thomas Paulson

Sure.

R. Scott Graham – Jefferies LLC

I like to come back to you with crispy, the second question is kind of more again for Tom. So let me just ask you this. I know you don’t give quarterly guidance. I’m asking for that, but if you’re saying that the year is going to be kind of more back-half loaded it just seems as if that the range – the high-end of the ranges would be pretty remarkable second half of the year. What’s behind that thinking on the high end?

Thomas Paulson

We obviously think we’re going to grow solidly organically in every quarter. We expect to exit the year in our highest level of year-on-year organic growth. And $800 million of revenue would be a good quarter, but we wouldn’t give guidance that that was the highest. We didn’t believe it was achievable. So it would be accelerating organic performance. We are going to monitor closely, and if we’re not achieving the higher growth rates we’ll back off on our spending a bit, but we did give a range and we did that on purpose, but we are not saying that the higher end is not achievable.

R. Scott Graham – Jefferies LLC

But the higher end is about 6% growth.

Thomas Paulson

Yes, $800 million, 6.4% recorded growth and that would be 7.4% roughly, if we’re at the…

R. Scott Graham – Jefferies LLC

I was actually talking about earnings per share.

Thomas Paulson

Oh, I got you.

R. Scott Graham – Jefferies LLC

So do you kind of refashion your response, now that I was talking about earnings per share? Again it just seems as if the first half is let’s say flat or up slightly?

Thomas Paulson

Yes, and the way to think about that is gross margins should get better during the year. And that tends to be a given Q1 is always our low point from a gross margin stand point. We are going to, we have done some free investment, our expectation is that we will make significantly higher incremental margins in the back half of the year as we get to a higher sustained revenue base and we got some of the investments that we’ve frontend loaded, part of that was this year, part will be front year. And you’ve seen the power of our business model as we begin to take advantage of the investments and down further invest and get the kind of incremental margins that we can make as we begin to accelerate our revenue growth. So we are assuming a higher incremental structure in the back part of the year.

R. Scott Graham – Jefferies LLC

Okay, very good.

H. Chris Killingstad

But again the growth is the key component.

Thomas Paulson

The key critical component.

H. Chris Killingstad

Because you know we plan to maintain the discipline we’ve established around gross margins and our operating expenses. Yes, we’re taking operating expenses up especially in the first half to fund some of these strategic investments, which are going to pay dividends in the second half and help us get to the $800 million. And with the appropriate margin structure and getting to the EPS goal, hopefully on the high side of the range that we’ve put out there.

Thomas Paulson

And we do think Scott, we’ll get a good read as we’ve had and we’ve got an read on the ability to get revenue going. We think we’ll get a read in the front part of the year and that will dictate how we meet our spending out. If we don’t get comfortable or we are going to be at the mid point or higher on our revenue range, we’ll meter back some of the spending. So we’re still very cognizant of the need to keep moving margins on the right direction. We are taking on a little bit more risk in this profile than we have in the past, but we are not getting that far ahead of ourselves.

H. Chris Killingstad

But the reward of getting it right is significant lead.

Thomas Paulson

Absolutely.

R. Scott Graham – Jefferies LLC

I understand. Chris last question is more directed to the product, the new product pipeline. When you look at this range that you’ve given which I think you guys mentioned that this was a wide range, I actually consider that a fairly narrow range which seems to be somewhat indicative of confidence in the placements in the new product pipeline. Well, if I am right in my supposition there Chris, would you be able to tell us those placements, is that higher mixed channel or is that still kind of same channel mix?

H. Chris Killingstad

I don’t think we are going to see a big shift in channel mix in terms of where the new products are going. Although the new industrial product we’re launching in the second year is an industrial product we are launching in the second year is an industrial product. It’s going into our industrial vertical markets which inherently has higher margins and should be a net positive for us. So that is the one shift versus last year where the majority of the products were all commercially oriented with a little bit lower gross margins. So I would say that’s positive.

The other thing about new products you got to remember, all the new products we launched last year we often say that it takes three years to get the peak annual sales on products launch in a specific year. So we are going to get a lot of benefit from the new products, incremental benefits from the new products launched last year, this year plus the benefits of the 2014 new products. And if you look at the T12 which we launched last year and the success we’ve had with that and we anticipate we’re going to have similar success with this next product, that’s another very nice gain for us in 2014, which gives us the confidence that we can both get to our revenue goals and our margin gross.

R. Scott Graham – Jefferies LLC

Thanks very much.

H. Chris Killingstad

You’re welcome.

Thomas Paulson

With pleasure, thanks Scott.

Operator

(Operator Instructions) your next question comes from the line of Kevin Sonnett with RK Capital.

Kevin S. Sonnett – RK Capital Management LLC

Thanks. Hi guys.

H. Chris Killingstad

Hi, Kevin.

Kevin S. Sonnett – RK Capital Management LLC

So along the lines to some degree of which Scott was getting at, understanding we’re much more focused on the year and even more than the year we’re focused on several years and rightfully.

The last couple of years we’ve seen a pretty similar decline from Q4 to Q1 about 10% little over 10%. Then I think that would come forward with Tom what you were saying about growth increasing as we move to the year. So you start off with something similar to the growth we just saw 4% growth give or take and then that ramps to what something like 678 as we end the year to get as per as the middle of that range.

Thomas Paulson

If you did the math like quarter, that’s not far off.

Kevin S. Sonnett – RK Capital Management LLC

Okay, and then with the spending you gave a good forecast for SG&A first half. It should grow about with revenue so that helps a lot especially in terms of the initiatives you have with new product launches et cetera, on the R&D line I apologize if I missed that. If the R&D step down a lot in dollars and as a percent of sales this quarter, it had been running closer to $7.5 million to $8 million or just new products, new product work and some shift in timing for that.

Thomas Paulson

Yes, we were more frontend loader with our R&D and we had guided that we would be right around that 4% level for the full year which really just kind of half spending the down in Q4 not only versus the run rate but versus the prior year, but we were still at adjusted over 4% for the full year last year and we are going to be somewhere up to 4% in R&D next year. But it was a planned way of the way our spending we that we are spending was loaded in R&D.

Kevin S. Sonnett – RK Capital Management LLC

Okay and then as we think about 2014, understanding it should be around $4 million maybe a little bit less, up to $4 million for the year. Is that more front-half or back-half loaded, does it look like last year or just given the timing of the new product works.

Thomas Paulson

It will likely be a bit more front-end loaded, as a percent of revenue.

Kevin S. Sonnett – RK Capital Management LLC

Okay, so may be a little over four in the front-half, a little under flow in the back-half?

Thomas Paulson

It could very well be.

Kevin S. Sonnett – RK Capital Management LLC

Okay and maybe this is a good time to and I guess get everyone one the same page since we are in a public call. So if we understanding you don’t want to get so specific that you are giving quarterly guidance because I know you are not managing the business that way and you don’t want to get locked into making decisions for a quarter. Can we still get to the, let say the mid point of your range give or take maybe its not the high end but we can still get solidly in that range. If the first half was flattish like in terms of the planning you have as far as spending on an EPS basis?

H. Chris Killingstad

Yes, the answer would be yes. We could very easily have a first quarter that’s going to be quite similar at the EPS line that we had in our first quarter of last year and then Q2 becomes a much become revenue quarter. Typically I mean Q2 at times has been bigger than Q4. So that’s the easier quarter to manage within and then our expectation as we begin to create further leverage in the back part of the year, solid. But we can be flattish at the EPS line through the first part of the year to slightly better and we expect some acceleration in the back part of the year.

Kevin S. Sonnett – RK Capital Management LLC

Okay, thanks. That’s really helpful thanks guys.

H. Chris Killingstad

Welcome.

Operator

And at this time there are no further questions, I will turn it back over to speakers for closing remark.

H. Chris Killingstad

All right, well, we are pleased with our progress today and confident that we have laid a strong foundation for our future. By placing a renewed focus on growing Tennant’s revenues while continuing to leverage our cost structure we expect to generate stronger bottom line performance. We are committed to reaching $1 billion in revenue by 2017, while achieving a 12% or greater operating profit margins. Thank you for your time today and for your questions and we look forward at updating you on our 2014 first quarter results in April. Take care everyone.

Thomas Paulson

I understand there is one more question before we close, is that possible?

Operator

Yes. Your question comes from the line of John Rosenberg.

Thomas Paulson

Hi, John.

Unidentified Analyst

Hi, guys. Thank you for taking my question. How are you doing Tom?

Thomas Paulson

Thanks.

Unidentified Analyst

Sorry to reiterate a lot of the things that you’ve already said. My focus is more on operating profit. Of course as you’ve said and as discussed in the prior questions, not really looking for anything quarter-to-quarter. You don’t want to manage business and I certainly agree with that on a quarterly basis, but can you give us a sense of how much of the improvement in operating markets and gross margin might come from not just the new products but also from your moving to a modular manufacturing process? If you like to hit the high end of your range, are we likely to still see some, I mean 8% to 12% is pretty significant improvement. Are we still going to see some significant improvement even if the year does not turn out as good as hoped?

Thomas Paulson

I mean obviously revenues, I think it helps gross margin improvements a lot. So the higher revenue, so you do generally create significant amount of leverage. And so it’s a hard question to answer. Modularity will have begun to and will continue to drive some upside in our gross margins, but you got to remember we’re at the front end of that security modularity, we’re only introducing the second industrial product that’s modular in nature in 2014. We’ve begun to modularize our commercial line.

The real benefits of that both from a margin point of view and an inventory and a cost point of view is out in front of us and I think that that’s more of a long-term two, three, four or five year kind of a benefit than it is going to benefit us significantly in the short-term, but it is very beneficial in multiple fronts over the long-term.

Unidentified Analyst

So, ultimately you will start to see that in more churns, lower DSOs, cash flow as well as margins?

Thomas Paulson

We think it’s one of the efforts that is – it’s beneficial to margin growth, it’s beneficial to cash generation et cetera. So it’s positive on lots of fronts.

Unidentified Analyst

Okay and thank you. And lastly just one quick kind of housekeeping question, I might have missed this. The new Orbio product what is its particular end uses, are you selling it to the same channels or is it – are you entering an entirely new market?

Thomas Paulson

No, the Orbio product it’s obviously very different from our core product portfolio. As we mentioned, it’s a product that has both an anti-microbial and a multi-surface cleaning capability that you can generate on site on demand. It is relevant in our existing customer base across the board and into some new customer segments maybe where we haven’t competed in the past. We have decided with this product that we are not necessarily going to be focusing on our existing sales organization, our distributor structure to launch it. We are putting in place an organization with account specialist who are well versed in the product and the size behind the product and understand the regulatory environment that we will be competing in.

And we will be focusing much more on what we think are the early adopter customers who have the ability to take many, many units up front versus trying to sell one sites and two sites across many, many different customers. Because one of things we’ve learned is that, it’s one thing they get the product into the customer you need to hold their hand a little bit up front until they get comfortable using it. And you can only do that if you limit the customer base you go after, but those customers for example a university campus that could take upwards of 100 of these units potentially, then you focus a resource on that university campus hold the hand of the people involved until it’s up and running to their satisfaction and then you can move on.

Unidentified Analyst

Great. All right, well thank you very much for that color and of course best of luck. Thanks a lot.

Thomas Paulson

Thanks a lot John, I appreciate it.

Operator

Thank you. That concludes the call today. You may now disconnect.

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