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Power Solutions International, Inc. (NASDAQ:PSIX)

Q4 2013 Earnings Conference Call

February 27, 2014 4:30 PM ET

Executives

Gary Dvorchak – IR

Gary Winemaster – Chairman, President and CEO

Eric Cohen – COO

Dan Gorey – CFO

Analysts

Philip Shen – ROTH Capital

Eric Stine – Craig-Hallum

Aditya Satghare – FBR Capital Markets

Robert Brown – Lake Street Capital Markets

Rudy Hokanson – Barrington Research

Walter Liptak – Global Hunter

Greg McKinley – Dougherty

John Rosenberg – Loughlin Water Partners

Ross Silver – Vista Partners

Operator

Good day and welcome to the Power Solutions International’s Fourth Quarter 2013 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Gary Dvorchak, Senior Vice President of ICR. You may begin, sir.

Gary Dvorchak

Thank you, Jane (ph) and good afternoon everyone. We are pleased that you’re joining us for the Power Solutions International fourth quarter and full-year earnings conference call. Speaking on the call today are Gary Winemaster, Chairman and Chief Executive Officer; Eric Cohen, Chief Operating Officer; and Daniel Gorey, Chief Financial Officer.

By now everyone should have access to our press release that we announced today. If you have not received the release, it is available on the Investor Relations portion of the PSI website at www.psiengines.com.

Before we begin, I’d like to remind you that the information in today’s press release and the remarks made by our executives on this call may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on information currently available to us and involve risks and uncertainties that could cause our actual financial results, performance, prospects and opportunities to differ materially from those expressed in or implied by these statements. These risks and uncertainties include, but are not limited to, the factors identified in our news release and our filings with the SEC. You may access any of these filings at www.sec.gov.

Please also note that the information provided on this call should be considered current only as of today. Except as expressly required by the federal securities laws, we undertake no duty to update that information. Finally, I want to mention that a replay of this call can be accessed after the call ends and will be available for approximately one year.

And with that, I’d like to turn the call over to the company’s Chairman and CEO, Gary Winemaster.

Gary Winemaster

Thank you, Gary, and thank you everyone for joining the call. After I review the year, our COO, Eric Cohen will offer more detail on our Q4 operating highlights, and then Dan Gorey, will discuss the details of our financial results. I will conclude with the discussion of our outlook for growth.

2013 was a year of building the foundation for our future growth. Even as we again recorded solid results, two years ago, we addressed our need for capacity with our expansion as the Wood Dale campus. And in 2013, we addressed our need for financial strength.

During the year, we completed a secondary offering that raised $34.6 million for the company. And we listed our stock on the NASDAQ.

We entered the year with reasonably good line of credit but little cash at the end of each quarter and an OTC stock with little trading volume. We exited the year with cash in the bank and expanded line of credit and an exchange traded stock with good liquidity.

Our debt to capital ratio declined from 34% to 14% during the year. And cash is now 12% of equity up from 2.4% at the start of the year. We recently filed a shelf registration that enables us to quickly as capital markets should any compelling business development opportunity arise. Therefore, we have far more flexibility to fund the growth we see ahead.

While we shored up our financial position, we also forged ahead with initiatives that are going to drive the growth over the next three to five year timeframe. We are focused on large, high-margin power systems and are seeing success in generators that are deployed in the field at oil and gas wells.

Our partnership with Caterpillar Perkins as the center of excellence will enable us to further extend our product line into larger engines. We believe that our demand in oil and gas will continue to grow for three reasons. One, frenetic exploration activity driven by fracking, two, the economics of using flair gas as free fuel and three, the new environmental regulations that will reduce the flaring of gas, creating the need to utilize it.

That second point is particularly important. The economics of virtually free source to power well jack and other oil field equipment is compelling. When you consider the alternative of truck and diesel, while at the same time burning off free natural gas, the power behind this shift seems obvious.

In small power systems, growth has been driven by our success in the forklift market. We expect that success to accelerate in 2014 and beyond.

Earlier in the year, we announced our collaboration with Hyundai Heavy Industries for their 7A forklift series. More recently we announced an agreement with NACCO Materials Handling Group, an industry leader in forklifts. We look forward to expanding our partnership with NACCO as well as continuing to penetrate other forklift opportunities with our new Mitsubishi based 2-liter and 2.4-liter engines.

The 2-liter and 2.4-liter engines earned both EPA and ARB Certification earlier in the year. So, we are now strongly positioned with a rugged environmentally and economically compelling solution for our small industrial application customers.

We also have supply commitments that extend for years. We expect to be selling our 2-liter and 2.4-engines in the 2020 and beyond.

Asia represents outstanding opportunity for us in many industrial and on-road applications, including forklift. We are starting to ramp our joint venture with MAT Holdings in China and envision this effort contributing to profit in 2015 and beyond.

We have a number of forklift opportunities that maybe supplied in China and we are seeing high interest from medium duty truck manufacturers as well.

Along those lines, we continue to build our foundation in the U.S. medium duty truck and bus market and expect that all the marketing, testing and evaluations by customers will continue – will come to fruition in 2015 and beyond.

We announced some early wins such as the deal with capacity of Texas for their TJ5000 tractor. We also announced that our relationship with GM will expand even more as we begin to use their 4.8-liter and 6-liter engines and transmissions to address the Class 4 to Class 7, truck market.

Although our activity level is not highly visible to you, all due to the early stage of the market, be assured that we are aggressively pursuing many on-road opportunities and believe the payoff will be substantial in the years ahead.

Let me now turn the call over to our COO Eric Cohen to discuss Q4 operating highlights. Eric?

Eric Cohen

Thank you, Gary. I will cover some of our operating accomplishments in the quarter and then Dan will go over the financials. Q4 was really one- off execution as we filed through on the many initiatives we’ve announced over the past year or two.

For instance, EPA and ARB Certification is critical for our market position, as we’ve become the manufacture of record and does save all of our customers depend on certifying their power systems separately.

Gary mentioned the certification for the small mist engine earlier in the year. In Q4, we also completed an on-road certification test for our new 8.8-liter engine. Beyond our multi-fuel capability, certification is a critical element of our value proposition to all of our customers but especially future truck customers.

Most of our competitors are offering retrofit kits or fuel system kits that then require the OEM to integrate into a power system. In contrast, we offer complete turnkey solution. OEM simply drop in our engine, catch a few wires and hoses and it works. And their mission certification is taken care of.

At the moment, we are all seeing retrofit projects lesser rate, the fleet operators are using to test alternative fuel engines. For small tests, it makes complete sense to retrofit rather than designing engine from scratch. But when tests move into adoption and then volume production, we believe our total solution will be far more attractive to OEMs.

Another example of execution this quarter is efforts to further strengthen our supply chain. Part of our value added in supply chain is that we integrate literally thousands of SKUs while volume purchasing power enables a cost advantage to our customers.

We recently found some exceptionally good suppliers in India, and are expanding our global sourcing in order to pass on further cost reductions to our customers. Supply chain is a continuous focus for us, and you should expect us to regularly stand and improve our sourcing year-in and year-out.

I would note that our suppliers recognize the good work we do in sourcing and also appreciate the growth they can experience working with us. Doosan Infracore, a global 500 Korean supplier that sells us engine blocks recently awarded us their Customer of the Year award for North America. We are honored by this recognition from a valued supplier.

Gary also alluded to a product line extension of our partnership with Perkins. Working with them and using their 4,000 series engine blocks, we will soon be able to offer alternative fuel powered engines all the way up to 61-liter displacement. This is a very large engine and will be well suited for the heavy duty applications that are driving our growth such as power generation for oil and gas.

With this extension we now have power notes stand in a range from 25 kilowatts to over 1 megawatt, which we believe is the most comprehensive range in the industry.

Finally, I wanted to add some detail to Gary’s comments on our China JV. We’re starting to hire and train production workers for the plan. We are midway in getting ISO Certification which is important in terms of building trust in our standard of quality.

All this proprietary activity should result in first revenue shipments later this year. High volume is still planned for 2015 though.

I will now turn the call over to our CFO, Dan Gorey to discuss our financial result in detail. Dan?

Dan Gorey

Thank you, Eric, and hello everyone. I would like to review our operating results and financial condition in more detail and then return the call to Gary for our outlook. Here are the details of our fourth quarter and year ended 2013 financial performance.

Net sales for the fourth quarter were $61.5 million compared to $52.5 million last year. This represents a 17% increase in revenue. Sales growth in the fourth quarter was due principally the strong growth in our heavy duty power generation systems for the oil and gas end market as well as from aftermarket sales.

Our gross margin for the fourth quarter was 19.2% compared to 16.1% in the fourth quarter last year. This strong increase in gross margin was due to a favorable shift in mix to the higher margin heavy duty engines as well as the various other initiatives. Our gross margin this quarter at 19.2% expanded slightly from the 19.1% achieved in our third quarter this year.

Operating expenses which include research and development, selling and service and general and administrative costs, came in at $7.9 million for the fourth quarter. While these expenses increased from last year’s fourth quarter to support the increased sales among other things, they decreased $374,000 from our third quarter. As a percentage of sales, operating expenses were $12.8% of sales.

R&D spending in the quarter was $3.1 million down slightly from the third quarter. We continue to make significant investments in R&D spending as we developed advanced technologies both for future customer platforms and around road capabilities.

For selling expense and general and administrative expense increased from last year, but declined modestly from the third quarter.

Operating income for the fourth quarter was $3.9 million and grew 30% year-over-year. Operating margin expanded to 6.4% this quarter from 5.7% last year and was consistent with the third quarter.

Interest expense was $87,000 in the current quarter, compared to $257,000 last year due to a higher level of borrowings last year.

Other income and expense includes the revaluation of our warrant liability. As a reminder, our April 2011 private placement included warrants, the liability for which we are required to carry on our balance sheet at fair-value.

Each quarter, the change in value must be run through the income statement. This is a non-cash item that for GAAP accounting purposes impacts the bottom-line. This quarter, we booked a non-cash expense of approximately $6.4 million or $0.60 per diluted share resulting from an increase in the estimated fair-value of the warrant liability.

The value of these warrants will change regularly so you should expect to see valuation adjustments both positive and negative in future quarters. Therefore, we encourage investors to look at our results both with and without the warrant revaluation and assessing our performance on a quarterly basis.

The GAAP on a diluted loss per share was $0.36 in the fourth quarter compared to earnings of $0.08 a year ago. Removing the effects of the warrant revaluation, our adjusted EPS was $0.24 in our current quarter. This compares to $0.21 in our fourth quarter last year and $0.24 for our third quarter of this year.

I have a few comments regarding our full year 2013. Sales reached $238 million, an increase of 18% from $202 million last year. The sales gain in 2014 was helped by both our heavy duty power system offerings for the oil and gas market along with strong aftermarket sales. Heavy duty power system sales increased over 87% to $60 million during the year.

Adjusted net income for 2013 which removes the effects of the warrant revaluation was $9.4 million or $0.92 per share, this compares to 2012 adjusted net income of $7.5 million or $0.81 per share.

Now, let’s discuss the balance sheet and liquidity. Our balance sheet is solid with $78 million in working capital which includes $6 million in cash and almost $50 million in shareholders’ equity.

We have about $18 million borrowed on our line of credit this leaves $48 million available to support our anticipated growth in the business. We are withstanding with the bank and then compliance with our covenants. I believe cash generated from operations as well as availability on our line of credit will be sufficient for all near-term operating and capital needs.

For 2014, we estimate CapEx to be in the range of $5 million to $7 million, and depreciation and amortization to be about $3 million. Our effective income tax rate excluding any warrant impaired will be provided at 37%.

That concludes my comments. Let me now turn the call back to Gary to discuss our outlook. Gary?

Gary Winemaster

Thanks Dan. My opening remarks described the foundation for growth we built in 2013. And we expect to deliver that growth in 2014. We are reiterating that we expect 2014 sales in the range of $310 million to $330 million. Keep in mind that represents growth of 30% to 38% from 2013. And would mean we would double our revenue from 2011.

We believe that market demand is in place to achieve this goal. Sales of our largest systems into the oil and gas industry should remain strong this year. Our deal with NACCO adds visibility to our outlook. And we would be solid. It would be a solid contributor as it ramps up this year.

To be conservative, our outlook includes no contribution from our on-road or China JV. But obviously, we are working hard in these initiatives and expect them to contribute in the years ahead.

Now, operator, let’s open the call to questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we first go to Philip Shen with ROTH Capital.

Philip Shen – ROTH Capital

Hi guys, thanks for taking my questions.

Gary Winemaster

Hi Philip.

Eric Cohen

Hi Phil.

Philip Shen – ROTH Capital

And nice drive on the quarter as well. I’d like to start off with margins you guys had a nice margin quarter. What do you guys see ahead, I know, long-term gross margins are targeted at 20%, operating margins are what you want to target 10% to 12%. But as we go through the year in 2014, what you see in Q1 as we go through the year?

Dan Gorey

So, thanks for the question. As you know, we don’t comment specifically on gross margin but let me give you some color on margin. We’re proud of all of the effort that was made by the team here and we saw great expanding margins in 2013.

My job in forecasting margin was fairly easy in ‘13 because we really had one major growth initiative and that was the heavy duty profit line that we have and we sell into the oil and gas market. And that happens to be one of our highest margin categories. So we saw a nice increase in gross margins.

The other nice area of growth for us was in aftermarket as I mentioned in my comments and that also happens to be a very good high margin piece of business for us.

When we look into ‘14, we’ve got a couple of different drivers, I mean, we’re going to continue to see, we think very good growth in both aftermarket and oil and gas, but we now are going to have also some good forklift growth in 2014. Each of these pieces of business have different margin attributes. And so, it’s a little more difficult to forecast particularly on our quarter-by-quarter basis.

In a perfect world I’d like to see, I’d like to see a balance between the two, there could be timing differences that may or give us opportunity or challenge depending on the quarter that we’re in.

But the other thing to keep in mind, and I think many of you and you particularly may know this but whenever we start a new major program, whether it be forklift or something else, traditionally we’re beginning with prototype parts and parts that are bought at much lower quantities than full production quantities.

So, as you can imagine, particularly starting out, you might have a little bit lighter margins than you would expect to have at kind of its full run-rate with ordering at full production quantities. We’ve got a great team of procurement guys that are already very aggressively costing down the new forklift order that we have. And we’re going to make very significant progress in that through the quarter.

So, I know I didn’t specifically answer the question but I hope I gave you some color that will give you some perspective on our thinking.

Philip Shen – ROTH Capital

Thanks, Dan. That definitely helps. In terms of heavy duty power systems, or stationery engines, I think you mentioned in your prepared remarks that you had about $60 million of revenue still oil and gas. I think on the last call, you were talking about maybe driving $75 million in revenues in ‘14. Can you give us your latest outlook on or kind of perspective on what oil and gas could do in terms of revenues in ‘14?

Gary Winemaster

Well, we believe that that is still a very good number. $75 million is a number that we feel very, very comfortable with. We believe there is an opportunity for that to improve. But I think that every indication that we have right now is that our products are very well accepted and doing very well in the field.

Philip Shen – ROTH Capital

Great, thanks Gary. And one question on the EPA, can you just give us the latest updates in terms of certification for the end, the propane fuel as well as when you expect the natural gas engine as well as gasoline engines to be served by the EPA?

Eric Cohen

Yes, so, the first certification that we passed was the 88 on propane. And the certification is done at an EPA approved lab. And the certification was passed and so now it’s into the EPA curve, the process, the paperwork. What we’re doing is shortly CNG will be going through that same test. I mean, all indications look like that’s on a good track as well. And then after that we’ll be focusing on gasoline later on into the year.

Philip Shen – ROTH Capital

Okay, great, Eric. Any sense of timing as to when the test maybe completed and passed?

Gary Winemaster

Well, for CNG the expectation would be before the next earnings call for completing the test in the EPA lab. And then for gasoline, we’re not giving any detailed guidance at this point.

Philip Shen – ROTH Capital

Okay. Thanks. And I’ll jump back in queue.

Operator

And next we go to Eric Stine with Craig-Hallum.

Eric Stine – Craig-Hallum

Hi, everyone. Congrats on the quarter.

Gary Winemaster

Thanks Eric.

Eric Cohen

Thank you.

Eric Stine – Craig-Hallum

Maybe if we can just start the industrial side as a whole in tier 4 emission standards. As that gets spaced in through 2015, I know it’s tough to quantify but any thoughts on and what percentage of your products as it stands right now are cheaper? And then, as you look at the schedule of how that tier 4 is spaced in, is there a point you can or a time you can point to where that really starts to get going and the majority of your offerings is cheaper than diesel?

Gary Winemaster

Well, I think we’re in a position right now to be more competitive than diesel. Like we’ve talked, we’ve said before, it’s not purely the purchase price, it’s also the inability to fit some of these larger tier 4 diesels into the same application envelops. So those two things together I think put us in a very, very attractive position to take some of the applications that are equally suited for alternative fuels as they are for diesel.

So, we start, we believe that we’re starting to see some business this year. We’re already seeing some opportunities in the wood chipper business that has been historically diesel over the last five years, five or 10 years. We’re starting to see some of the national free accounts come online with some gasoline applications and offering LP and gasoline dual fuel.

So, I think that you’re going to start to see revenues in the reports that we have gone powered this year and I think next year will even be a greater opportunity for us.

Eric Stine – Craig-Hallum

Okay. That’s great to hear. Maybe just turning to the forklift side, great that the NACCO, now that deal is announced. I know in the past you’ve talked about working with multiple OEMs on prototypes and I don’t know if possible, but anyway to share details on maybe how many of those that might be or the size compared to this NACCO contract?

Gary Winemaster

Well, I would tell you that we have a number of opportunities in the queue. Obviously NACCO is a very, very strategic and great partner of ours. And we’re very proud to have this opportunity to work with them. But we have other opportunities that we’ve been working on for a long time. We see the volume of this product in ‘14 to go north of 40,000 engines.

So, I think it really gives us a solid position in the marketplace. We’ve now installed high-speed four-cylinder line in our factory. I think we’ve shown some videos and I think there will be a video on our website in the near future which actually shows those engines being manufactured. So it’s an exciting time for the company, we’re really pushing hard to grow that business. And I think there is a large opportunity in the next two years for us to take a real dominant share in that space.

Eric Stine – Craig-Hallum

Okay, perfect. Maybe just last one from me, just turning to on-road. I know in the past you provided an update on the number of programs you’re working on right now, engine, truck OEMs and fleets. Just any thought on the annual size that that group of programs might represent?

Eric Cohen

Yes. So, we think when we look at on-road, just given the timing characteristics of it, it’s more of a long-term type forecast because it does take time to integrate the units into vehicles and then also have them field tested. But we still feel comfortable that group of products could get us to our goal of having on-road contribute up to $500 million of revenue annually to PSI.

Eric Stine – Craig-Hallum

Got it, thanks again.

Gary Winemaster

Thank you.

Operator

And next we go to Aditya Satghare with FBR Capital Markets.

Aditya Satghare – FBR Capital Markets

Thank you, good afternoon everyone. Good execution in the quarter.

Gary Winemaster

Thank you.

Eric Cohen

Thank you.

Aditya Satghare – FBR Capital Markets

I had two questions. The first one on the on-road market. Could you sort of remind us again on some of the advantages of your on-road product versus some of the upcoming launches coming in this category next year?

Eric Cohen

Yes, so we’re very unique for our product offering. One again, we target a segment of the market it’s really the Class 3 to Class 7 which is light to medium duty vehicles. And in that space we really feel we have the – we do have the most comprehensive offering and with multiple advantages.

One of them is just in terms of share kind of cost and weight based on some of our proprietary designs and what we’ve done to modify GM engines, it offers a very compelling cost and weight advantage over other competitors.

Another clear advantage is that we have a common control system or platform across the engines, and then really, a final one, probably the most important is that we offer multiple fuel capabilities. So many other offerings might offer a certain engine which is with one fuel it’s kind of a one-trip pony. With our engines it can run multiple fuels, a variety of fuels. It can also run heavy option to on-board two different types of fuels. Again, along our range and that flexibility it’s very unique in the industry.

Aditya Satghare – FBR Capital Markets

Got it. My second question is more a broad question here, are you seeing any push-back from your customers given the recent spike in natural gas prices or do the operating cost savings and the emission reduction dominate the conversation?

Dan Gorey

No, I thought that question might come up. So, I answered one no, not at all. In fact just the opposite. We see the interest accelerating, because – just because there has been cold weather snap in the U.S. short-term spot prices might have spiked. But if you look at the long-term futures, those still remained relatively compelling.

And that again, remember that even though you might have a spot price of what you pay for the commodity of natural gas, very little of it, most of the cost is in the infrastructure, so very little of that will get passed on to the actual fuelling station. So I just – I took a look at about 50 fuelling stations around the country just today. And those prices are still very low, some of them are – there is still right around that – the $2 recruitment range where diesel is still looking around $4 equivalent range.

So, again most of our customers are looking more long term and not just what’s happening on our spot price, we’re at particularly low now.

Aditya Satghare – FBR Capital Markets

Got it, thanks. That’s all I had.

Gary Winemaster

Thank you.

Dan Gorey

Thank you.

Operator

And next we go to Robert Brown with Lake Street Capital Markets.

Robert Brown – Lake Street Capital Markets

Good afternoon guys, congrats on a nice quarter. In your guidance didn’t include any revenue from China or really on-road. Can you give us a sense of I was trying to understand sort of what is the timing of potential revenue in China? Could we see some this year and sort of how does that really look at potential?

Eric Cohen

Yes, no, we say that we will – the China JV will start servicing customers, we expect this year. And just remember that it is the equity method. So, it’s going to show up as a line-item rather as a revenue source. But we see, we see it’s starting to ramp in 2014 and really more fall into the fact into 2015, we’ve got some significant projects in the works.

Robert Brown – Lake Street Capital Markets

Okay, okay great. And then more broadly, trying to achieve the footprint in China, does that give you an ability to go to other kind of countries in the region or should we just think that’s really a China market?

Eric Cohen

Yes, it really enables two things, well it’s a footprint, it starts to enable us to look into even other sectors in the marketplace. So a lot of the trends that are playing out in the U.S. are also playing out in China, so the JV relates down on its own, just on the forklift business. But there is many other applications from oil and gas to scissor-lift to street sweepers that could use some of our solutions in our engine.

So, it kind of gives us dates to look at other markets in China as well. And then on top of that having a competitive base there in Asia, you have countries right across the border, Korea and others that it does allow some other interesting options that were before, we were not targeting those in-country options.

Robert Brown – Lake Street Capital Markets

Okay, got it. Then the last question, just sort of turning to your guidance, I know the new forklift customers in part of that, but could you give us a sense of how much kind of those forklift customer contributes to this year’s number and maybe how much it can kind of grow into next year, sort of one potential total. But what sort of falls into this year in your thinking?

Eric Cohen

Yes, no, we don’t – good question. We don’t break out the exact numbers, but what we expect as the new customer win, we would expect it to contribute meaningful amount to the guidance for 2014. We also have other projects in other growth areas too which will contribute to those numbers.

Robert Brown – Lake Street Capital Markets

Okay. Thanks a lot.

Operator

And we next go to Rudy Hokanson with Barrington Research.

Rudy Hokanson – Barrington Research

Thank you. The oil and gas area has become very important for you, I mean, that’s given. You’re incrementally adding meaningful contract extent of talked about for a while in 2014. But I was wondering net-net its annual (inaudible) the base is certainly – there is got to be some growth there, other things are happening.

And I was wondering if you could maybe pull that apart a little bit, I mean, you used to breakdown revenue more in terms of various end-markets, so I know it’s hard to know with some things go all the time. But I was wondering what kind of growth are you seeing in pure power generation or does that just get lumped into oil and gas now? Or in the environmental side, you were talking about wood chipping and the industrial and commercial sweepers?

Can you give us some kind of sense about the dynamics that are happening elsewhere or is it becoming more and more focused on forklift and oil and gas/power gen?

Dan Gorey

If you knew the sales team here Rudy, I mean, well, we emphasize the big-big routers right to help everybody understand our business. What we’re in many markets as you know and it’s a fight in everyone. I mean, these guys take each of these markets very, very seriously.

We’ve made a decision not to breakout all of these markets in detail. But again, and we’ve highlighted for you the areas of growth that we think will largely contribute to the success of the business growing at up to the targets that Gary outlined a few minutes ago.

And just to repeat right, its oil and gas, we think they’re just tremendous opportunity there. Forklift 10, as you may know it tends to move in steps and big programs like this program we recently rewarded is a huge win for us. And I think either Gary or Eric mentioned, we believe that there is others behind that.

That mix engine is a winner, it’s ideally suited for the lighter duty under the forklift market and we think there is going to be great growth there.

Without getting into any detail, there is ups and downs in each of these other businesses. My recollection is, its power gen, non-oil and gas was a grower last year. And so, we really believe that the rest of the business contributes growth and it’s kind of the last piece to provide the necessary sales that we need to meet the objectives for ‘14.

Eric Cohen

I think one thing I would add is that, in all of those markets, we’re still in the leader in that segment. We have always worked very hard to drive to be selling to the blue chip companies in each segment. And we’ve been successful with that.

So, winning that business is always contributes to some of the smaller players in the market as well. So, with that being said, we have a very strong position in each one of those segments.

Rudy Hokanson – Barrington Research

Are you noticing any kind of pricing pressure or questions of let’s negotiate this because there are other players with natural gas or natural gas type engines, like in the oil and gas field right now. I mean, there might be a different configuration and you may have the best product. But are you noticing any kind of push back in terms of negotiations as to what people are having or measuring your value versus the other offerings that are out there?

Eric Cohen

One of the thing, we’ve been very fortunate that a lot of the end users have been requesting our product. So, a lot of the packagers are now getting driven to relationships with us. And I think the product is performed so well that we have a lot of the rental companies and a lot of the guys that are providing services to the oil field, now coming back and saying okay, we like your product, who can we get – who is somebody that we can go to and get that that final configuration in our application.

So, I think there is pressure always to be competitive. And I think that we drive to be competitive and also provide excellent quality. So I think as long as we can provide competitive price and the same type of quality that we’ve been known to develop, I think we’re going to hold our share and increase that.

Rudy Hokanson – Barrington Research

Okay. Thank you, those are my questions.

Gary Winemaster

Thank you.

Operator

(Operator Instructions). And we will next go to Walter Liptak with Global Hunter.

Walter Liptak – Global Hunter

Hi, thanks. Congratulations guys on a really remarkable year.

Gary Winemaster

Thanks Walt.

Eric Cohen

Thanks.

Walter Liptak – Global Hunter

I wanted to ask about top line with the outlook, you have a definite seasonality I think to the way that the revenue ramps. And I wonder if you could talk about, if that’s going to happen again in 2014?

Gary Winemaster

I’m not really sure it’s seasonality anymore. I mean that it’s really the introduction of programs and the position they are as far as maturing inside of our company. We continue to develop more complicated offerings, we’re going to move for heavy oil and gas product, we’re going to offer explosion proof ignition systems this year which takes us into another market. We’re expanding the range of product in that space.

We continue to develop plans that we’ve had in place for a long time. We have entered the market, we’ve taken in the lion’s share, we’ve tried to introduce ourselves into a strong position. And now we’re expanding inside of those customers. That has always been our model, is to not necessarily look forward to pioneering customers we don’t have but growing inside of customers that we do. And I think that’s been very successful for us.

Walter Liptak – Global Hunter

Okay. I guess, my question was in part related to the ramp in sales that you have with the NACCO business, is there any ramp that takes place during the year that we should be thinking about?

Gary Winemaster

Well, I think it’s – the program is beginning and the program will move forward. Obviously, that – some of that information is proprietary to our customer. But I think that we have been given an opportunity to be the 1-8 ton supplier for this range of product. And we’re very proud of that.

So, I think that we’re very bullish about what they’re doing and what other people are doing. So I think we’re going to see a ramp as we go forward. And in ‘15, I think it looks phenomenal.

Walter Liptak – Global Hunter

Okay, sounds good. Given the amount of programs going on, engineering programs were on-road and other things. I wonder if you could comment at all about engineering costs and what those might look like during 2014, is there anything significantly incremental that we should consider?

Dan Gorey

I’ll take a shot at that Walt, and if Eric or Gary have anything to add, I’ll ride it and they add it. But I’ll address something more broadly which is just generally operating expenses right. Operating expenses I think for the year came in around 12.4% that’s 2013. And I think your question, you’re focusing on research but it’s kind of like okay, so what does it look like in ‘14.

I’ll address it more as percentage of sales and then let me break it down a bit from there. But as I’ve said in the past, I mean, we really are seeing maturing of expenses on the selling side and the G&A side. Those expenses will grow in terms of dollars but they will grow much slower than the increase in sales. So, we will get, we’ll start to get some operating leverage from selling and from G&A.

R&D, it is critical to the success of the business, there is a lot that is ongoing, not only with the industrial business but also getting this on road. And I would say that that line item will probably grow consistent with the increase in revenue or slightly a little, slightly more.

I think if you look at that operating expenses as a category and you’re targeting kind of the mid-point of our guidance, it would probably suggest that we’re going to see a little bit of leverage next year. So it might be in the 11s as a percent and I’m talking about OpEx as a category while trading.

Eric Cohen

Yes. Thank you, Dan. Let me just add on that that in terms of R&D and engineering expense, I’d just be careful trying to forecast that too tightly because it’s also dependent on what opportunities come in. So, for example, if there is a very compelling new opportunity or we’re going to accelerate that opportunity, we might take that on and thereby we would incur engineering or additional R&D expense.

However, if it has a very attractive return on investment or a very compelling opportunity, we might make that business decision to do that. So, it also depends on the opportunities and new opportunities really to come our way in 2014.

And my comments were really more focused on the expenses for the full year. In other words, I think given the ramp, that we won’t be at $300 million, let’s $320 million run-rate in Q1, given the ramp. And so I don’t think we should get too optimistic relative to operating expenses and any leverage earlier in the year.

Walter Liptak – Global Hunter

Okay, very good. Sounds great.

Gary Winemaster

Thanks.

Eric Cohen

Sure.

Operator

And next we go to Greg McKinley with Dougherty.

Greg McKinley – Dougherty

Yes, thank you. So, Gary, you started off the call making some comments regarding the three drivers of your oil and gas business talking about these regulations and flare gas recovery. That’s – I just wonder if that’s a market that you can provide any sort of context for investors around how many engines are out there that maybe non-compliant or may need to be changed out as some of these new rules and regulations come into places. Is there any way people can quantify that opportunity?

Gary Winemaster

Well, I think we’ve got some information on the number of sites that are with flare gas. We have a number of sites that will be affected. I think one of the things that we have been able to do is up until now, as far as the competitive landscape, it’s historically been diesel.

We’ve aggressively moved into that space and we’ve taken share. And I think that we’re really right at the beginning of that opportunity. I think if we looked at the thing overall, it maybe 10% of the potential going forward.

So, I think we’re very bullish, I don’t know if we really identify the ceiling of that market yet. But I think that there is still a long way to go and it is very significant part of our business today.

Greg McKinley – Dougherty

Okay. Thank you. And then, maybe Dan addressed it a little bit, which is commented on operating expenses. But as the business grows where are your greatest needs for people going to be, is that sales teams to more deeper penetrate niches about oil and gas market, you haven’t capitalized on yet or how should people think about where your people investments need to be coming from?

Gary Winemaster

Well, we made significant investments in engineering. I think that we’ve really put a lot of effort in that area. We bolstered our procurements teams, operation teams. I think we are looking for strong sales people in the different spaces that we’re trying to expand into. We just made a couple of announcements of some key individuals to our team.

If you check the website you’ll see who they are. But I think we’ve really developed a strong team and I think we’re well positioned to realize the growth that is in front of us.

Greg McKinley – Dougherty

In terms of just on the balance sheet for a moment, working capital, my guess is you probably have parts in inventory in advance of some of these programs ramping. How should we think of maybe inventories depleting a little bit as the year progresses or how should we think about cash conversion?

Dan Gorey

We do have inventory in excess of current needs. I mean, we do take advantage in opportunistically buy what makes sense for us to do so. And if you look at the inventory today, I think it’s around $55 million. There is probably a good $7 million to $10 of that that’s probably in excess in terms of our true short-term need. But it made a lot of sense for us to do it and we did it.

And some of that will probably be worked off during 2014. Having said that, I mean, we’re also set fairly ambitious goals top-line, which in turn will need working capital. I forget what the forecast shows Greg, but I mean, I think it shows probably a little bit of depletion in inventory sub-March kind of second quarter but then starts to build as the ramp goes up. So…

Greg McKinley – Dougherty

Okay.

Gary Winemaster

Greg, I think it also – when we look at the large power systems, I mean, I don’t think we even understand how large the opportunity is. We’ve given some guidance on what we think will happen in 2014. And we’ve taken a position in some of those engine blocks, because incrementally we’re seeing order drop in that, if we were to wait for supply chain to react, we probably might miss some of those opportunities.

So, based on the type of ramp we had in large engine systems, in 2013, we’re very bullish in our inventory position and we’re starting to see the benefits of us being able to deliver inside of what historically would be a three to four month lead time.

Greg McKinley – Dougherty

Okay, okay. Thank you. And then, last question, I think Gary, in your prepared comments, you made a reference to 40,000 engines. I just wanted to make sure I understood what that was applicable to?

Gary Winemaster

Yes, that’s our four-cylinder business. The mid-product that we have, we look out to 2015, I mean, 40,000 I think is a very conservative number. I believe that that number will approach 60,000 as we move towards 2016.

But I think that we’ve touched the market that we go to, we have such a large customer base in that segment. And we have a lot of programs that are well in the process. So, we feel that 40,000 is a very comfortable number for us going forward. And I think that there is opportunity for us to see 60,000 units in our four-cylinder business.

Greg McKinley – Dougherty

Thank you.

Gary Winemaster

Thank you very much.

Operator

And next we go to John Rosenberg with Loughlin Water Partners.

John Rosenberg – Loughlin Water Partners

Hi, thanks very much for taking my call. Couple of questions, actually two related questions. You had mentioned in your commentary about selling into the oil and gas space. Did you describe your channel into that space, how your sales were made and also how you’re compensating your sales people in that regard?

Dan Gorey

Well, I mean, as far as compensation for sales people I think that’s probably a proprietary discussion. But, our sales guys are very aggressive in that space. We have worked very hard to identify the end-users in the space. Today we’re servicing, we’re selling to people that provide engines to the service industry for the oil and gas market.

There is a number of gen-set packagers, compressor packagers that we have barged relationships with over the years. And I think that the success of our product is now something that is very key to their businesses.

John Rosenberg – Loughlin Water Partners

That’s great. And, as a corollary to that question, just to ballpark, roughly what are the ASPs on those engines?

Dan Gorey

The average sell price on those engines could be in the heavy duty product, we’re probably looking at somewhere between $50,000 and $55,000 a piece.

John Rosenberg – Loughlin Water Partners

Okay.

Dan Gorey

The high-end is that, the high-end is 90 and the low end is probably 20.

John Rosenberg – Loughlin Water Partners

Thank you very much.

Operator

And we next go to Ross Silver with Vista Partners.

Ross Silver – Vista Partners

Hi guys, congratulations on the quarter and the year.

Gary Winemaster

Thanks Ross.

Eric Cohen

Thanks Ross.

John Rosenberg – Loughlin Water Partners

So, question for you just as it relates, just kind of on the same note as growth is. When you think of acquisitions going forward, I mean what sort of opportunities are you seeing there, is that something that you think might be a possibility to acquire some opportunities here in 2014 or what sort of commentary can you say or do you have as it relates to acquisitions?

Eric Cohen

Yes. So, it’s kind of a philosophy of our company. We believe we should always be looking at acquisitions, because as you’re growing, as a company, you always have to evaluate should you grow organically or acquisitively. And so, we’re always on the lookout for the right acquisition versus growing organically.

And so, currently there is multiple opportunities that we’re looking at some of them that we’re working on. And as we look forward, some of those might come to fruition or something they might not. But really the goal is to continue to kind of aggressively look, add acquisitions as a kind of future growth driver for the business.

John Rosenberg – Loughlin Water Partners

Okay.

Gary Winemaster

One of the other things, I would tell you that acquisitions are something that will be strategic and in line with what we’re doing today. I think we’re very focused on looking at those opportunities that are out there that’s bit was what we’re doing. And I think we’ve identified some of that makes some sense.

John Rosenberg – Loughlin Water Partners

Well, thanks. And then one other question as it relates to oil and gas segment. So, when you think about well operators and the solution that you provide to them. I mean, it’s still relatively early in terms of adoption of your engines, I mean, can you talk about sort of where the cycle is for some of these operators, wherein, in terms of their decision making process to continue to adopt and sort of what the growth rate you might expect from some of those well operators?

Gary Winemaster

Yes, well, good question. I think when you look at a lot of markets, typically adoption of new products or technology falls really in S-curve, where you have some beta early adopters. And then as it comes more well-known are accepted. It has a very steep ramp up.

And so we really, we think in the early stages of this adoption curve, what we’re seeing is for the last few years, there has been some early adopters. But what’s happened is, now that we’ve sold thousands of these units into the field and have had excellent success, the opportunities and what the customers know of our product is really spread. And so we’re really seeing a very fast ramp up into our product becoming very well accepted and almost the go-to solution in the field.

And I think it’s becoming a very standard and accepted now to say we’re oil and gas operators, say why we’re flaring off this well had gas, so, why aren’t we using it. There are engine solutions out there that have been proven and working very well. Let’s do that rather than bring in diesel.

John Rosenberg – Loughlin Water Partners

Got it, well thanks so much for taking my questions. And again, congratulations on the quarter and the year.

Dan Gorey

Thank you.

Eric Cohen

Thank you.

Gary Winemaster

Thank you.

Operator

(Operator Instructions). And it appears there are no further questions in queue. At this time, I would like to turn the conference back over to Mr. Gary Winemaster for any closing remarks.

John Rosenberg – Loughlin Water Partners

Okay. Before we close, I want to mention some upcoming conference appearances. We will be presenting at the ROTH Capital Conference in Southern California on March 10. On March 18, we will be hosting or we will be participating in one-on-one meetings at the Global Hunter Industrial HVAC and Machinery Conference in San Francisco.

We will be exhibiting at some trade shows and we would be happy to meet with investors that might be attending those shows. March 4 through 6, we will be exhibiting at the Work Truck Show in the Indiana Convention Center in Indianapolis. May 5 through 8, we will be exhibiting at the Alternative Clean Transportation Expo in Long Beach Convention Center in Southern California as well.

So, with this, I would like to conclude our call. Thank you for your interest in Power Solutions International. Look forward to our next conference with you in May, when we report first quarter results. Thank you very much.

Operator

And that does conclude today’s conference. We do thank you for your participation. You may now disconnect. Have a great rest of your day.

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