C&D Technologies, Inc. F2Q09 (Qtr End 07/31/08) Earnings Call Transcript

| About: C&D Technologies (CHP)

C&D Technologies, Inc. (CHP) F2Q09 Earnings Call September 9, 2008 10:00 AM ET

Executives

Ian J. Harvie – Vice President and Chief Financial Officer

Jeffrey A. Graves – President and Chief Executive Officer

Analysts

Michael Gallo – CL King and Associates

John Franzreb – Sidoti & Company, LLC

Todd Cooper – Stephens, Inc.

Richard Baxter – Ardour Capital Investments

Craig Irwin – Merriman Curhan Ford & Co.

Bill Dezellem – Tieton Capital Management

Operator

Welcome to the C&D Technologies fiscal 2009 second quarter earnings conference call. (Operator Instructions) I would now like to turn the conference over to Ian Harvie.

Ian J. Harvie

Let me start by reminding you that this call is the property of C&D Technologies, Inc. Any redistribution, retransmission, or rebroadcast of this call in any form without the express written consent of C&D Technologies is strictly prohibited. Further, as this call is being webcast live and will be made available for a period of time on C & D’s website, this call contains time sensitive information that is accurate only as of the date of the live webcast for this call on September 9, 2008.

This conference call may contain forward-looking statements within the meaning of section 27(a) of the Securities Act of 1933 and section 21(e) of the Securities Exchange Act of 1934. During this call words and expressions reflecting something other than historical fact are intended to identify forward looking statements that are not the exact, exclusive means of identifying such statements. Factors that appear within any forward-looking statement or in the company`s Securities and Exchange Commission filings, including without limitation the company`s annual report on Form 10K for the fiscal year ended January 31st, 2008, and various 10Q and 8K filings, could cause the company`s actual results to differ materially from those expressed in any forward-looking statements made herein.

Now let me turn the call over to our president and chief executive officer, Dr. Jeffrey A. Graves.

Jeffrey A. Graves

It gives me great pleasure to report our second consecutive quarter of profitable operations as we achieve widening profit margins benefitting from our cost reduction programs and pricing strategies.

To put this quarter into context of our four-year plans, our objective for this year is very simple: hold our leading market share position while delivering consistent improvements and profitability each quarter targeting a 20% gross margin run rate as we exit the year. These efforts, which include the launch of several key new products throughout the year, will then position us for continuing margin expansion and, very importantly, accelerating share growth next year and beyond. We’re executing consistently along this path, as can be seen in our second quarter’s results, and have high confidence in reaching our objective.

Last evening we were pleased to report net income of $1.2 million or $0.05 per fully diluted share for the second quarter of fiscal 2009, a doubling of profitability from the first quarter and consistent with the momentum needed to support our year-end objectives. These results reflect the benefits from additional cost reductions, effective management of lead price volatility, and maintenance of our share position in the growing stand-by power market.

A key element of our success is the stability of demand for our products despite the prevailing general economic conditions. As we now focus exclusively on stand-by power and have begun in earnest the re-investment in our new product offerings and operations, there is no doubt in my mind that C & D’s reputation for innovative technology leadership, reliability, and product quality is once again driving strong customer support for our business. Indeed, we exited the quarter with continued positive performance in our book-to-bill ratio, which was up slightly over the first quarter, and an increasing backlog of business showing the effectiveness of our sales efforts and continuing resilience of the in markets. We would expect these trends to continue as our new product introductions gain traction in the second half of the year.

The ongoing improvements in our operating efficiencies and the strategies implemented over the last year to mitigate lead price volatility have also improved our competitive position. For shareholders this has meant significantly improved financial performance with less volatility, as the first two quarters of this year clearly demonstrate.

Let me now review a few highlights of the quarter, then Ian will summarize the full financial results in more detail.

For the second quarter we reported net income of $1.2 million or $0.05 per diluted share. In second quarter, revenues were $92.5 million, up 12% from $82.9 million in the second quarter of last year and down only slightly from the first quarter revenue of $93.8 million. Revenue growth this quarter was driven primarily by pricing, although unit volume was up in all of our markets except for cable television where prior year volume demand had been extremely high. The net effect was essentially flat consolidated unit volume growth for the quarter.

We were happy with the progress achieved in all of our various operating initiatives in the second quarter, but we were particularly pleased with the increase in gross margins, which expanded to 16.9% for the quarter of significantly on a sequential basis from 14.6% in the first quarter. Margin expansion was driven primarily by our cost-reduction initiatives. Margin improvements in both the first two quarters of this year have us on a trajectory to achieve our goal of 20% gross margin exiting this year. We’re expecting continued improvement looking forward from there with margins rising to 25% target exiting next fiscal year.

Keep in mind that, while we have managed to essentially neutralize the impact of lead on margins with our pricing mechanisms, we’re battling rising commodity costs on many other fronts, such as plastics, steels, chemicals, and energy. I take my hat off to all of our dedicated employees who have managed through this highly volatile cost environment to deliver the significantly improved margin performance that we committed to this year. We’re proud of these accomplishments.

Rising input costs demand a disciplined pricing strategy and we remain resolute in maintaining our pricing discipline in this unpredictable commodity cost environment.

While expanding margins are our most immediate path to increased profitability and strengthening cash flows, we’re positioning ourselves for an acceleration of our growth rates and accompanying share rates. These exciting growth prospects stem from the launch of new products which deliver improved performance and longer lives to our customers while filing key product gaps that have existed in our product line in recent years. This presents an exciting vision of growth for our company as we look to the quarters and years ahead.

From an end-market standpoint our largest end-markets, namely telecommunications, utilities, and uninterrupted power supply or EPS systems, remain stable, showing little ill effect from the general economic softness that our economy is currently experiencing. Our best estimates currently show this end-market resilience continuing in the quarters ahead.

We are also pleased with our global expansion rates outside of North America, particularly in the fastest growing regions of the world where significant infrastructure investment continues unabated.

Fuelled by oil revenues, we’re experiencing rapid growth in the Middle East and other oil-rich areas where our strong brand represents technology leadership and quality to our expanding customer base. These regions are investing heavily in a broad range of infrastructure projects as they look to increase industrialization and sustainable long-term growth for their economies. We see this momentum continuing in the future.

In Europe we continue to leverage our relationships with our customers that have a global reach, particularly in the EPS industry, to drive growth at above market rates. Given our historically small market share in Europe, this growth is encouraging and we continue to incrementally expand our sales and distribution network to sustain the gains we’re now making.

Looking to China, where infrastructure investment continues at near double-digit levels, we were reminded with great pride this summer of our selection as the supplier of back-up power for the Beijing National Stadium where the world witnessed a spectacular and historic celebration at the recent Olympic Games. Leveraging the same characteristics that enabled C & D to be a supplier for the Olympics, the second quarter saw robust sales growth in China which translated to continued improvement in bottom line performance in the quarter reaching break-even EBIDTA performance by quarters end. Looking to the future, we intend to further broaden the range of products we’re making available to this large and fast-growing marketplace, driving increased plant utilization and exciting growth rates for this rapidly developing region of the world.

We believe these markets in Europe, the Middle East, and Asia, along with Central and South America, offer outstanding upside growth opportunity at margins that are consistent with our overall expectations for the company.

In addition to our opportunity to grow through geographic expansion, we are also developing new products for both our existing markets and to open new markets for C & D. We’ve already talked about the first wave of new stand-by power products. As you know, in the first quarter we introduced the msENDUR II, our new green battery system targeted at wireless telecommunications and data centre applications. In early August we launched an exciting new line of C & D True Front Access battery systems which are advanced valve-regulated lead acid, or VRLA, batteries designed specifically for telecommunications applications. These C & D True Front Access batteries are one of our first new products designed in cooperation with the major North American telecommunication companies through our Voice of the Customer program.

With this new family of batteries we enter a previously untapped segment of the telecommunications market and an opportunity to expand our already leading North American market share in telecommunications for stationary energy storage solutions. These unique batteries will set a new standard of performance in the industry supporting the build out of new digital fibre optic based systems and the upgrade of existing systems expected to be required to meet proposed increases in minimum backup power standards for telecom.

We’re proud to offer these new products which will address the rapidly increasing needs of our full video, voice, and data digital services customers, setting a new benchmark in battery performance and life while retaining the existing system footprint for maximum customer convenience. Advanced samples of these batteries have been placed with telecommunications operators for early qualification testing. Based on the positive customer feedback that continues to be received, we anticipate rapid market acceptance and expansion of market share in this increasingly vital portion of the telecommunications market as our new manufacturing lines move to full production later this year.

To better frame the opportunity ahead of us with these new products, the C & D new True Front Access product family alone represents an approximate $50 million cumulative incremental revenue opportunity over the next three years. By 2011 they should achieve a run rate of approximately $30 million in annualized revenues in North America alone. Together with the msENDUR II two-volt VLRA product family which we launched in the first quarter, we expect these two major new product families launched this year to provide accumulative incremental growth opportunity of over $90 million over the next three years. By 2011 we expect these two product families to achieve a run rate of approximately $50 million in combined annualized North American revenues.

It’s important to note that these revenue projections do not assume any significant benefit from the new FCC regulations that were issued following the Hurricane Katrina Commission recommendations. These regulations have been in dispute and are as yet not formally implemented. We would expect any new regulations that require longer backup power times to create additional incremental revenue opportunities for these new products.

You should anticipate additional exciting new product announcements from us over the next several quarters as our advanced designs continue to move from the drawing board to the factory floor.

As we move into the second half of the fiscal year we remain confident about the future of our company. We’re entering into the third quarter with a stable to improving book-to-bill ratio, despite the unfavourable influence of decreasing prices produced as a result of contractual lead adjustments through the quarter. Obviously that translates into real-unit volume growth in our backlog. In addition, quoting activity remains brisk in our major end markets. We would expect our volumes to continue to build as a result of our various growth levers. While lower lead costs will ultimately start to show up in our contractually agreed pricing mechanisms, because of our expectations regarding unit volume growth we believe third quarter revenues should remain in line with second quarter levels.

We’re once again pleased by our results this quarter and for the year to date, especially the significant momentum we have generated with improving margins and our consecutive quarters of positive earnings growth.

As we press toward our 20% gross profit margin target the balance of this year we believe we can attractively leverage our stable market share and resilient in-markets into continued value for our shareholders. We appreciate the support and encouragement of our shareholders and the contributions being made by our employees to our success. The fight’s not over yet, but we feel very encouraged by the more normalized and rational market that’s emerging, as well as the new products, new markets, and new geographies that are providing C & D the opportunity to achieve significant future growth.

Now let me turn the call over to Ian to discuss the financial results in more detail.

Ian J. Harvie

Net sales for the second quarter were $92.5 million, up 12% from $82.9 million in the second quarter of last year and essentially flat on a sequential basis compared to the first quarter. We estimate that the bulk of the year-over-year revenue increase was attributable to the impact of pricing of setting higher lead costs.

Unit volume growth was up in the low single-digit range for each of our call markets, except cable TV where second quarter unit volume was down from an especially strong year-ago quarter netting out to essentially flat unit growth on a consolidated basis.

Embedded within these results, our international businesses, including China and the Middle East, were quite strong. For the quarter the company reported net income of $1.2 million or $0.05 per diluted share compared to a net loss of $3.1 million or $0.12 per share in last year’s second quarter. Last year’s second quarter included $4.7 million or $0.18 per share charged for discontinued operations. There were no corresponding unusual items or discontinued operations in the second quarter of this year.

On a sequential basis, financial performance improved by over $600,000 or $0.03 per share and is showing the kind of steady, consistent improvement we have been planning.

Gross profit in absolute dollar terms for the quarter was up 26% to $15.6 million from $12.4 million last year, increasing at better than twice the rate of the revenue growth.

Gross margins were 16.9% in the second quarter versus 14.9% last year. Sequentially, second quarter margins were up from 14.6% in the first quarter. Second quarter margins reflect continuing progress with our cost reduction programs, benefits from pricing, and moderating lead costs. Cost reductions remain centered around new product designs, improved plan efficiencies, and from our strategic sourcing initiatives. As we previously mentioned, we expect to drive margins to 20% exiting this year with the goal of leveraging additional top-line growth to achieve 25% gross margins exiting next fiscal year.

SG&A and technology expenses of $12.1 million were up from $10.4 million in the second quarter last year and $11.3 million sequentially. Driven by higher selling costs such as warranties and commissions, tracking the increase in dollars sales, and increased investment activity supporting our new product introductions and higher incentive compensation costs, including non-cash costs associated with deferred compensation plans.

Interest expense was $2.3 million for the quarter, up from $2.1 million in last year’s second quarter and essentially unchanged from the first quarter. The increase relative to the year ago quarter was attributable to slightly higher debt levels in our China operations.

Minority interests reflecting our joint venture partner share or results of operations in China was $147,000, down from $526,000 in the second quarter last year. This change reflects significant and sustained improvement. We’re very encouraged by our progress in China, where we have benefited from revenue growth and the continued diligent control of costs. With the planned introduction of a broader range of products in that market in the next few years we remain excited about the future growth prospects in this region of the world.

Income tax expense in the quarter was $161,000, compared to an income tax benefit of nearly $1 million in the second quarter last year. Last year’s favourability was primarily impacted by tax allocations related to the company’s para-electronics [sic] division and mode of operations in every classification as discontinued operations. As many of you know, as a company we have significant tax loss carry forwards available to us in the United States and based on current projections do not expect to be a significant cash tax payer in this region in the near term.

Our liquidity position continues to improve. For the quarter, cash flow from operating activities was $2.6 million and $8.3 million turnaround from last year’s $5.7 million second quarter use of cash. The moderating price of lead is beginning to help our investment of working capital, a key management objective in fiscal 2009.

Inventory levels alone are now down $14.6 million from year end. Accounts receivable were also down $3 million since the beginning of the year.

Capital spending for the quarter was $4.9 million, up from $2.5 million last year. We’re now forecasting total CapEx for fiscal 2009 to be between $17 million and $20 million, primarily to support new product introductions and ongoing cost reduction initiatives.

Long-term debt net of unamortized finance costs at the end of the quarter was $125 million, unchanged from the end of the year.

Cash shift was a little under $5 million, just down slightly from the year end and par to fund over a $20 million reduction in current liabilities. In addition, we also had restricted cash balances of some $1.7 million.

Other than utilization for outstanding letters of credit, we remain undrawn on our revolving credit facility at this time with over $35 million in revolver availability.

At the end of August we also executed an important amendment to our credit facility which further improved our liquidity by increasing our borrowing capacity and credit availability by approximately $7 million through changes and modifications to our borrowing base provisions. In addition, we now have $15 million of leasing capacity and $160 million R&B in China borrowing capacity, up from $40 million R&B borrowing capacity previously. That translates to approximately $23 million US dollars or $5.5 million US dollars previously.

The purpose of this amendment was simple. To improve our financial flexibility to support future growth options and in today’s tough credit markets clearly demonstrates the confidence our banks have in the company and in our improving financial performance.

With that we’ll now open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from Michael Gallo - CL King & Associates.

Michael Gallo – CL King & Associates

Jeff, on the volume expectations for the back half of the year, I guess the volumes were somewhat anaemic in the second quarter. I know you alluded to cable being down and some of the other areas being up. I was wondering what we should assume in your forecast for the third quarter in terms of volume versus pricing reductions and whether you expect cable to kind of start to flatten out or whether you think cable will still be a head wind in the third quarter.

Jeffrey A. Graves

Well, I’ll take the second piece first, Mike. I think cable certainly has returned to normalized buying patterns now. They had a tremendous build out last year, off to a very anaemic start in the first half of this year and that’s starting to come back to normalized levels as they got that inventory installed, presumably. So that’s looking encouraging going forward.

The rest of our end markets were growing slightly through the first half of the year. What I would tell you is we expect volume growth to continue through the rest of the year. Obviously with our contractual pricing mechanisms where we have contracts, lead coming down on the LME will flow through on those contracts and impact pricing. So some pricing will come off. We expect that to be fully offset by volume and that’s why we said we would expect total revenues to be roughly flat. So volume will be up, pricing will be off a little bit on the contracts due to the lead flow-through. Obviously we’re doing everything we can to hold pricing wherever we have the option because other commodity costs are up. We’re confident we can offset those commodity costs in order to drive our margin improvement, but from a top-line standpoint we see volumes up, pricing off a little bit on our contract piece, which is significant to us, and that all nets out to roughly flat revenue guidance from here.

Michael Gallo – CL King & Associates

I mean, have you seen any change in the pricing rationality in your competitors? Is everybody still trying to hold price?

Jeffrey A. Graves

No, I think the industry by and large has become very disciplined at this point. I think everybody’s facing the same kind of pressures. We all got pressures on plastics and sulphuric acid and energy costs in the plants. So I would expect everybody’s doing the same thing we are: we’re trying to explain those to customers and hold on to pricing where we can. The lead components that is embedded in some contracts is a pass through. So that has to happen by contract whether it’s up or down. Clearly in recent months it’s been volatile after coming down significantly a couple quarters ago. So that piece of the pricing will pass through. Everything else we have flexibility on. We’re holding on to pricing wherever we can, as I believe everybody is because people are facing the same pressures. So I would net it all out, Mike, and say in markets are nicely stable and growing in all of our core markets. Looking forward, cable’s run down, but we expect that to be flattish going forward as far as we can see right now. So you’ll have an in-market that’s growing not at super rates but at modest single-digit kind of rates will be growing with that market. Our objective has been to hold on to share while we have our margins where they needed to be this year and lost our new products, which will help us gain some share next year. So it’s probably more than you just asked, but we see that all netting out for Q3 either at roughly flat revenue expectations at this point.

Michael Gallo – CL King & Associates

With that you would expect again just steady improvement on the gross margins again.

Jeffrey A. Graves

Yup. Steady as you go. We feel very good about our 20% goal for the end of the year as we exit this year and 25% next year. Fully attainable. With the launch of our new products we feel very good about that and with the reception they’re getting in the market place. All in all we’re looking forward to a nice future here.

Michael Gallo – CL King & Associates

Perhaps I missed it from the prepared remarks, but where were you on the cost-cutting plan year to date? On that $15 million goal.

Jeffrey A. Graves

Well, I can tell you it’s best reflected in the gross margin improvement, Mike. We were up from 14.6% to almost 17% gross margin. Any other details, Ian, that you want to add?

Ian J. Harvie

No. I mean, I think overall we’re on track in terms of the total target and that $15 million all translates basically into the 20% gross margin target exiting Q4.

Jeffrey A. Graves

Certainly, Mike, with no pricing benefits now you can see that rolling right through the bottom line. That improvement is being driven by our cost reduction activities at this point, Q2 and forward.

Operator

Your next question comes from John Franzreb – Sidoti & Company, LLC.

John Franzreb – Sidoti & Company, LLC

I was wondering if there’s been any discussion about reversing course. Some of these contracts are now anniversarying. Maybe reversing the lead pass-through clauses and tightening maybe a pricing more to a fixed-price mechanism.

Jeffrey A. Graves

John, the way luck usually works in this industry as soon as we did that lead would skyrocket again. So no, I would tell you that I think we’re quite comfortable with lead being a pass through in the industry. Up or down it creates an environment that’s very predictable for us and our customers. So I believe they’ve now got their pricing mechanisms aligned with their own customers, we’ve got our pricing mechanisms aligned with them in terms of handling lead, which is the major volatile item to us. So from a shareholders perspective they can be lead now is just a pass through. It may create, if it really loses quickly, some very short-term volatility, but looking out a few quarters it’s a pass through and you can really see the bottom-line performance of the business. So I think we’re comfortable with that. I expect, my guess is, the industry, that’s the way we’ll act going forward.

John Franzreb – Sidoti & Company, LLC

And with cable such a head wind what’s the industries that are offsetting that lack of growth? What are the industries that are doing particularly well for you guys?

Jeffrey A. Graves

Well, you know, I would tell you virtually all of them. Our big three end markets are telecom, wireless and wire line, and we put cable in that as well when we look at the numbers, but wireless and wire line continue to grow. UPS continues to be nice and stable and growing. It’s just been a continual pattern in that end market. And utilities this year has been a nice grower as well. So all three of those, and you kind of view it in the context of the overall economy, these industries have really been very well insulated from the overall economic sluggishness. They’ve continued to grow and expand, and they invest the capital that they saw at the beginning of the year. There’s a couple of companies out there that are in some financial distress that have tightened the reigns a little bit, but by and large that’s been offset by others and the industries all continue to grow. So the only exception for us is we’d had some exposure to cable television, which was a great year last year and has been kind of digesting all that this year, and as I mentioned, it’s flattened down and we see at least some modest growth there looking forward.

John Franzreb – Sidoti & Company, LLC

You know, it’s funny, I just read a piece this morning about the spending in the cable market in Europe and during your prepared remarks you talked about how much overseas growth is important to your strategy. Two questions, I guess. Could you, (a) give us a breakdown of your revenues by geography, and (b) what does that change look like on a year-over-year basis?

Jeffrey A. Graves

You know, I don’t have the numbers split out by specific geographic regions, John. I can tell you historically we always talked about a 12% to 15% kind of international sales number, if you would, outside of North America. That’s certainly growing. It’s probably north of 17% now and heading higher. We’ve continued to work hard at leveraging our brand name and relationship with global customers to actively grow in those regions. We’re hiring some sales folks. We’re putting in distribution centres. I would tell you all of those regions are growing for us. Every one of them. When I look at sustainable growth, you really don’t know these days what’s going to happen in Western Europe with it looking a little bit more like North America over the years. But in terms of the oil-rich regions, we love the growth there and those are great projects. It’s great growth for us. China is an enormous opportunity with our underutilized plant there that we just built last year we‘ve got a lot of upside in terms of filling that plant with volume. We’ve just got to get the products they need in the plant. That economy looks like, again, coming out of the Olympics, it’s ready to take off. So we’re very pleased with the position and the upside opportunity for us in those. I would again tell you we’re targeting the exactly logical places you would expect. It’s where infrastructure’s being built out. It’s China, for us it is a big factor. The oil-rich regions in the Middle East are big factors because at this point in time they’re investing a lot of money and infrastructure. And we’ll have more on those stories as the year rolls forward and as we really target our international resources in those directions.

Operator

Your next question comes from Todd Cooper – Stephens, Inc.

Todd Cooper – Stephens, Inc.

You’ve done a nice job of talking in generalities, but do you plan to introduce any new metrics relative to unit growth on upcoming conference calls so that we can kind of keep track of that outside what lead is doing?

Jeffrey A. Graves

We will certainly provide as much colour as we can, Todd, on that. What we would tell you right now, and it’s been consistent for the last quarter and probably earlier, is we would expect kind of mid-single-digit kind of growth rates, maybe a little more mild than that, but those kind of growth rates in our end markets and we believe we’re holding our share. So we can expect those kind of growth rates going forward on a volume basis. As far as we can see into next year, we think at least the markets will continue that kind of growth rate. I would tell you we expect to be growing faster than market growth rate next year with the new products we’re introducing. So if you wanted to say, you know, low to mid-single-digit kind of range for the rest of this year moving to a doubling of that kind of number next year, that’s what we’ve been talking about, I see no reason to change that outlook right now.

Todd Cooper – Stephens, Inc.

And on that keeping score thing, can you quantify the cost savings during the quarter as you target the $15 million for the full year? What did you actually achieve this quarter?

Ian J. Harvie

Todd, I would say approximately, we talked in the first quarter about $2.5 million, so I would say in the second quarter it was more like $3.5 million. And that gets us to the sort of run rate if you like by Q4 and I’ll call it a $5.5 million level. So it ramps up sort of $2.5 million, $3.5 million, up to $5.5 million by the end of the year. That’s how you get to the $15 million.

Todd Cooper – Stephens, Inc.

Ian, what was the average price of lead during the quarter?

Ian J. Harvie

The average, I’ll call it LME price was $0.91. They’re about, that compares to about an average LME price in Q1, $1.35. So clearly it would, being on [inaudible] returns, clearly we’ll get low lead costs coming through our PNL in Q3, but as you know, a lot of our contracts and arrangements now have lead clauses, so our pricing adjusts similarly. So that pricing impact in Q3 in terms of that lower lead is quite large and that also supports, given we’ve indicated an overall flat or call it to in line sales number for Q3 with Q2 that there is some significant volume benefit there too still coming through.

Todd Cooper – Stephens, Inc.

Certainly the way that the delay in the mechanisms work, the biggest impact on the lower lead prices would be in Q3.

Ian J. Harvie

Correct.

Todd Cooper – Stephens, Inc.

And SG&A expenses went up a fair amount in the quarter. Was there anything in particular behind that?

Ian J. Harvie

Yes, a couple things, I guess. First one would be, you know, clearly we had some costs associated with some of these new product launches and product introductions, including the front access battery in terms of product testing, etcetera, and qualification. Warranty and commissions were up in the quarter versus last year. That’s somewhat driven because they both sort of get approved or tracked or paid out as a percentage of sales. So with sales being up $12 million quarter over quarter that had an impact on those accruals and reserves. And deferred compensation costs were up quarter over quarter, including the impact we have a deferred compensation plan that’s sort of, I’ll call it non-cash, but with the increase in our stock price there’s a non-cash impact of, I’ll call it, if you like, revaluation of that liability on our balance sheet. So they were the three principal drivers.

Todd Cooper – Stephens, Inc.

And any guidance for the third quarter on the SG&A line?

Ian J. Harvie

I mean, clearly the product introduction costs and launches, you know, I would hope that some of those don’t repeat. Clearly the incentive comp depends a little bit on our stock price. That was a reasonably large impact on the quarter at nearly $400,000. Otherwise I think, you know, it’s probably going to be at a similar level absent those two items.

Todd Cooper – Stephens, Inc.

Okay. And Jeff, one last one, if I might. The cable television market, you say it’s flat. Are your sales really specifically for voice over IP applications or are the battery sales for other CMTS, Doxis 3.0 Video [sic], any other type of application that’s capable operators might be operating?

Jeffrey A. Graves

I would tell you it’s probably all of that, Todd. I don’t see any change very much in the product mix than it was historically. Just more of it. They went through, I think when they went into it – and this is speculation on my part – when they moved into the voice component to compete with the other telecom companies there was a requirement to do a fairly significant refresh and built out of their system. So they went through a lot of batteries last year in doing that. This year has returned to more normal maintenance levels as they have digested that. We’re seeing kind of an uptick in volume here. Again, it’s kind of back now to what we would say are historic buying patterns. So I think looking forward it’s up quarter over quarter rather than down, but it’s not streaking back toward last-year levels at this point either.

And Todd, just back on one of your prior questions. I think you’ve spent a lot of time trying to understand lead costs and pricing and all of that flow through. I think you’ve done a nice job with that and your comment, and the reason that we feel pretty good about Q3 is your comment about the timing on pricing impact is accurate. That’s why we feel good about saying revenues should be at least flat next quarter because we’ve got a majority of the pricing impact rolling through and we’ve got volumes up. So we feel good about the resilience of the in markets, we feel good about our sales effectiveness and our rising volumes looking forward.

Operator

Your next question comes from Richard Baxter – Ardour Capital Investments.

Richard Baxter – Ardour Capital Investments

I guess I have a question on the update on the China operations. You’d said that previously there’d been significant capacity expansion ability and I was just wondering a little bit about, if I could hear some more on the strategy to build out the plant, I guess. The product mix or the market roll out.

Jeffrey A. Graves

Just to kind of recap, we built a large plant last year which we finished off last year. That plant was really built very large in order to accommodate a fair bit of export back to North America and sales growth into Asia and largely into China. As we got about mid-way through building that plant the Chinese changed the tax law, the currency appreciated, and it put tariffs on lead, all of which made it more economical to build those batteries in the states. So we’ve expanded in Milwaukee and other places back in this geography to accommodate the growth we see in North America. What that meant was the plant that we finished, which is again the most modern industrial battery manufacture plant in the world, in China, is now solely committed to growth in Asia. What that translates to for a short period of time is underutilization. We got a lot of fixed costs and we’ve got a plant that’s not very full. Now it’s been ramping nicely and continues to ramp nicely. Because that plant was built around only one or two products we need to continue to put new products into the plant. We’ve got all the designs completed, they’d be very much like the products that we’ve rolled out here in North America, so we’ve largely got the designs completed and we need to put them in the plant, expand the production capability, and we need to expand our sales activity over there.

I would tell you the growth rates are fantastic, but it’s coming off a small base. So it’s going to continue to take quarter-over-quarter execution there to get the plant full. But we built that plant to be basically the largest or one of the largest in our systems capable of doing $1 million to $2 million worth of revenue when it’s full utilized. So today it’s on the order of thirtyish. So we’ve got a lot of growth potential, we’ve got a lot of better absorption capability over there. I was very proud that we got to break even EBIDTA by the end of the quarter, that was a good first step. Now we have to continue to grow our sales activity and put more products in that plant to continue the momentum.

Richard Baxter – Ardour Capital Investments

I mean, sort of looking at milestones there, break even EBIDTA is one, obviously a good one. Are there other ones we should be looking forward to on this one?

Jeffrey A. Graves

Oh, I think it will just be steady quarter-over-quarter, year-over-year growth. The in-market demand is enormous. It’s a very fractured market. There’s not a lot of dominant players over there. So we’re all trying to create our share of that market, our mind share of the customers and grow in parallel. The in-market growth is fantastic. So it’s really a matter of expanding your sales team and getting the right products in place. I would just expect continued quarter-over-quarter growth. At some point in the future we’ll probably lay out some public milestones for it, but the first step was getting to cash break even and it will be upward from here.

As Ian mentioned, we’ve expanded our capability to borrow in China to support that growth from a working capital standpoint. We’ll put our new products over there, populate and expand the sales team to grow.

Operator

Your next question comes from Craig Irwin – Merriman Curhan Ford & Co.

Craig Irwin – Merriman Curhan Ford & Co.

Great progress on the gross margins. I really want to commend you for that. First question is the higher warranty costs. In your Q you said $600,000 higher warranty costs in the quarter. Can you give us a little more colour around that? Really whether or not you think this is one time in nature and what the products were?

Ian J. Harvie

I think clearly that high warranty costs, Craig, in the P&L relates to the continuing operations to the stand-by power business. As I’ve sort of said, when we talk about the increase in SG&A really I call it two drivers, if you like. With the high sales dollars that was sort of a crude methodology in terms of warranty reserves. As I call it, an expense as percentage of sales, though our expense is higher just as the sales dollars are higher. Inherently it figures that the cost of settling that future potential warranty obligation has a, if you like, higher lead cost component within there. So that’s one driver in terms of the higher expense year on year.

The other areas is just clearly every month, every quarter we continue to update the best estimate of our sort of reserve requirements and true those reserves up. So I wouldn’t necessarily say I see anything one time in nature there, but clearly just reflection in the ongoing business activity.

Richard Baxter – Ardour Capital Investments

I noticed that unit volumes were basically 1% year over year on an organic basis from continuing operations, yet commissions were up $300,000. I was hoping you could give us a little more colour on how you compensate the sales force. Whether they’re compensated based on unit sales or if they get a little bit of benefit from the higher selling prices with higher lead in there.

Ian J. Harvie

I guess just a couple comments that I’d make and then if Jeff wants to add anything. Clearly there’s some mixed differences in terms of which channel we’re selling through that can have an impact in terms of their commission expense. So if we’re selling more through, I’ll call it the rec channel, if you like, there can be some impact there on commissions. Inherently, commissions generally do run more as the percentage of sales, so there is some benefit there including something that we continue to look at in terms of the way that compensation philosophy is invoked.

Jeffrey A. Graves

Yes, I would tell you, Craig, that the other piece of this, it really strikes me, I guess I’m here three years now, it really strikes me we’re rolling out new products at a faster rate than I think this company has in many years and we’re stressing these guys a lot. We’re trying to push very hard on the sale of new products, the technical education, if you will, of the sales force out there to understand why the products are superior, what technically allows them to divest, to save at. Those kind of details. That requires a little bit more time on their part. It most probably leads again through mix effects, as Ian pointed out, to a richer product mix and a higher commission level for the folks in the field.

Certainly as the pace of new products rolls off at some point that component should come down, but you can clearly see we’re throwing an awful lot at them with this host of new products we’re rolling out.

Craig Irwin – Merriman Curhan Ford & Co.

And then regarding the new products, NEBS [sic] certification of those products, I understand it’s very expensive. It can cost sort of $500,000 to $1 million easily. I was wondering if there was a timeline for NEBS certification of the new product groups that you’re rolling out and really whether or not we should maybe view that R&D expenses associated as sort of one-time in nature.

Jeffrey A. Graves

Yes, yes, it is. We would embed that in our SG&A costs, Craig. That’s certainly represented in Q2. That’s good you picked that up. NEBS certification is a big barrier to entry in terms of newcomers coming into the market, so we like that. We’re very rigorous certification requirements. It does take time and we work through that like on the msENDUR for wireless telecom, we pounded away on that for probably Q1 and Q2. We got all of the certifications completed, all of the costs were borne, all of that would be embedded in our SG&A looking backwards.

Operator

Your next question comes from Bill Dezellem – Tieton Capital Management.

Bill Dezellem – Tieton Capital Management

First of all, are there further product gaps that you are wanting to fill with the new product introductions that you referenced will be coming in the future quarters?

Jeffrey A. Graves

Yes, Bill. Absolutely. The biggest one we just filled. The one, I would tell you the move to this front access telecom product has been coming for a while and, to Craig Irwin’s question that just followed, it takes a while to get through all the qualifications and certifications and everything coming out. So the msENDUR worked its way through that in Q1, the front access product is working its way through that right now. That was a big gap for us and that’s one that we’re very happy to have this product now coming out. Customers like it and we’re about done with the certifications required to go and effectively sell it as we ramp production later in the year. That was a big one for us.

There is an opportunity to take that basic design and develop some sizes and configurations that are more appropriate for international telecom business or global telecom business, if you will, with the OEM players that are selling not only in Europe, eastern and western, but in China and India. Those designs will be coming out, I would consider that a product gap, if you will, because we haven’t serviced those guys before.

On the flooded side we’ve got some smaller gaps there, but we still have some gaps that we’re planning to fill as well. So those gap filling ones are great because we don’t bear any more sales costs, or at least not any significant sales costs, and we can take our share of the market up higher than it even is today.

Bill Dezellem – Tieton Capital Management

And relative to your future progression of UPS, would it be fair to interpret your comments on this call that it would be incremental going forward probably each quarter as opposed to some large step function or a springboard in any particular quarter?

Jeffrey A. Graves

With regard to what?

Ian J. Harvie

With regard to earnings per share?

Bill Dezellem – Tieton Capital Management

Yes.

Jeffrey A. Graves

Of UPS? Yes, I think you can expect, what you can expect, Bill, is quarter by quarter systematic improvements in earnings. Again, we’re very comfortable with the objective we laid out at the beginning of the year in terms of our gross margins at the end of the year. I think we’ve talked a bit about the other cost cutting components, so you can get to modelling the business pretty effectively. But the number we continue to throw out is our regular systematic growth to 20% gross margin, which should translate directly into UPS.

Bill Dezellem – Tieton Capital Management

And a completely unrelated question. I don’t know that I have heard you all talk about this at all. But, wind farms. To what degree is stand-by power an opportunity in the wind farms? It would seem to me, and I’m a real novice at this, but it would seem to me as though there are times when the wind farmers are producing more electricity than can be consumed and then there are times when the turbines are not turning and it would be nice to have some that’s not there.

Jeffrey A. Graves

Yes, if you look at renewable, Bill, divided into two camps. You’ve got solar, for which batteries are an integral part of the system. Okay? They’re always sold with the system. They’re replaced. That’s, clearly batteries benefit from the expanded solar applications. From a wind standpoint, historically wind turbines have been wired directly to the grid. They’re generally only run in the day time when the grid really needs power. That’s been a historical use of them. If you look at a much expanded use going forward, which is what everybody talks about, at some point you’d want to run those 24 hours a day and you can envision, and at that point if the grid doesn’t need the power you’d envision storing it in a storage facility of some type. Lead acid batteries have traditionally been one of the least expensive and most reliable ways of doing that, so the logical progression would be as the country uses more and more solar power – and not only the United States, but every country in the world that’s reliant on buying oil from outside of its borders – as wind farms become more common and large people are going to want to get every ounce out of them that they can, which means storing the energy with some means. Now, our bet would be that will be lead acid batteries and it could be a nice thing for us. I would tell you wind today is obviously a very small component of our country’s energy generation, so not really a factor. But given our position with the utility companies, our market share with the utility companies, I am excited about that. I’d love to see that trend happen and I think we’d be well positioned for it if it did.

Bill Dezellem – Tieton Capital Management

I may be going too far down the path for this call, so tell me if you’d like me to stop, but is it more cost effective to double a wind farm’s size or more cost effective to run the 12 hours at night by adding battery power?

Jeffrey A. Graves

I would think better utilization of the capital you’ve already spent. Running them at night is probably a good thing. It depends on how much, obviously, the storage means costs and all of that. And frankly, Bill, I don’t have an answer for you. I haven’t done the analysis. It would be more at a generation company level that you’d have to see that kind of thing. I’d be shocked if people weren’t doing the studies and publishing reports though as we speak.

Operator

And at this time we have no further question.

Jeffrey A. Graves

In closing I’d like to thank our shareholders for their continued strong support. Over the last few months Ian and I have had a chance to meet once again with many of you and we’ve enjoyed having the chance to review the company’s progress and our exciting plans for the future.

As we touched upon once again this morning, our objective is simple: we want to be the best energy storage company in the world. Building up0on over 100 years of experience in stationary power, we look to leverage our leading market share and globally recognized brand known for technology and quality excellence, deliver the highest value to our customers worldwide, and in doing so create attractive returns for our shareholders.

You can continue to anticipate improving profitability as we move through the second half of the year and increasingly exciting growth rates next year and beyond as our new products and expanding global footprint open new revenue streams for our company. We’ll look forward to updating you once again on our progress next quarter. Thanks for joining us today.

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