Motorcar Parts of America's (MPAA) CEO Selwyn Joffe on Q2 2018 Results - Earnings Call Transcript

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About: Motorcar Parts of America, Inc. (MPAA)
by: SA Transcripts

Motorcar Parts of America, Inc. (NASDAQ:MPAA) Q2 2018 Earnings Conference Call November 9, 2017 1:00 PM ET

Executives

Gary Maier – Investor Relations

Selwyn Joffe – Chairman, President and Chief Executive Officer

David Lee – Chief Financial Officer

Analysts

Steve Dyer – Craig-Hallum

Scott Stember – CL King

Chris Van Horn – B. Riley

Brad Noss – Roth Capital Partners

Operator

Good day, ladies and gentlemen, and welcome to the Motorcar Parts of America Fiscal 2018 Second Quarter Results Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] Later we will conduct a question-and-answer session and instructions will follow at that time. As a reminder today’s conference is being recorded.

I’d now like to introduce your host for today’s conference Mr. Gary Maier, Investor Relations. Sir, please go ahead.

Gary Maier

Thank you. Thank you very much. Thanks everyone for joining us for our fiscal 2018 second quarter conference call. Before we begin and I turn the call over to Selwyn Joffe, Chairman, President and Chief Executive Officer; and David Lee, the company’s Chief Financial Officer, let me remind everyone of the safe harbor statement included in today’s press release.

The Private Securities Litigation Reform Act of 1995 provides a safe harbor for certain forward-looking statements, including statements made during the course of today’s call. Such forward-looking statements are based on the company’s current expectations and beliefs concerning future developments and their potential effects on the company. There can be no assurance that future developments affecting the company will be those anticipated by the company. Actual results may differ from those projected in these forward-looking statements.

These forward-looking statements involve significant risks and uncertainties, some of which are beyond the control of the company and subject to change based upon various factors. The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For a more detailed discussion of some of these ongoing risks and uncertainties of the company’s business, please refer to the various filings with the Securities and Exchange Commission.

With that I’d like to begin the call and turn the call over to Selwyn Joffe.

Selwyn Joffe

Okay, thank you, Gary. I appreciate everyone joining us today. As highlighted in our earnings press release this morning, despite industry-wide softness due to various widely discussed factors, we achieved record sales for second quarter even though the sales were adversely impacted by approximately 5% due to certain customer inventory reduction initiatives.

Despite this factor and record sales, we were disappointed that our performance was not inline with historical growth rates. I want to stress however that we remain bullish. Our products are gaining market share. Our new product initiatives are gaining momentum. Our physical infrastructure and human resources are exceptional. And our expectations for accelerated growth are as strong as ever.

We expect our second half of this fiscal year to have stronger sales more in line with our historical performance and strengthening at an accelerated rate for our fiscal 2019 year. We are beginning to see sales momentum return albeit at a moderate pace. We believe that given today’s favorable automotive hard parts statistics such as the age of vehicles, miles driven and the related factors demand for nondiscretionary parts is recovering and will continue to get stronger.

It is important to understand that our adjusted gross margins were negatively affected by a reduction in overhead absorption due to lower purchasing volume and higher returns as a percentage of sales. We expect gross margins will improve as sales volume increases. Our current product categories excluding diagnostic test equipment represent approximately $4.7 billion of the estimated $125 billion U.S. automotive hard parts aftermarket industry. We are aggressively growing our company and we see a lot of growth opportunities on the horizon.

Furthermore with our recent D&V Electronics acquisition, a new market opportunity has been added, which greatly expands our growth potential in a $5 billion global diagnostic market. Diagnostic and testing products complement our already well-recognized value-added client services and are well positioned for fast growth. We believe that revenue growth over the next five years from D&V should be a significant contributor to our overall sales growth.

We are fortunate to have a global footprint and an exceptional management team that enables the company to maintain a competitive cost structure for our existing product lines and to affectively pursue new product line expansion opportunities based on sound economics and quality. Our ongoing focus on acquiring companies and expanding product lines and developing and offering innovative state-of-the-art technologies remains an important component of the company’s growth strategy.

I think it’s worth spending a few more minutes this morning discussing D&V. It is a recognized leader in diagnostics for alternators, starters and stop-start technology testing systems including state-of-the-art benchtop alternator and starters testing systems. These testers are used both in the manufacturing and retail environment. We believe that the North American market for benchtop testers alone exceeds $150 million just in automotive parts outlets.

In addition to the potential for expanding its rotating electrical testing business, D&V is also a leader with respect to new evolving technologies. The company works hand in hand developing diagnostic equipment for OE company applications in the development and manufacturing of electric vehicles and related technologies. In addition, it has developed some unique capabilities for lithium-ion battery testing technology that should have the potential for widespread appeal as batteries are utilized more and more as a power source. We’re excited by the prospects for testing equipment and look forward to keeping you updated on our progress.

For those of you new to our story let me reiterate our business plan fundamentals. First, we are growing our existing product lines. Second, we are launching new product lines leveraging our strong customer relationships. Third, we deploy capital to enhance shareholder value including potential stock buybacks and acquisitions. And fourth, we are committed on a daily basis to be more important to our customers through industry leading value-added customer services. Many of our initiatives are proprietary, so I will not get too specific.

Our first initiative is to build market share in all of our product lines. In fact, I’m pleased to say that we continue to receive new business commitments for each and every one of our product lines. Our second initiative is to focus on launching additional product lines. We are making great progress in this regard. Our third initiative is to deploy capital accretively. Alternatives include acquisitions and stock buybacks. We plan to continue our stock repurchase program and pursue acquisition opportunities whether they are small strategic bolt-ons or a more significant in size.

We have successfully deployed capital at a pretax rate of approximately 29% return on invested capital for the trailing 12-months and we remain committed to further deploying capital effectively as we execute our plans. We have repurchased approximately $6.9 million worth of shares to date. With respect to our fourth initiative have been more important to our customer we continue to make great strides. As I’ve emphasized before we are an industry leader in supporting our customers and this clearly distinguishes us in the industry.

We have committed resources in the areas of evolving technology, education, data management, category management, cataloguing and many other customer support functions. Our investments in these areas are instrumental in gaining increased business and establishing long-term relationships with our customers. In summary, as I noted last quarter, we have significant new business commitments, some of which are ramping up now.

We will continue to pursue new product line opportunities and appropriate acquisitions and we remain optimistic on both fronts. The rotating electrical market at the consumer sales level represents an estimated $2.4 of which we hold an approximately 45% market share at the supplier level, which is generally 50% of the consumer level. We continue to expect growth in this category and all others. There is a $900 million market for wheel hub, which we entered in June of 2013 of which we currently have an estimated 18% market share.

Brake master cylinder is an estimated $500 million market at the consumer sales level, which we entered into in July of 2014. We have an approximately 5% market share in this category. Break power boosters, which we added last year, is estimated to be a $350 million market and we currently hold about a 5% share in this market. Turbochargers is a $500 million market. This technology is emerging in the domestic market and is utilized in both diesel and gas applications. Turbochargers became mainstream in Europe more than ten years ago and the aftermarket in the United States is still in its infancy. Our way of perspective, the European turbocharger market including OE, which was an early adopter of turbocharger technology, is estimated to be more than $5 billion. This bodes well for the future opportunity in the U.S. market.

Today in the U.S. approximately 8% of passenger vehicles have turbochargers, with expectations for significant growth. Approximately 25% of new vehicles sold each year have turbochargers. Turbochargers provide a nice solution to add power to small-engine vehicles while still enhancing fuel consumption. In addition, turbochargers are used in numerous heavy-duty applications, including industrial, agricultural and power sports. This represents a significant opportunity for aftermarket replacement.

Clearly, there’s a lot of growth potential for us in our existing product lines. We see excellent opportunities in all of these categories for us to leverage our footprint and provide value-added customer services, all of which further enables Motorcar Parts of America to continue to enhance shareholder value.

All of our categories are expected to continue to grow as the car population expands and ages. While there are various factors that may influence replacement rates on a short-term basis, as has been the case during the last few quarters, the majority of the approximately 270 million vehicles on the road will require replacement parts in our product categories. When you analyze the average age of vehicles, it is clear that each year for the next three years, there will be growth in the 4 to 7, 8 to 11 and 12-year-plus categories. Please refer to Slide 10 on our investor presentation, which is available on the company’s website.

Demand for our existing product lines will benefit as the average age of vehicles increase. In addition, increased miles driven accelerates part replacement. We believe that the growth of the 12-year-plus vehicle category will continue and will continue to drive repair demand. As the number of cars in the 12-plus-year-old category continues to grow, the failure rates for parts in these vehicles increase significantly, resulting in increased parts replacement. Also, each year, the 12-plus-year category includes more sophisticated and higher-priced parts. We anticipate continued positive contributions as we move forward through the aging cycle.

We subscribe to the theory that it is not a question of whether there is a repair for a vehicle; it is just a question of when. While we have achieved market share gains, we haven’t seen the commensurate revenue gains due to the replenishment softness. Once again, we believe that the softness is beginning to reverse. All of this bodes well for our current and future business. We are proud that our service levels and the quality of our products continue to exceed expectations, which we believe in part has allowed us to gain market share in our product categories. Today, we supply more than 25,000 stores, and our customers continue to gain share in both the DIY and the professional installer markets. We expect continued growth in both segments as we further leverage our award-winning customer service and product quality, coupled with growing offerings of nondiscretionary products.

I’ll now turn the call over to David to review the results for the fiscal second quarter in more detail, and I’ll then provide an update on the numerous initiatives and progress that company has made and then we will open the call up for questions. David?

David Lee

Thank you, Selwyn. I will now review the financial highlights for the fiscal 2018 second quarter, reflecting, as Selwyn noted, record sales for our second quarter. Before I begin, I encourage everyone to read the 8-K filed this morning with respect to our September 30, 2017, earnings press release for more detailed explanations of the results, including reconciliation of GAAP to non-GAAP financial measures, and the 10-Q, which will be filed later today.

Net sales increased 2.7% to $111.8 million for the second quarter from $108.8 million for the prior year fiscal second quarter. Adjusted net sales increased 1.7% to $114.3 million for the second quarter from $112.4 million net sales for the prior year. The adjusted net sales increase of $1.9 million was due to the following.

Rotating electrical net sales increased $1.2 million to $87.8 million for the second quarter from $86.6 million for the prior year. Wheel hub assemblies and bearings net sales decreased $2.1 million to $19.7 million for the second quarter from $21.8 million a year earlier. Net sales for break master cylinders were $3.8 million for the second quarter compared with $3.4 million a year ago. Additionally, the combined net sales for the second quarter for brake power boosters, turbochargers and testers was $3 million compared with $661,000 in the prior year. Tester sales began in July this year in connection with the acquisition of D&V Electronics.

Gross profit for the second quarter was $27.2 million compared with $30.7 million a year earlier. Gross profit as a percentage of net sales for the second quarter was 24.3% compared with 28.2% a year earlier. For the second quarter, gross margin was impacted by return accruals related to new business, higher returns as a percentage of sales, lower purchasing volume impacting overhead absorption and lower of costs or net realizable value of cores that are part of finished goods on the customer shelves.

To further explain, the standard cost of cores at customers’ locations is revalued each quarter, and due to lower core prices, a noncash charge was recorded to cost of goods sold to lower the standard cost. For the prior year second quarter, gross margin was impacted by customer allowances and initial return and stock adjustment accruals related to new business, new product line start-up costs and lower of cost or net realizable value of cores that are part of finished goods on the customer shelves.

Adjusted gross profit for the second quarter was $32.3 million compared with $34.5 million a year earlier. Adjusted gross profit as a percentage of adjusted net sales for the second quarter was 28.2% compared with 30.7% for the prior year second quarter. The current quarter adjusted gross profit as a percentage of adjusted net sales was impacted by higher returns as a percentage of adjusted sales and lower purchasing volume impacting overhead absorption as mentioned previously.

Total operating expenses decreased $169,000 to $13.3 million for the second quarter from $13.5 million for the prior year impacted by $1 million mark-to-market net gains, which offset general and administrative expenses compared to $824,000 net loss in the prior year second quarter, for the change in the fair value of warrant liability. This decrease was partially offset by an increase for D&V Electronics operating expenses.

Adjusted operating expenses increased $1.9 million to $12.9 million from $10.9 million for the prior year impacted by expenses to support our value-added customer service programs and growth as well as expenses for D&V Electronics. Operating income was $13.9 million for the fiscal 2018 second quarter compared with $17.2 million for the prior year second quarter. Adjusted EBITDA was $20.5 million for the second quarter compared with $24.5 million for the period a year ago.

Depreciation and amortization expense was $1.1 million for the second quarter. Interest expense was $3.5 million for the second quarter compared with $3.2 million last year. The increase in interest expense was due primarily to increased use of our accounts receivable discount programs and increased average outstanding borrowings. Income tax expense rate was approximately 39% for the second quarter. Net income for the second quarter was $6.3 million, or $0.33 per diluted share, compared with $9.1 million, or $0.47 per diluted share a year ago. Adjusted net income was $9.7 million or $0.50 per diluted share compared with $12.4 million or $0.64 per diluted share last year.

I will now discuss the results for the six months ended September 30, 2017. Net sales were $206.8 million compared with net sales of $194.2 million for the prior year six months. Adjusted net sales for the six months were $209.3 million compared with adjusted net sales of $206.2 million for the last year. Net income for the six month period was $13.9 million compared with $16.7 million for the prior year and diluted earnings per share for the six months was $0.72 compared with $0.86 a year ago. Adjusted net income for the six months was $17 million compared with $22.5 million for the prior year six months.

And adjusted diluted earnings per share were $0.88 compared with $1.16 last year. Adjusted EBITDA was $36.9 million for the six month period compared with $44.7 million a year earlier. As of September 30, 2017, trailing 12 month adjusted EBITDA was $83.7 million and the average equity and net debt balance was $291.2 million, resulting in a 28.7% return on invested capital on a pretax basis. Our method of calculating ROIC is to divide trailing 12-months adjusted EBITDA by the average equity and net debt balance for the 12-month period.

At September 30, 2017, we had an $18.5 million term loan, borrowings of $36 million on the revolving credit facility and approximately $15.1 million in cash, resulting in net bank debt of approximately $39.4 million. Total cash and availability on the revolver credit facility was approximately $98.2 million at September 30, 2017. Currently, loans outstanding under the $120 million revolver credit facility and our $18.5 million term loan bear interest currently at 3.74%, consisting of LIBOR of 1.2% plus a margin of 2.5%.

At September 30, 2017, the company had approximately $461 million in total assets. Current assets of $144 million plus long-term core inventory at MPA locations of $72 million totaled $216 million with current liabilities of $161 million. Net cash used in operating activities during the three months ended September 30, 2017, was approximately $7.5 million. The $7.5 million cash used in operating activities reflects an increase in inventory for new business, an increase in various prepaid deposits, income tax payments and a decrease in accrued core payment, offset by net income during the quarter.

During the second quarter, the company also repurchased approximately 97,000 shares totaling $2.5 million. As of September 30, 2017, $6.9 million of the $15 million stock repurchase program approved by the Board of Directors has been utilized and $8.1 million remains available to repurchase shares under the authorized share repurchase program. Additionally during the second quarter, the warrant holder exercised their warrant in full and paid us $4 million. As a result of the exercise, the warrant is no longer outstanding, and the fair value of the warrant on the exercise date was $9.6 million. For the reconciliation of non-GAAP financial measures, please refer to Exhibits 1 through 7 in this morning’s earnings press release.

At this time, I would like to detail the components of the $265.6 million long-term core inventory on our balance sheet as of September 30, 2017. As disclosed in the company’s filings, long-term core inventory consists of four categories, including used cores held at the company’s facilities of $40.2 million; used cores expected to be returned by customers of $16.5 million; remanufactured cores held in finished goods of $34.7 million; and remanufactured cores held at customer locations of $176.5 million, which represent a core portion of the company’s customer finished goods at the company’s customers’ locations.

Of these four categories of long-term core inventory, it should be noted that the company directly manages only the sum of used cores of $40.2 million and remanufactured cores of $34.7 million at the company’s facilities less allowance for excess and obsolete inventory of $2.3 million, totaling $72.6 million or 27% of the total balance. The remaining balance of $193 million or 73% represents the core portion of finished goods at the customer locations of $176.5 million and used cores expected to be returned by customers of $16.5 million and is tracked by the company to ensure that we either get a core back or receive payment for the core as a result of a non-return core but the company does not directly manage if or when that core will be returned.

We know that many of you have viewed our recently produced video on the company’s website discussing the dynamics of the core exchange program, and we encourage those who haven’t to take a look. The feedback we have received since the posting of the video continue to be quite positive.

I will now turn the call back to Selwyn.

Selwyn Joffe

Thank you, David. We’re excited about the multiproduct line growth outlook in our business despite the short-term industry challenges and look forward to continued success. As I stated earlier, we have significant new business that is ramping up in the current third quarter. And as such, our sales run rate at the end of the year should exceed our annual guided sales for fiscal year 2018.

Based on negative impact of mild weather experienced during this past winter and related factors such as natural disasters, we are a revising our adjusted net sales guidance to between $445 million and $465 million for this year ending March 31, 2018. This growth represents 4.8% to 9.5%, excluding a $9.3 million revenue gain due to the change in our accrual for anticipated stock adjustments returns for the December 2016 quarter.

Our adjusted gross margin target remains between 27.5% million 30.5% with an updated estimate of $53 million of total operating expenses, reflecting the additional operating expenses for D&V Electronics. In summary, there are more cars on the road than ever before, gasoline remains relatively inexpensive, miles driven is stronger than ever, and we have the best customer base for our products in the industry. We expect to continue to gain share in existing product lines and to introduce new product lines in our hard parts business.

In addition, we have exciting new opportunities to grow our tester business, our financial position remains strong, and our capacity for further accretive growth is excellent. As always, I want to thank all of our team members for their commitment and customer-centric focus on service and for their exceptional pride in all the products we sell and the customer services that we provide. The energy of our team is exciting to see as we continue to push to execute our plans. I thank you for your interest in Motorcar Parts of America.

And now we’ll open up the line for further questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Steve Dyer with Craig-Hallum. Your line is now open.

Steve Dyer

Thanks. Good morning.

Selwyn Joffe

Thanks, David.

Steve Dyer

You’d talked about, in the quarter, there being inventory reduction at one of your customers. And I’m wondering if you sort of see that as a one-quarter thing and that’s starting to improve, as sort of somebody else in the industry had said, or if that’s kind of a longer term thing?

Selwyn Joffe

We’re not really trying to refer to any of our customers specifically, and we don’t want to really get into any granular discussion of any of our customers. I would tell you that in general, that we believe return rates will come down and we think volume is going to go up. And I think, Steve, the important thing there is that we ramped down a little bit on our inventory. I mean, we have ramped up pretty significantly, anticipating a strong year through the end of our fiscal and so that hurt our gross margins. I expect our gross margins to also return to the upper range of our guidance this quarter.

Steve Dyer

Got it. And then the tester business, as that ramps, obviously it’s very early, but how should we think about sort of the revenue ramp there? Do you have – typically, you’ve had a big customer, a bigger order in hand well before you enter a space. And then just maybe what the margins on that look like at scale?

David Lee

Yeah, I think the margins, we are operating margins about – of 17% to 20%, I think our operating margins on normal quarters. And I don’t think that, that will negatively impact that at all. I think we’re going to be the same, same margin profile from the tester business. In terms of the revenue ramp, it’s a little more difficult to predict, but they have made excellent progress in terms of their initiatives on growth. And I expect that next fiscal year, we should see certainly well above 20% growth rates from them and maybe higher.

So it’s a percentage of completion-type business. So they construct these, they don’t recognize revenue, so you have disproportioned operating expenses as you ramp up for new orders, and then you get the revenue recognition a little later. So right now, we’ve had a little bit of an overhang from the operating expenses that they’re incurring. But I mean, their revenue expectation and profile, I think, in the first year, is very positive. And I’m not sure I want to quantify it quite yet, but certainly, off that base, I would say, I’m expecting at least 30% growth from that, at least.

Steve Dyer

Yeah, okay. And then lastly, I just wanted to make sure that I understood correctly. OpEx guidance of about $53 million, and that’s at a fairly – a much higher run rate than you have been on, it implies, and kind of taken in combination with gross margin and revenue guidance, implies sort of an operating margin sort of lower than we have seen in the last number of years. Is that – is all that right? And then maybe some color around kind of what’s driving that?

Selwyn Joffe

Yeah, so maybe I will start with the color, and then David can give you the more granular detail. We’ve got a lot of new business coming onboard. We are ramping up. Part of what we offer is expertise in our product lines. We definitely are ahead of the curve in terms of ramping up infrastructure to make sure we support our product lines appropriately as we launch them. And so there’s a lot of – there’s a fair amount of spend already in that, and that relates to all of our category management and our educational support programs and our field training programs, our cataloging programs.

And again, I think you’re going to see next fiscal year disproportionately higher growth rate for us. And so we’re – I’m a little ahead of my skis on that, but I think it’s important for everybody to understand that’s where our operating gross – our operating expenses have gone on. And then obviously, we made the acquisition of D&V, and sort of half of that growth is in the D&V number. So it’s about 50:50. So David, I don’t know if you want to give more granular – if you could get more granular.

David Lee

Yes, so the guidance we’re giving is $53 million operating expenses for fiscal 2018. We did about $25 million through the first six months, so that would imply about $28 million for the back six months or about $14 million per quarter.

Selwyn Joffe

Yeah, I think one other thing I wanted to point out in it, so – is that we were also – we have just recently got possession of our New Mexico building, and we have a new 400,000 square foot of capacity there. And we’re in the process of doing the FF&E there now and consolidating our freights and logistics. And so, I believe that as we get complete with that, there would be a fair amount of savings in our whole logistics model. And as importantly, our customers are going to be able to have much more flexibility in how they order and the ability to consolidate freight between multiple product lines.

Steve Dyer

Thank you.

Operator

Our next question comes from the line of Scott Stember with CL King. Your line is now open.

Scott Stember

Good afternoon.

Selwyn Joffe

Hi, Scott.

Scott Stember

Selwyn, you talked about, I guess, sales rates modestly or moderately turning back towards normalized levels. Are we talking sell-through at the POS that you’re monitoring? Or are you talking about everything, just whether the selling to your customers and what they’re taking from you right now?

Selwyn Joffe

I am looking at both, Scott. That’s great question. Again, I think, it’s up to our customers to sort of decide on how they want to communicate with their sales. Also, I can’t really comment on the POS sales. But in general for us, and I think it just involves all elements and we’re optimistic that our sales are increasing. And we’ve already seen that.

Scott Stember

All right, and as far as new products last year, there was a weighting of – a significant weighting of some of these new products coming to the market into the fourth quarter. It sounds as if it’s a little bit more evenly dispersed between the two quarters in the back half of this year. Can you maybe comment on that?

Selwyn Joffe

Well, so, the growth in the back half of this year is all organic, and – I mean, it’s all organic even with new products. But the new product revenue, we don’t include – that’s not included in that guidance. So we don’t expect this year to be affected by new product revenue. And again, I don’t want to get ahead of our skis. I mean, we’re continuously working on new products. But I would tell you, the focus right now in the guidance we’ve given you is based on our organic status. We have picked up market share commitments.

We haven’t started shipping all, but in every single one of our categories, so including D&V. So we’re excited about that. And then if new products come, I mean, that’ll be more value add to that story. But that’s not part of the reason that we’re forecasting the back half growth. I mean, we’re seeing the back half growth by increased replenishments, increased market share in every product line.

Scott Stember

All right, when taking all of these factors into account that you guys talked about for the – at least for the bottom line for earnings, can you just talk about growth expectations, which quarter – is this more of a fourth quarter event? Or are we starting to talk about a resumption of earnings growth in the third quarter?

Selwyn Joffe

Well, I think third quarter is going to be better than the second quarter sequentially. So I think we have growth in both in revenue – and I’m looking at David to make sure I’m saying this accurately. But I think you’re going to see sequential growth in the second quarter and a return to our more normalized margins in this quarter. And certainly, in the fourth quarter, I think it will get more robust. And then hopefully, we’ll see what the weather brings us, but regardless of the weather, we expect a big fourth quarter as well, so moving into the next fiscal year.

A lot of initiatives have been building up. I mean, we’ve had a soft market, unfortunately, it’s being camouflaged. But a lot of initiatives in new market share have been building up for the company. And as we sat and prepared to do this call, I – and I met with our team and went through our status. And I would tell you that as a team and as the CEO of this company, we feel like our outlook is probably as good as it’s ever been.

Scott Stember

Got it. And just last question. David, can you give an update on where you think interest expense will be for the year?

David Lee

All right, so if you look at the interest expense in the second quarter as a percentage of sales, for the back half, that percentage will go up a little bit. We’re seeing interest rate increase a little bit, but it will proportionately increase.

Scott Stember

Okay, got it. Thant’s all I have. Thanks for taking my questions guys.

Selwyn Joffe

Thank you.

David Lee

Thank you.

Operator

Our next question comes from the line of Chris Van Horn with B. Riley. Your line is now open.

Chris Van Horn

Good morning guys. Thanks for taking my call.

Selwyn Joffe

Thanks, Chris.

Chris Van Horn

I just want to dig a little bit deeper into the market share gains you’re seeing and just hope to get a little more color. How are you gaining some of the share? Are competitors dropping out? Is it quality? Is it price? Combination of all? What’s really driving that?

Selwyn Joffe

It’s hard for me to get too granular on that. I mean, obviously, there’s a lot of competitive factors that we are proud of, which has enabled us to win business. But I think if you boil it down to sort of one statement as to why, I think our customers trust us, we are reliable and we send out a great product. And I think we have industry-leading backbone, customer service support levels. And so when you combine that all together, that’s what the customers are looking for. And I think we have some granular competitive advantages. I think our infrastructure is ready to absorb.

We have plenty of capacity to sell. So with the new capacity that we’re bringing on board, I mean, I think we can grow our business significantly. And with the capacity we have in our side pocket that – ready to even further grow, we’re in a position to take on big projects that perhaps others are not willing to or not capable of taking on. I’m not sure. But we have plenty of capability to scale this business, and we want to scale it, and we are going to scale it. And we think we can continue to get the returns that we’ve historically been able to get. And I mean, I don’t know anything more than that. But that’s probably a good question. The rest of the question is probably a good question for the customers. I don’t know.

Chris Van Horn

Okay, good. Thanks for the color. When we think about product line expansion and the opportunity there, you’ve definitely done, like, complementary products when you went from cylinders to boosters. How do you – do you look for just the best opportunity for growth or for complementing your portfolio? How do you think about when you think about what you’re going to add?

Selwyn Joffe

Well, I think that’s a two prong approach. I mean, we are busy filtering opportunities that we see just based on market dynamics or statistics out there and that – a lot of that has driven the D&V, electric vehicle and belt starter generator testing capability that we’ve had. We think that there’s – certainly, there’s going to be some growth in the hybrid technology and some growth in electric technology. And we look at what we think we can do in the hard parts, legacy part of the – of our business, which is ongoing combustion engine applications and hybrid technology applications and even electric applications, but – that relate to existing technology.

And then we fold that into customer opportunities. So it’s a matrix of all of the above. And at the end of the day, we are not looking to go into any businesses that don’t return our targeted ratios on invested capital. So that’s – at the end of the day, the ultimate filter is, does it make strategic sense? Are we capable of doing it? Is there market opportunity? And last but not least, I mean, is the return on capital going to be there? Otherwise, we can invest in our stock and other things.

Chris Van Horn

Okay, great. And then finally for me, the guidance, just wanted to see if we can get into, like, some – the puts and the takes that go into that range of guidance, if you don’t mind.

Selwyn Joffe

Yes. So I think the big thing, I mean, again, it gives me heartburn to have to reduce the lower level of our guidance and the top level a little bit. But the first six months certainly were much softer than we had hoped it to be with the – we just – we know we have bigger share, and then we know that when replenishment comes back and which we feel it is, that you’re going to see a disproportionate amount of growth resurrect itself within us. And so on the low end, we’re being conservative.

I mean, there’s no guarantee right now. I mean, it’s a very short period of time that we are assessing our moderate growth on replenishment. But again, I look at statistics, and I’ve been – I think we’re probably one of the first people in the industry that started throwing these statistics out 13 years ago on carpool, car population, failure rates by age of vehicle. And these categories are growing, and these cars are going to stop failing at these – at the rates. And we’re firmly convinced that what we saw is something that’s happened periodically through the industry. And we are firmly convinced, regardless of weather that we’re going to see an increase in replenishment coming down the plank.

We may not – most people or many people may not agree with us, but we’re putting our neck out on the line, and we see it. And I – again, I’m convinced that the statistics don’t lie and that you’re going to see some great growth from us coming forward just in our base products. I mean, I’m not even referring to the new products at all. And the new products will have to stand on their own feet. When we get to announce them, we’ll announce them. But at this point, I’m just referring to our organic business. Sorry for rambling a little bit, but I wanted to give you – make sure you got the flavor.

Chris Van Horn

Yes, that’s great. Thank you, very much for the time.

Selwyn Joffe

Thank you.

Operator

[Operator Instructions] Our next question comes from the line of Matt Koranda with Roth Capital Partners. Your line is now open.

Brad Noss

Hi guys, this is Brad Noss on for Matt.

Selwyn Joffe

Hi, Brad.

Brad Noss

I just wanted to start with the lower revenue guidance. And based on your commentary, it seems like it’s due to more of a sustained underlying industry dynamics. But does a slower ramp-up of new business play into that lower guide at all?

Selwyn Joffe

It’s not that there’s a slower – well, again, yes, there’s a slower ramp, but it’s not based on us being able to ramp because we were ready to do it early. And that’s why you see some of this use of cash going into inventory, which will reverse itself out. But we are ready to roll. But the orders are much slower in coming in than we thought they would be.

Brad Noss

Okay, that’s helpful. And then just in regards to sort of the gross margin pressure that you saw this quarter, would you be able to help kind of quantify the impacts between just, like, the return accruals versus just fixed cost absorption on lower volumes?

Selwyn Joffe

Yes. I mean, I don’t know if we can give it – get that granular. But again, I think that our structure is geared for volume and growth that we anticipate. And so the lower purchasing volume certainly affects the number of units that you allocate your overhead to, and so that played a big part in it. And then if you don’t have the replenishment, returns are out there whether the market has the product that they have.

And so whether your sales are up or down, there’s a certain level of returns that are going to come in. And I think the inventory adjustment initiatives in general throughout the supply chain are starting to mature maybe is the best way to describe it. And I think, I mean, again, I think customers are going to see the opportunity for increased POS sales. And my belief is that those initiatives will have seen their way through pretty – in the near future. I don’t think it’s completely over, but I do think that they’re minimizing.

Brad Noss

Okay. And then just based on some of the margins in the past couple of quarters, I mean, has there been any new business that’s weighed on margins just from a mix perspective or anything like that?

Selwyn Joffe

No. I think the fundamentals of our business are the same. It’s strictly relating – the margin pressure is strictly relating to the volume and the returns. I mean, that is really the big drive. We set up some big accruals as well for the new business. I mean, that’s in the adjusted number. So anytime we take on business, we got to set up a warranty accrual. And those expenses have come upfront before you start to recognize any revenue from that business.

So, I mean, that we’ve adjusted out, but over and above that, it’s really – it’s the return rate because of the sales – for the most part because of the sales and some inventory reduction and clearly an overhead absorption. And my instinct now – and it’s very early in this quarter, but my instinct and the statistic that I look at show that, that should reverse out to a more normal higher – but still within our guidance right now but at the higher within our guidance right now but at the higher levels within our guidance, starting with this quarter and, again, hopefully continue on.

Brad Noss

Okay. And then just in terms of that, the confidence that you think you’ll be able to get better margins in the second half of this year, can you just expand on exactly what you’re seeing for production or in regards to customer return activity that – so far that leads you to believe there should be a better margin profile for the second half?

Selwyn Joffe

Well, yes. What I can tell you, we’ve turned purchases back on. I mean, we’re seeing demand, and we’ve turned that back on. So we know that there’ll be more volume of the product coming in. And we’ve ramped up, and we’ve turned production back on, not 100% to where it’s been, but we’ve turned it back on. And so again, I mean, we’ve lowered our guidance for the back six months, but we’re cautious. But if you look at the next 1.5 years or 2 years out for us, we’re going to need a lot more product than we got right now. So we’re back ramping up.

Brad Noss

Okay, perfect. And then just I think one more here for me. But just in regards to the ramp on the new rotating electrical business in the second half, I believe $25 million annualized is sort of the figure to think about there. Can you just give us some more color on how that ramps and what that implies for rotating electrical growth in the second half?

Selwyn Joffe

Yes. And again, it’s hard to quantify again what it is. But I mean, I think using $25 million as an example, which is not certainly a reasonable expectation, but that’s beginning to ramp now. So we’re shipping, and we – again, we have multiple customers where we have picked up share. So it’s shipping and not only in rotating electrical but across the board.

Brad Noss

Okay. And so would you think that it should be almost fully ramped this quarter? Or would it still be a stronger Q4?

Selwyn Joffe

I think at the end of this quarter, we’ll be fully ramped, yes. And I think it’s – I mean, we are ready to – we have all the business that we – in certain of these customers that we’re going to get. It’s just a question when do the ordering patterns ramp. So – but we’re convinced that it will by the end of the quarter.

Brad Noss

Okay, thanks guys I’ll step back in queue.

Selwyn Joffe

Thank you.

Operator

[Operator Instructions] I’m showing no further questions in queue at this time. I’d like to turn the call back to Mr. Joffe for any closing remarks.

Selwyn Joffe

Thank you very much. We appreciate everybody’s continued support, and we thank you again for joining us for the call. We look forward to speaking to you when we host our fiscal 2018 third quarter call in February and at the various conferences that we’re going to be in, in the interim. And again, thank you to everybody, and hopefully, we look forward to returning volume as we go down the road. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program, and you may now disconnect. Everyone, have a great day.