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Generac Holdings Inc. (GNRC)

Q2 2012 Earnings Call

August 2, 2012 9:00 AM ET

Executives

Aaron Jagdfeld – President and Chief Executive Officer

York Ragen – Chief Financial Officer

Analysts

Mike Halloran – Robert W. Baird & Co.

Jerry Revich – Goldman Sachs

Christopher Glynn – Oppenheimer & Co.

Jeff Hammond – Keybanc Capital Markets

Chris Godby – Stephens Inc.

Brian Drab – William Blair

Stanley Elliott – Stifel Nicolaus

Operator

Good day ladies and gentlemen, and welcome to Second Quarter 2012 Generac Holdings Inc. Earnings Conference Call. My name is Fab and I’ll be your operator for today. (Operator instructions) As a reminder this conference is being recorded for replay purposes.

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

York Ragen

Thank you. Good morning and welcome to our second quarter 2012 earnings call. I like to thank everyone for joining us this morning. With me today Aaron Jagdfeld, our President and CEO.

We will begin our call today by commenting on forward looking statements. Certain statements made during this presentation as well as other information provided from time-to-time but Generac Holdings employees may contain forward-looking statements and involve risk and uncertainties that could cause actual results to differ materially from those in these forward looking statements.

Please see our earnings release or SEC filings for a list of words or expressions that identify such statements in the associated risk factors.

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

I’ll now turn the call over to Aaron.

Aaron Jagdfeld

Thanks, York. Good morning everyone and thank you for joining us today. We’re pleased to report our second quarter 2012 results this morning which we believe reflect the powerful macro growth drivers for our business and a continued progress we’re making and executing our powering ahead strategic plan.

Our second quarter net sales increased 48% to $239.1 million and on a pro forma basis our net sales for the last 12 months as of the end of the second quarter were approximately $1.1 billion. Growth in shipments of home standby generators were again strong during the quarter as the market for this product category continuous to further develop with more home owners becoming aware of the importance of having a backup power system for their home.

Major outage events like the ones recently experienced in the Midwest and Mid-Atlantic regions in late June and early July are further examples of the powerful macro drivers for our business, as the prolonged under investment in the aging electrical grid is leading to more frequent and longer power disruptions for homeowners and businesses.

With only 2.5% of US households owning a home standby generator, we believe the latest series of outages both during the second half of 2011 and again at the end of the second quarter of 2012 have helped to create significant awareness for this growing product category.

As we’ve experienced in the past, we expect this to make increased awareness will accelerate the adoption of these products, leading to a new and higher baseline level of demand over the longer term. As part of our powering ahead strategic plan we have a number of sales and marketing initiatives designed to extend the positive impact that outages have on home standby generator demand.

In addition, increased home standby sales we also experience solid double digit growth in portable generator shipments as we further expanded placements for these products during the quarter. Our ongoing success in portable generators after reentering in this category four years ago has further solidified our leading position and providing a full range of backup power products for the residential market.

Additionally, well we’re still in the early stages of both programs we continue to be encouraged by the quarterly sales trends related to our recent residential product introductions of power washers and Honeywell licensed generators.

Magnum products has also contributed to our year-over-year sales growth as demand for mobile equipment has benefited from a secular shift towards renting versus buying and the equipment rental companies replace our aging fleets. As we have mentioned previously, with little to know overlap with Generac’s products, distribution channels and end markets. The Magnum acquisition brings additional diversification to our business, while also providing cross selling opportunities for our sales teams.

We’re also making good progress with integrating Magnum’s operations and are on track to achieve our cost synergy targets laid out the time of the acquisition. After three quarters of ownership we continue to see Magnum as a complementary and strategic fit with Generac.

Another important driver for our business going forward is the increase market interest in cleaner burning, more cost effective natural gas fuel backup power solutions. While still a much smaller portion of the overall C&I market, demand for these products is increasing at a faster rate than traditional diesel fuel generators given their low capital and operating cost.

As a leader in the Northern American market for natural fuel generators for over 30 years, we believe we are well positioned to capitalize on the secular shift towards these products. During the second quarter we continue to see increase year-over-year shipments of natural gas generators providing attractive organic growth for our C&I business.

In addition, to capitalizing on the powerful macro growth drivers for our business we’re making important progress in executing our powering ahead strategic plan. This strategy implemented less than two years ago it’s served as a template for our investments in the company that we expect we’ll drive our longer term base line growth.

These initiatives are linked to each of our four strategic objectives of growing a residential standby market, gaining share of the commercial industrial market, diversifying our business for the introduction of new products and services and expanding our geographic reach.

Commenting specifically on geographic reach, international expansion continues to remain a focus as we look to increase our distribution footprint and support functions globally. Earlier this week we announced assigning of a distribution agreement with all power industries of Victoria, Australia to sell and service Generac branded home standby generators, portable generators and power washers through their well established network of over 400 dealers in Australia and a 150 dealers in New Zealand.

Even though total family household, single family households are projected to grow to $9.5 million by 2017 then market by for home standby generators in Australia and New Zealand is currently underdeveloped, with no manufacturer having any meaning level of market penetration.

As such, we see this agreement with all power as an attractive entry point into this market. Going forward we will continue to make international expansion of priority given the significant global market opportunity that exists for backup power generations.

Finally, during the quarter we pay to our shareholders previously announced special cash dividend of $6 per share. Our ability to return significant capital of shareholders with special cash dividend and directly attributable to our strong free cash flow and demonstrated track record of paying down debt.

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

York Ragen

Thanks, Aaron. As previously mentioned net sales for the second quarter 2012 were $239.1 million, a 48.2% increase as compared to $161.4 million in the second quarter of 2011.

Looking at net sales by product class, residential product sales increased 33.8% to $123.4 million in the second quarter of 2012, from net sales of $92.2 million in the second quarter of 2011. During the second quarter, Generac continues to experience the strong double digit increase in shipments for home standby generators in comparison to the prior year.

The major outage events that have occurred over the past year combined with the company’s initiative to increase the awareness and availability of home standby generators that help to drive baseline growth for this product category.

As demand for home standby generators has significantly increased over the last several quarters, we’ve been able to execute by rapidly increasing our production level to meet this demand. With regards to portable generators we continue to see strength for these products during the second quarter 2012 with solid double digit growth versus prior year.

Our broad relationships at retail have brought us with an increase in portable generator shell space and corresponding market share compared to prior year, further enhancing our leading position in the market for residential backup power in the US. Also contributing modestly to the revenue growth for residential products during the second quarter 2012 was increased revenue from our power washer product line which first began shipping in the second quarter of 2011.

Looking at our commercial industrial products, net sales increased 76.4% to $101.1 million in the second quarter 2012 from $57.3 million in the second quarter of 2011. The increase in net sales was primarily driven by the Magnum products acquisition into a lesser extent increase shipments of natural gas fields of backup generators, partially offsetting these gains was a decline in shipments in national account customers during the current year second quarter.

As a reminder, there can be some variability in our C&I product shipments primarily due to the timing of capital spending by our national account customers. With regards to Magnum, our progress to date with the integration of this business continues to be favorable as we work further goal achieving roughly $2 million in cost synergies on a run rate basis. Much of the savings we were projecting will come primarily as a result of improved purchasing scale with certain components and commodities as well as from improved utilization and efficiencies in Magnum operations and the consolidation of certain administration related expenses.

We will continue to realize these cost synergies throughout 2012 and remain no track to achieve the full realization on an annualized basis by the end of the year. Looking forward, we expect to take advantage of future cross selling opportunities, as we’ve had a early successes with Generac’s industrial national account customers and industrial dealers purchasing Magnum mobile generators, and we continue to track a number of leads across sales teams both domestically and internationally.

Our other product sales category improved a $14.6 million in the second quarter of 2012, and increase of 23.7% from the prior year second quarter sales of $11.8 million. As a reminder, this product category is mostly comprised with sales of after market service parts as well as lose engines to equipment OEMs.

The increase in the other product category primarily relates to the contribution of parts revenue from the Magnum acquisition increased service part sales as there were local several initiatives aimed at improving our focus on after market sales opportunities, as well as increased demand for service parts generated by the major outage events.

Gross margin as a percent of sales for the second quarter 2012, with 36.6% compared to 37.4% in the prior year second quarter. The 80 basis point decrease in gross margin percent over the prior year was primarily due to the mixed impact from the addition of Magnum product sales. Partially offsetting this decline with the higher sales mix of home standby generators, and the positive impact from certain pricing increases implemented in the prior year, as well as improvements in our overhead absorption and the moderation of certain commodity cost.

Operating expenses for the second quarter of 2012 increased by $11.7 million or 30.4% as compared to the second quarter of 2011. These additional expenses were driven primarily by operating expenses associated with Magnum, increased sales, engineering and administrative infrastructure to support the strategic growth initiatives and higher baseline sales levels of the Company, increased incentive compensation expenses as a result of the Company’s financial performance during the quarter, and lastly increased variable operating expenses resulting from the strong double-digit increase in organic sales.

Adjusted EBITDA increased 45.1% to $54.6 million in the second quarter of 2012 as compared to $37.6 million in the same period last year. Proforma for the Magnum acquisitions, last 12 months adjusted EBITDA as of June 30, 2012 was $258.3 million or 23.9% of proforma net sales during that period and $56.4 million increase since December 31, 2012.

GAAP net income for the second quarter of 2012 was $9.3 million as compared to $15.3 million for the second quarter of 2011. Current year net income include the pretax charge for refinancing related cost of $11 million and a normalized income tax provision of $6.4 million.

As previously announced, on May 30, 2012, the Company completed a refinancing of its senior secured credit facilities, pursuant to which it has incurred $900 million of senior secured term loans to replace its prior $575 million term loan facilities.

Additionally, the Company obtained $150 million asset-backed revolving credit facility to replace its existing $150 million unfunded revolving credit facilities.

The new term loans will mature in 2018 with interest accruing at LIBOR plus 5% with the LIBOR floor of 1.25%. The new revolving credit facility will terminate in 2017 and interests will accrue on drawn proceeds using availability-based pricing grid starting at LIBOR plus 2.0%.

Following the refinancing, the Company use the remaining proceeds from the new term loans along with cash on hand to fund a special cash dividend to stockholders of $6.00 per share and to pay related financing fees and expenses. The special dividend which paid on June 29, 2012 constituted a declared amount of approximately $408 million in aggregate of which $404 million was paid in the quarter.

As a result of the refinancing transaction, a non-recurring charge of approximately $11 million was recorded during the second quarter of 2012 related to financing cost and other related expenses.

Due to higher debt levels and cost of debt from the refinancing, interest expense in the second quarter of 2012 increased to $9.9 million as compared to $5.9 million in the same period last year.

With regards to income taxes, the second quarter of 2012 include the impact of a normalized effective income tax rate of 40.5% as compared to a tax rate of 0.6% in the prior year second quarter.

As we have discussed during the last two earnings calls, until the fourth quarter of 2011 a full valuation allowance was recorded in the Company’s net differed tax assets resulting in substantially no tax provision.

In the fourth quarter of 2011, it was determined that a full valuation allowance was no longer required on the Company’s net differed tax assets. Therefore starting in the first quarter of 2012, a normalized income tax provision has been recorded.

Looking forward, we continue to expect the full year normalized tax rate in the 38% to 40% range during 2012. More importantly though, this expected tax provision rate is virtually all not cash in nature as we will continue to realize significant cash tax savings primarily from the step up on asset basis and NOL carry forwards relating to the 2006 change in control transaction and to a lesser extent the recent Magnum acquisition. As a result, we believe we will not be paying federal income taxes for the perceivable future which is why we only reflect cash taxes in our adjusted net income calculations.

Adjusted net income as defined in our earnings release increased to $39.9 million versus $27.7 million in the prior year of second quarter. The strong increase in adjusted net income is attributable to improved operating earnings during the second quarter resulting from the 48.2% increase in revenue, including the incremental results from the Magnum acquisitions partially offset by higher interest expense due to the refinancing of the Company’s credit facilities.

Diluted net income per share for the second quarter was $0.14 compared to the $0.23 per share in the second quarter of 2011. Diluted earnings per share for the second quarter of 2012 include the net $0.25 impact from the aforementioned items relating to the non-recurring refinancing cost and normalized effective income tax rate. Adjusted diluted net income pre share as reconciled in our earnings release was $0.58 for the current year quarter compared to $0.41 per share in the prior year quarter.

Free cash flow defined as net cash provided by operating activities less CapEx was $17.8 million in the second quarter of 2012 as compared to $13.5 million in the same period of last year.

Strong operating earnings were partially offset by increased working capital investment driven by seasonal finished goods inventory replenishment and additional raw material safety stock for rapid demand response. Free cash flow over the past 12 months was $187.3 million, representing a conversion of 90% of the adjusted net income reported during that period.

As of June 30, 2012 we had $895.3 million of bank debt outstanding, net of unamortized original issue discount and $10.3 million of consolidated cash and cash equivalents on hand resulting in consolidated net debt of $885 million.

Our consolidated net debt to LTM adjusted EBITDA leverage ratio at the end of second quarter was 3.4 times on a proforma basis as compared to 4.5 times net debt leverage ratio at the time of our IPO in February 2010 and a 2.0 times net debt leverage ratio at the end of the previous quarter on March 31, 2012.

We’re confident in our new capital structure will allow us to further invest in our future organic growth initiatives and will provide the flexibility for potential acquisitions.

With that I now like to turn the call back over to Aaron to provide some additional comments on our updated outlook for 2012.

Aaron Jagdfeld

Thanks, York. As a result of solid execution in the second quarter of 2012 and an increased outlook for residential sales for the third quarter, we were revising upward our sales guidance for full-year 2012.

Full-year total net sales are now expected to increase in the low-20% range over the prior year, which represents an increase from the high-teens growth rate previously expected. The higher revenue outlook is primarily attributable to an expected increase in portable and home standby generator shipments as a result of the recent power outage events that occurred in the Midwest and Mid-Atlantic regions in late June and early July.

As one of the keys with our previous guidance our revise guidance assumes no material change in the macroeconomic environment and no additional major power outage events during the remainder of the year.

Despite the fact that there have been a number of recent data points that suggest a clearly more cautious tone for commercial and industrial markets for the remainder of 2012, our sales outlook for our C&I products for the full year remains largely unchanged. And we continue to expect a low single digit organic growth rate for the year on a proforma basis assuming Magnum was included in our results for all of 2011.

On an as reported basis, we expect our C&I products to be up in the high 40% range for the full-year of 2012. Specifically for residential products, we expect shipments for full-year 2012 to increase approximately 10% over the strong comparison in 2011.

Consistent with our previously issued guidance, gross margins are expected to be approximately flat for full-year 2012 when compared to the prior year. The unfavorable mix impact of adding Magnum products is still expected to be offset by a higher sales mix shift towards home standby generators and a lower mix of portable generators.

Additionally, the realization of price increases, improved manufacturing overhead absorption and commodity cost moderation should also impact gross margins favorably for the full-year 2012 in comparison to the prior year.

Also inline with our previous guidance, as reported consolidated operating expenses as a percentage of net sales excluding amortization of intangibles are expected to be slightly higher as compared to 2011 as we continue to invest in our infrastructure to support our strategic growth initiatives and our overall higher level of sales.

As a result of our improved sales outlook, we have also raised our guidance for adjusted EBITDA for the full year as we now expect an increase in the high-teens range over the prior year, representing an increase from the mid-teens growth rate from our previous guidance.

As previously announced of the refinancing of our credit facility during the second quarter, we are also reiterating our guidance for interest expense for full-year 2012. We expect interest expense to be in the range of $49 million to $50 million which includes approximately $45 million of debt service cost at current LIBOR rates plus approximately $4.5 million for differed financing cost and original issue discount amortization for the new credit facility.

Interest expense during the third quarter of 2012 specifically, we expect the full – which is the first full quarter under the new capital structure is expected to be $17.1 million to $17.3 million which includes approximately $1.5 million of differed financing cost and original issue discount amortization.

In closing, we believe our second quarter results clearly provide further validation of the powerful growth drivers for our business. Execution on our Powering Ahead strategy is leading the revenue growth and overall diversification in our business. We would continue to grow the Company’s top line to product innovation expanded distribution and increased awareness for our products.

When considering all of these factors combined with our competitor advantages and our intense focus, we believe Generac is well positioned to capitalize on the expected increase and demand for backup power.

This concludes our prepared remarks. Thank you again for joining us today at this time. We would like to open up the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And your first question will come from the line of Mike Halloran with Robert W. Baird.

Mike Halloran – Robert W. Baird & Co.

Good morning guys.

Aaron Jagdfeld

Good morning, Mike.

York Ragen

Good morning, Mike.

Mike Halloran – Robert W. Baird & Co.

So, on the guidance side a lot of color there, I appreciate it. Just could you give us a sense qualitatively for how much of that increased on the revenue side fell into 2Q and how much you expect to come into the 3Q?

Aaron Jagdfeld

I think the bulk of it is something we’re looking out of 3Q. Obviously we…

York Ragen

Yeah. I think there was a little bit of a beat in Q2 as – from our prior guidance. So the bulk like…

Aaron Jagdfeld

A lot of that, Mike, is a result of the events that occurred, event I think it happened the night of June 29, our quarter ends on June 30. So there is not a heck of a lot of that event in Q2, it’s mostly in Q3.

Mike Halloran – Robert W. Baird & Co.

And it sounds like but for that the back half of the year guidance is unchanged. Right?

York Ragen

That would be…

Mike Halloran – Robert W. Baird & Co.

On the top line side…

Aaron Jagdfeld

On the top line side, I think that’s the way to think of that, right.

Mike Halloran – Robert W. Baird & Co.

All right. And then on the international side, really good to see start – seeing some wins on that side after the increased investments you guys have made. Maybe you could talk a little bit about what other opportunities like this you see in other regions? Is it a pretty ridge pipeline or is this kind of a one off type thing?

Aaron Jagdfeld

Yeah. I mean basically what we’ve done and this is our approach, I don’t know if it’s exactly the right approach, but it’s our approach and I think it fits what we’re trying to accomplish here. But we’re taking the globe and we’re looking at regions of the globe that fit our products where we can be most competitive and certainly where outages are more prevalent and we just still that down into kind of a roadmap if you will for ourselves to follow. And we started out with Latin America last year as we I think previously described to everybody on the calls. We believe Australia, the New Zealand market is really kind of a fairly logical step, frankly a fairly easy step for us in those markets. You can think of Australia, Australia is a big island. A lot of the housing is kind of towards the costal regions. They do get some severity of weather similar to U.S., the outages aren’t quite – the same frequency levels what we experience here in the U.S., but home values, single family home values actually equips that of the U.S. on average.

So we believe that it’s a market that’s got some potential. Certainly other parts of the world where natural gas, Australia being an area, the world where net gas is very prevalent, other areas of the world where net gas is prevalent, you can think of Russia, the Ukraine, there are parts of Latin America where natural gas is becoming a bigger force in terms of the fuel source. Those are the areas on our roadmap that we’re concentrating on.

Mike Halloran – Robert W. Baird & Co.

Good color there. And then last from me, could you just talk a little bit about how C&I and then the legacy business and as well as separately the Magnum business, how those have tracked through the year and through – specifically through the second quarter? If you have seen signs of slowing on the organic side, those platforms or has it been a little bit more stable?

Aaron Jagdfeld

Yeah, I think it’s a great question. I mean obviously we’re peppered with news from other companies and macro economic news that on the C&I side that this should give us pass and frankly it does. I think we might too – we might take the position that we were a bit conservative early on in our guidance on C&I for the full year. I think we may have suffered a bit for that relative to other companies coming out a little bit stronger out of the gate than we did, but I think the year is playing a bit into our hand relative to – our business is a late cycle business when we talk about stationary products in particular and so we look for some of those things that are early on that are kind of leading indicators across. We saw a few of those things earlier this year, we started issuing that guidance that kind of gave us pause.

The other thing I would tell you, the second half of the year traditionally in particular with national accounts for us tends to be a lighter – first half is stronger than second half generally, because budgets dry up, it’s not always the case, but in general it’s kind of a rule of thumb. So as far as what we’re seeing, I think it’s playing out along those trends. I do think there are some areas of concern relative to – when we look at Magnum’s business in particular, we look at the large national rental houses, just their plans for CapEx spending in 2H versus 1H that obviously gives us a little bit more pause. We think that’s appropriately reflected in our guidance here as we kind of come back out for the second half.

So on the legacy business, I think what we’re seeing there is we still – again as we mentioned we like the net gas space, that’s been I think a nice area of growth, continues to be more aligned what we refer as the optional standby market. So it’s geared towards smaller businesses, those companies for which standby power generation is really a business decision and with net gas being priced appropriately relative to the capital cost of that equipment as well as the operating cost, associated with gas, net gas is really come on strong is I think a very solid way for businesses to protect revenue streams, inventories from spoilage and whatnot and particular in light of some of the outage events that occurred last year.

On the diesel side and with in particular larger projects appear for us anyway looking at our quote book and our quoting activity appeared to be moving out further in terms of the quote-to-order conversion, the things we’re taking longer on bigger projects. So I think that’s fairly consistent with what we heard across the market. I don’t think we’re seeing anything that’s specific at Generac as much as it is, more of a – some uncertainty forming around the market.

Mike Halloran – Robert W. Baird & Co.

That’s fair. I appreciate the time.

Aaron Jagdfeld

All right, thanks Mike.

York Ragen

Thanks Mike.

Operator

Your next question will come from the line of Jerry Revich with Goldman Sachs.

Jerry Revich – Goldman Sachs

Hi, good morning.

Aaron Jagdfeld

Good morning, Jerry.

York Ragen

Good morning, Jerry.

Jerry Revich – Goldman Sachs

Can you tell me, just say a bit more about the opportunity in Australia and how meaningful you see that part of the business over the next three to five years, maybe frame for us the level of investment you’re considering and help us understand that pace of introduction path?

Aaron Jagdfeld

Yeah and it’s a great question Jerry, the one that we’re trying to obviously get our arms around as well. In terms of the market opportunity in Australia, again is what as I said just a minute ago, I think we see it as a very logical step for us and it’s a country rich in net gas. It’s a country with single family home values, but a viable that of the U.S. which is, frankly it’s typical to find markets like U.S. and housing anywhere in the world, Australia probably approximates the U.S. closer than any other market from a valuation standpoint.

And then the fact that they are coastally located, most of the housing that is in populace areas and they do have the severity of weather from strong winter weather to obviously typhoons and things that impact them in their summer months. So 9.5 million homes is the projection for single family homes by 2017. I do think, just if you wind the clock back and you look at what our North America here, it’s taken us some 20, 25 years to get to the point where we’re at a 2.5% penetration. So I don’t think that we went overstate the impact that this could happen to the Company, but I think it’s a very logical step for us to, it’s kind of an entry point to get in this market. We’re doing it through a very well loan distributor who has a lot of locations relative to distribution, 400 dealers in Australia, another 150 in New Zealand.

We think that we picked a good partner here. We do have to figure this market out though, there is no question it’s going to take time sometime to break that out and figure out the best way to sell them in this market. It may not form out the same way as the U.S. market in terms of just the sales process. We have to figure that out how to engage the electrical contractors who’re going to be needed to install the products and things like that. But we’re excited about it. It really represents for all intense of purposes our first major 4A outside of the U.S. We’re going to staff it appropriately. We’re going to have some dedicated resources internally here that will shepherd that market eventually, probably aiming up in the Australian market directly working for us. But right now we’re going to have in the startup phase, the distributor is going to provide really all of the support and the requirements that we’re going to need to launch the products there.

Jerry Revich – Goldman Sachs

And in terms of the residential standby business in the U.S., can you just frame for us where lead times outstand today? And just if you could give us an update on how the Honeywell branded generator program is going?

Aaron Jagdfeld

Sure. So lead times as we said at the end of Q2 or at the end of Q1 excuse me, we’re coming back into kind of the normal range of anywhere between zero and two weeks depending upon the model. I think they really came into full, back to that level in the beginning of Q2 and by the end of Q2 we remained there and in fact here in the beginning of Q3, we remained there even with the outage event. So I mean we don’t see lead times any longer than what they normally are at this point.

As for Honeywell product line, that continues as we said in our prepared remarks we like the trajectory of that product launch. It’s been about a year now since we launched it about three and half quarters here and it’s doing exactly what we wanted to do which was to give us access with this product category to the HVAC market more directly.

Our 4600 dealers are roughly, there is a high concentration of dealer if not all then that are somehow involved with the electrical trade businesses as oppose to the HVAC business. We see the HVAC distribution channels are viable distribution channel for these products and the Honeywell brand is a great way to go after that channel we believe with a brand that’s not specific to anyone HVAC OEM which is the former program that we had in place, which was a good program, but frankly only gave us access to that percentage for the market for which that OEM had share in. So Honeywell we believe is more agnostic as a brand going into the HVAC space and therefore it should give us a broader opportunity set over the long haul, but we like where it’s heading.

Jerry Revich – Goldman Sachs

Okay, thank you.

Aaron Jagdfeld

Okay.

York Ragen

Thanks, Jerry.

Operator

Your next question will come from the line of Christopher Glynn with Oppenheimer.

Christopher Glynn – Oppenheimer & Co.

Thanks, good morning.

Aaron Jagdfeld

Good morning, Chris.

York Ragen

Good morning, Chris.

Christopher Glynn – Oppenheimer & Co.

Again maybe the lead times answers, but I was just wondering what your thoughts out on channel inventory and sell through given the dynamics over the past year and half, maybe some eager beaver channel partners out there.

Aaron Jagdfeld

Yeah. I mean channel inventory as it stands today is we believe probably frankly we’ll like going into what would be – should be the busiest time of the year for us as it relates to standby generators, which as we said on previous comments and previous remarks Chris, standby is not a category of product that’s heavily inventories begin with, but in places where it is such as the wholesale channel, some are larger dealers, some are ecommerce partners, those inventories are we believe probably at a lower level than they would normally be as – more as a result of this latest series of events.

Portable generators are probably and latest channel checks that we had are roughly inline with where we need to be for that. We are ordering – we’re probably a little bit a later than we would like to be there coming into season, so we’re bringing a little bit more stock in just to make sure that we are set for the upcoming season should and outage event curve of the kind of magnitude that we saw last year. We want to be ready to handle that. But I think for right now I would tell you that inventory levels are, if they are not at normal they are maybe just slightly under where they would – where we would want to see them at this point.

Christopher Glynn – Oppenheimer & Co.

It sounds good. And just wanted to try to frame the recent outage events, if I look at the two events last year and the total impact on your business, maybe I had to put a Snowtober at a third and Irene at two thirds and looking at the Derecho, it’s comparable to Snowtober. So I just wanted to bounce that of you.

Aaron Jagdfeld

Yeah. I think you look at the Derecho is, we’re feeling it’s somewhat smaller than Snowtober. I think the thing that Snowtober benefited from the easier term and other situations we acquainted. That event because it follows only eight weeks apart from the Irene event and roughly in the same geographical location, because of the closeness of those two events I think it exhausterbated somewhat the echo effect that Snowtober had and therefore may have made it a bigger event strictly from the impact that it has in our business, right.

I won’t speak to your one third, two thirds relative to the impact, but I would say that if you had the right corner of the events, Irene was the bigger event, Snowtober was in the middle and then I would put the Derecho is somewhere kind of underneath that Snowtober event, you actually can see in same way, but…

York Ragen

Yeah, Chris I think if you look at our revised guidance in terms of total sales where we say previously we’re talking high-teens growth year-over-year and not talking low 20s and that predominantly as we talked about is as the result of some of these major outages we saw at the end of June or early July, they backed a little bit off for some of the Q2 beat, but majority of that upwardly revised guidance is in fact from those outages that you can sort of zero in from that standpoint.

Christopher Glynn – Oppenheimer & Co.

It sounds good, thanks.

Aaron Jagdfeld

Thanks Chris.

Operator

Your next question will come from the line of Jeff Hammond with Keybanc Capital Markets.

Jeff Hammond – Keybanc Capital Markets

Hi guys. Just to follow on the storms, can you just maybe frame how you’re thinking sequentially about the progression just given the storm activity and what you’re seeing around channel inventories and just to kind of frame how the rest of the year shapes up?

Aaron Jagdfeld

Yeah. I think – again and I think Jeff you can kind of look at our revised guidance which we said is mainly the result of this event. So I mean if you wanted to kind of bracket that guidance change as in terms of the impact of that and again I think a lot of that focus more on the third quarter as a result of that.

York Ragen

Right.

Jeff Hammond – Keybanc Capital Markets

So it’s a modest step down from 2Q? 3Q is a modest step down from 2Q and then you stepped out further into 4Q, is that the way to?

Aaron Jagdfeld

No, that’s not the way to look.

York Ragen

I reckon little pop I mean because of – from Q2 to Q3 I think quite a sequential.

Aaron Jagdfeld

Sequentially Q2 to Q3, we would say that would actually improve on the residential side. Again a lot of portable generators were solved during an event like that, it’s the immediate reaction. We do expect an after goal effect as well in those areas with home standby to come over the next six to 12 months.

Jeff Hammond – Keybanc Capital Markets

Okay. And then that would kind of back you into weaker – considerably weaker 4Q I guess.

Aaron Jagdfeld

Well again…

York Ragen

Again relative…

Aaron Jagdfeld

Yeah. If we don’t get the comparable outage events we had last year…

Jeff Hammond – Keybanc Capital Markets

Sure.

Aaron Jagdfeld

As our big events, right, so…

York Ragen

Yeah (inaudible) I think that’s a newer baseline, Jeff.

Aaron Jagdfeld

Right.

Jeff Hammond – Keybanc Capital Markets

Right, nicely above 2010, but certainly step down from the 4Q strength last year. Can you give us the Magnum revenues in the quarter?

York Ragen

Well I guess, I mean what we can say is C&I was up 76%. Organically we still saw some modest growth organically. So the majority of the C&I growth was Magnum. But we did still saw modest organic growth on the C&I side, so I think that’s – to be able to zero in from that standpoint.

Jeff Hammond – Keybanc Capital Markets

Okay. And then can you maybe bifurcate within that 34% growth was portable or home standby and outlier was one kind of notably better or where they both kind of in that range?

York Ragen

They were both – well, as we talked they are both strong double digit growth, so no – I mean there wasn’t like one was way up and one was way down. They both were strong solid…

Jeff Hammond – Keybanc Capital Markets

But there wasn’t one that was plus 45 and one that was plus 15, either.

Aaron Jagdfeld

No.

York Ragen

No.

Jeff Hammond – Keybanc Capital Markets

Okay.

Aaron Jagdfeld

And frankly Jeff I was – the residential business, we really didn’t have any outage events but for the Derecho…

York Ragen

On the last day of the quarter.

Aaron Jagdfeld

On the last day of the quarter, I mean we track outages and in tracking those outages, I mean we’ve tracked them now for three or four years, we saw some of the lowest ratings prior to that event for Q1 and Q2 than we see in a long time. So I mean it was really – it was a very mild winter, so there really wasn’t a lot of winter events. Obviously here in Q3 summer months have been, in particular July has been more active relative to just the kinds of outages. But certainly I think that we’re pretty pleased with our performance and rest given the fact that we just had – we really had no outages for the first six months of the year.

Jeff Hammond – Keybanc Capital Markets

Okay, great. And then just you mentioned kind of the rational for Australia, are there any other obvious markets like Australia and what are kind of – I mean is it management capacities that’s finding the right partner?

York Ragen

Yes. I mean from an obviousness standpoint there are some other markets around the world that we would say kind of approximate what was zeroing or not, whether it’s rich availability of net gas where power quality is an issue and where home values are elevated. But they are more scattered, I mean you get beyond Australia, those – there are pockets of them everywhere around the world frankly. I mean we’re finding them in the Ukraine, we’re finding them in parts of Latin America, the Caribbean, there are some very obvious areas like that that you would expect that had a backup power system, a home standby generator would be something that that would be – somebody would want to obtain.

From a management resource standpoint, clearly that’s always going to be a constraint when you are expanding. It’s back and straight as on the company we’ve added a lot of people over the last 12 months here. Its part of what you see in our operating expense line in terms of maybe not getting the kind of leverage, it’s something we might expect off of that we believe. Those are very live investments to make for our future. We need to make those. Some of its machinery work like what we’re doing here in Australia and going out and doing in other parts of the world, but we also have from a product standpoint you have to develop certain products for local markets, right, we have a very North American centric product offering, it’s highly regulated the North American market. Therefore the product has cost additional into that, frankly it may not be needed in other parts of the world.

So in terms of getting the right product offering, in terms of getting the right distribution partner that you eluted to is also critical. So again we’ve put a roadmap together, we think that we’re going to be executing on that roadmap very aggressively here over the next several years. Australia was a good step, we’ve been hammering away at Latin America over the last 12 months, seeing some good movement there in terms of adding new distribution it’s taking a while to just get that distribution on board which it does again because of you’re spreading yourself better into other languages and other cultures and product mixes and things for those local markets but we’re figuring it out, and it’s going to get – we’ve set all along with the upside with going global is it’s a big upside but if you take a while to get there we’re going to do it as we can in certain countries organically like what we’re doing in Australia and in other countries.

Frankly, it may make more sense for us to look at M&A as a better way to or partnerships or JVs or some other way to get into other markets more quickly. So we’re evaluating all of that and stay tuned, you’re going to see more that from us.

Jeff Hammond – Keybanc Capital Markets

Okay, great thanks guys.

Aaron Jagdfeld

Okay, thanks.

York Ragen

Thank you.

Operator

Your next question will come from the line of Zach Larkin with Stephens.

Chris Godby – Stephens Inc.

Hi, good morning guys, this is Chris Godby in for Zack Larkin, thanks for taking my taking my call.

York Ragen

Hi, Chris.

Aaron Jagdfeld

Hi Chris, good morning.

Chris Godby – Stephens Inc.

Good morning. So first of all thinking about the margin profile a little bit, given the mix impact of Magnum, do gross margin levels going forward feel sort of similar to what you saw in this quarter?

Aaron Jagdfeld

You’re talking the outlook, I mean…

Chris Godby – Stephens Inc.

Exactly, kind of looking forward at your gross margin would you expect levels similar to this quarter given the mix impact of Magnum as this quarter was little bit lower than kind of what we’ve seen historically or what do you expect kind of return to more normal levels?

Aaron Jagdfeld

Well, I think what we’ve been experienced has been the normal level ever since purchasing Magnum, so I think to answer your question I think it’s, it’d be more consistent maybe some upticks here as mix may change a bit but and some moderation, realization modernized, moderation commodities but I wouldn’t expect it to be dramatically different from current levels.

Chris Godby – Stephens Inc.

Okay great. And then also given the significant outage events in 2011 and what you’ve seen so far this year, do you have an estimate as to how penetrate your end markets may become by year end?

York Ragen

Well right now, we’ve been consistent saying it’s about 2.5% of US households, and frankly there are so many US households and everyone percent of penetration and visit the market as we define it relative to our opportunities that is really about 50 million US households. And that’s, so 1% would be 500,000 homes, so that’s a lot of generators I don’t think it’s – and we’re talking in total market as well.

So if we move to 2.6, 2.7 by the end of year that would be – that would probably somewhere in that range but it’s going to take, it takes a lot to move that needle. We see those outage events is great opportunities for us increase awareness on the category, more and more people are talking about home standby generators which is great for the category and it’s something that we’ve – we continue to work on in terms of education, in terms of how we pursue that market with being a lot more direct in our marketing activities, getting a lot smarter in how to sell this product, getting a lot smarter in helping our dealers get a lot smarter in terms of developing those dealers and turning them into the kinds of sales instruments that we need out on the street selling those products but it’s a slog, I mean it takes a while to grow market.

Chris Godby – Stephens Inc.

Certainly, I understand. Thanks a lot for taking my call.

York Ragen

Okay, thanks Chris.

Aaron Jagdfeld

Thanks Chris.

Operator

Your next question will come from the line of Brian Drab with William Blair.

Brian Drab – William Blair

Good morning.

York Ragen

Hey Brian.

Aaron Jagdfeld

Good morning, Brian.

Brian Drab – William Blair

Just wanted to ask couple more questions on Australia actually first, and you mentioned that the penetration rate there is low today. Can you talk a little bit about who the competition is in that market? Why the penetration rate is low and I’m assuming its s lack of effort more than a lack of opportunity. And what sort of distribution networks that competitors have?

York Ragen

Right.

Brian Drab – William Blair

Yeah.

Aaron Jagdfeld

That’s a great question. We see the penetration rate at nearly zero, I mean I’d say it’s frankly there is just not a lot going on there. The competitors who are they’re the same guys that are here in the US, and so, and the way they appear to be going to market and I can’t speak for them directly but the way they appear to be going to market is roughly the same where they’re going to market here. Although maybe a little more heavy reliance on outdoor power equipment dealers as oppose to electrical contractor, so again I think we have a lot to learn about this market, we think that because of our broad product offering, because of our competitiveness and pricing, because of the support that we give our distribution partners from a marketing standpoint and sales standpoint.

We think that we can approach that market similarly the way we approach it here in the US, but we haven’t quite figured that yet but right now it looks like a fairly Greenfield site relative to just not, just a lot of wide space. There is not, there is really nobody else doing anything there, it’s for lack of – probably a lack of focus, lack of effort and frankly the same reason they get low percentages here in the US is probably the same reason they’re getting low percentages there.

Brian Drab – William Blair

Okay, thanks. And one other thing and we were talking to Mike Harris about this recently but I wanted to get your take on it to, how do you think about the impact of a particular outage event with respect to whether there was an outage event in the geography the year before. And for example, we have these outages recently in the Midwest and in the Mid Atlantic states of last year we had Irene and flooding hit those same regions. Is it, would you – would your business be more impacted if there was a similar size event in a different geography or in the same geography the next year?

Aaron Jagdfeld

Yeah it’s really the time delta between events in a particular market has an impact, has a significant impact. And really it’s a compounding effect, what happens is when you get an event in a region where there hasn’t been any significant events in long time and I’m talking about years, years and years. What happens is, and because this category is still so new we often times don’t have their kind of distribution channel that has been built to handle an increase in baseline demand.

So the first step generally when an event happens is building out distribution, frankly. And so it really takes a second event within a couple of years after that even some set, some point whether it’s eight weeks like it was the case with the event in the snow even after Irene or as of the case here it’s eight months after that snow event with this Derecho, that compounding effect it gets magnified because you got additional distribution partners in the market that you didn’t have during the first go around.

So I think that does have a significant impact and so I guess to answer your question more bluntly in a mark, if you get an area and I won’t use in area like Florida because Florida had a lot of events, distribution is pretty well built out of there. If you get an event in Florida, a hurricane or something if that could have a nice impact for the company, not a nice impact obviously for the home owners there but it certainly has an impact on us more positively than it would say an event in some place it hasn’t had a major events in the long time, like it could’ve happened in Kentucky or some other – I’m picking a state but a state where events are not frequently. So that does have an impact and we think that distribution to build on a distribution plays a big role in that.

Brian Drab – William Blair

Okay thanks, that’s really helpful that you’re thinking on that.

Operator

(Operator Instructions) Your next question will come from the line of Stanley Elliott with Stifel Nicolaus.

Stanley Elliott – Stifel Nicolaus

Good morning guys, thank you very much for the time.

Aaron Jagdfeld

Good morning Elliott.

Stanley Elliott – Stifel Nicolaus

Question on expectations for power washers, you talked about picking up some new distribution on the residential side, is there a way to, I don’t know prepackage or package that’s the right way to think about it but with the leading share that you guys have on the portable generator side maybe talk about some expectations for power washer kind of thing as well.

Aaron Jagdfeld

Yeah, so on the power washer product category we reentered that, Stanley, about a year ago now, that was a market that we were very prevalent back in 1990s, we built the market frankly, there were others in it at the time but we took it to a different level relative to mass merchants and the DIY retailers and we had a very capable team at that time that did an awesome job with that product category.

We learned a lot, we still have some of those individuals here at the company and when we decided to reenter that category certainly leveraging our position after reentering portable generators was definitely in our math. The channel partners are roughly the same, portable generators are by and large a retail channel game, power washer is the same, a lot of times the buyers – not in all cases, but the buyers for these products at mass merchants is generally the same individual. So we were able to build on some of our relationships there.

And I think probably more importantly what’s, I think that’s a little bit, is the strength of the brand and the brand, the recognition of our brand in that market place it’s been refreshing to see how people have received it. And I think our success in portable generators have given us some creditability in going out and getting back in this market. We feel, we’re feeling pretty good about where we were going with innovating in this category, it’s line review season right now so we don’t have any direct feedback that we can give you about 2013 but we’re certainly planning as if we could end up with some additional market share there, for 2013. Just how much it’s going to be really the result of where these line reviews end up.

And line reviews are tough and our competitors are tough, they’re very good, they’ve been in this market a long time and they dilute ourselves into thinking that we’re just going to come in and take it all.

Stanley Elliott – Stifel Nicolaus

All right.

Aaron Jagdfeld

But we are, I think we’re cautiously optimistic that we are going to be a large player in this market place in the next several years.

Stanley Elliott – Stifel Nicolaus

Very good. And then, just shifting gears talking about acquisition potential down the road, I mean what sort of product categories as you guys are looking to kind of diversify and build out which you’re already have going on. I mean if there is anything to talk about generally speaking just from, just from a pure knowledge standpoint?

Aaron Jagdfeld

Yeah, we don’t comment specifically on the M&A pipeline but I think what we can say is that what would interest us most would be companies, I mean a lot like Magnum when you look at engine driven products that have, well we have the capability to take things that we do well here at a company from manufacturing and operations of global supply and leverage that or areas where we can leverage our distribution with other products. If we can find other product categories that fit well into our existing distribution, we built a very robust distribution pipeline for our products here, so where the products could go into that.

I think generally if I think in terms of engine and power products because that’s a bit of where our expertise lies. I would tell you the area that from an M&A standpoint that we continue to look at as I said in my previous comments would it make more sense geographically to get into some markets through an acquisition. We’re looking at that, that’s something I think is a little bit of a – it’s a bit of a harder step than would be buying a domestic company here to expand into other engine power products but yet I think of maybe at an important step in our development to go global and that’s something that we’re actively pursuing opportunities as they come and we think that the next several years there are some things that could be actionable, depends on where the global economy goes, depends on how our business goes but I think you could look at the Magnum acquisition as really kind of the first four.

We’ve actually completed now three acquisitions in really the last, it would be in the last 18 months and two of them very small, one of them Magnum much larger but we are ramping up a pipeline here and we believe that there is an opportunity to do some more that with the strength of our balance sheet and some of the areas where we want to grow with our strategy.

Stanley Elliott – Stifel Nicolaus

Yeah. And then from a cash flow perspective, what are the expectations for inventories kind of as we finish up the year?

York Ragen

Yeah I mean I think as Aaron mentioned, commenting to the season here at the end of June we seasonally ramp up our inventory levels for the season and then the expectation is we will broke (ph) that inventory down throughout the second half of the year. So should get a positive contribution of cash flow from working capital through the second half of the year as a result.

Stanley Elliott – Stifel Nicolaus

Very good, thanks guys.

Aaron Jagdfeld

I appreciate it.

Operator

And there are no further questions in the queue. I would now like to turn the call back over to Mr. Aaron Jagdfeld for closing remarks.

Aaron Jagdfeld

We want to thank everybody for your time this morning and we look forward to speaking with you on our third quarter earnings call. Thank you.

Operator

Thank you all for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a wonderful day.

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