Generac Holdings Inc. (GNRC) Q2 2019 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Second Quarter 2019 Generac Holdings Inc Earnings Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Mr. York Ragen, Chief Financial Officer. Please go ahead sir.

Thank you very much. Good morning and welcome to our second quarter 2019 earnings call. I'd like to thank everyone for joining us this morning. With me today is Aaron Jagdfeld, President and Chief Executive Officer. We'll begin our call today by commenting on forward-looking statements. Certain statements made during this presentation as well as other information provided from time to time by Generac or its employees may contain forward-looking statements and involve risks and uncertainties that could cause actual results to differ materially from those in these forward-looking statements. Please see our earnings release or SEC filings for a list of words or expressions that identify such statements and the associated risk factors. In addition, we will make reference to certain non-GAAP measures during today's call. Additional information regarding these measures, including reconciliation to comparable U.S. GAAP measures, is available in our earnings release and SEC filings. I will now turn the call over to Aaron.

Thanks, York. Good morning everyone and thank you for joining us today. Our second quarter results represent a continuation to the strong start we experienced this year in the first quarter and are the best second quarter numbers we've ever had as a company. Strong domestic sales growth of 11% was driven by our residential and industrial stationary power generation markets during the quarter. Overall, net sales increased approximately 9% compared to the prior year when including contributions from our acquisitions which was slightly offset by unfavorable foreign currency impacts during the quarter. EBITDA margins exceeded our internal expectations and were slightly higher year-over-year at 20.6% as a combination of improved product mix, pricing and operating leverage on the higher sales volumes help to more than offset the impact of rising input costs and strategic investments that we believe will provide future growth. EBITDA dollars on a trailing 12 month basis reached an all-time high of nearly $450 million, demonstrating the continued earnings power of the company. Once again, strength in end market demand underpinned the increases in the quarter with interest in home standby generators in particular remaining very robust has increased power outage activity over the last several years together with our initiatives to grow the market resulted in continuing penetration gains. Shipments of stationary C&I products were also significantly higher year-over-year as demand for backup power increased primarily with our telecom customers, which helped to more than offset softer shipments of mobile products as a number of our larger rental customers deferred the timing of certain fleet purchases. Home standby generators continue to benefit from increasing category awareness and remained very strong during the quarter as shipments were approximately 20% higher than the prior year. Both activations and in-home consultations continue to be robust in the quarter and additionally our close rates have been trending higher for the last several years and hit an all time high in the second quarter. Dealer counts also rose to a record level of 6,100 as we continue to add and develop new dealers to increase the important sales, installation and service bandwidth needed to continue to grow the category. We are also beginning to see the number of generators connected on our Mobile Link monitoring platform climb rapidly as it has now been a year since the launch of the industry’s only – first and only standby generator with WiFi connectability as a standard feature. The rich stream of data we are seeing is providing valuable insights with regard to product usage, which allows us to refine our future product development plans. Further, the Mobile Link platform is serving to enhance the customer experience with all metrics clearly showing that the system is adding to the peace of mind that our end users seek in protecting their home or business with a standby generator. Additionally, we continue to build out our fleet platform, which allows our distribution partners to track their entire installed base of machines, leading to improved efficiency and troubleshooting and scheduling of routine maintenance for their customers. We believe that connectivity as a standard feature has been a game changer for our customers, our dealers and Generac and we look forward to greatly expanding this value proposition as we begin to combine the remote monitoring of the generator with our newly acquired energy monitoring capabilities. Over the last two decades, we've invested heavily and worked extremely hard to create the home standby generator market. As our efforts to develop distribution, create targeted marketing and deploy in-home selling processes have dramatically increased the overall awareness and growth of the category. These efforts have helped to build a market that is more than $1 billion annually today and which continues to grow quickly as penetration rates of single family unattached homes in the U.S. are still only at 4.5%. Our estimate is that each 1% of additional penetration represents $2 billion of market opportunity at retail prices. Power outages have steadily increased in frequency and duration over the course of the last 25 years, primarily due to the underinvestment in the electrical grid, which has left it more vulnerable to the increasingly unpredictable and more severe weather patterns that are being driven by a changing climate. In addition to the direct impacts from severe weather that caused power outages, the indirect effects of an increase in the conditions that cause wildfires is creating a much higher level of interest in backup power as utility companies have announced their intentions to shutdown huge portions of their service areas to prevent the catastrophic effects of their equipment, possibly causing a fire. In California where penetration rates of home standby generators stand at less than 1%, we have seen an incredible increase in the number of in-home consultations and other leading indicators that point to the rapid expansion of this market. To date, however, local utilities have done very little in the way of actual shutoffs as the peak season for wildfire conditions generally occurs in the fall timeframe, but we do expect there is a high likelihood that shutoffs will in fact be triggered and millions of customers could be left in the dark for days at a time. As a result, we are proactively working with local residences, municipalities, and several utility companies in the region to position product close to the areas likely to be impacted with specific focus on developing solutions for those most vulnerable to the effects of power outages. We are also working to drive awareness of the home standby category in this part of the country through our new infomercial, which launched several weeks ago, as well as deploying other forms of targeted marketing to promote the category. With historically low penetration rates in California, however, our efforts could be limited in the near-term as we worked to qualify, train and onboard new distribution partners across the state. As is the case with any major power outage event, we know that in addition to increasing distribution, we also need local regulators, inspectors and gas utilities to expand their bandwidth and sense of urgency around improving and providing the infrastructure necessary for this product category. This is typical of any market that is in a development phase and we have dealt with this situation before and we have an incredible team of people working to get the residents of California ready for the possibility of extended outages. In addition to our efforts in this part of the country will be extremely beneficial in helping us grow the market for energy storage, monitoring and home energy management. We took an enormous step forward to accelerate our entry into this nascent but fast growing market with our acquisitions of Pika Energy during the quarter and Neurio Technologies last quarter. The energy landscape is on the verge of dramatic changes in the decade ahead as a result of rising utility rates, grid stability issues, environmental concerns and the continuing performance and cost improvements and renewable energy and batteries. We believe onsite power from a number of potential sources including solar, wind, geothermal and natural gas power generation will supplement or possibly even replace the current centralized utility model over time. The need to manage, monitor and store the power that is generated in this distributed fashion has the potential to develop into an enormous market opportunity and is projected over the next several years to become a multibillion dollar opportunity annually. We believe our recent acquisitions will help us dramatically accelerate the growth of this market and position Generac as a key player as it develops. The combination of Pika's power electronics, battery management software and proprietary inverter technologies, alongside Neurio's hardware and software for energy monitoring and management, will allow us to bring an intelligent and efficient energy saving solution for this exciting new market. With Pika's proprietary hybrid inverter design and the industry's best round-trip battery efficiency, combined with Neurio's uniquely monitoring hardware and energy consumption algorithms, customers can optimally generate, store and consume their power, which we believe can create significant energy savings opportunities for homeowners and businesses. From the over two million homeowners in North America that already have solar installed and are looking to dramatically improve the payback of their system to the millions more that want to take control of their energy costs while also providing added relief from short-term power outages, this new solution will be a natural fit. Although very different than the backup power space we serve today, we believe that the market creation opportunity around energy storage will develop in a very similar fashion to what we've experienced with the home standby generator market over the past two decades. Our efforts to develop omnichannel distribution, targeted consumer-based marketing content and proprietary in-home sales tools continue to be important elements for creating the market for home standby generators, and we believe our experience and capabilities in these areas will be invaluable as we work to grow the energy management and storage market. Our sourcing and manufacturing competencies will also allow us to produce an affordable solution, which is critical to increasing penetration of this kind of product. The combination of awareness, availability and affordability have been key ingredients to growing the home standby generator market, and we believe they will play an equally important role in developing the market for energy storage. In the first 90 days under our ownership, we have been working to combine our Pika and Neurio organizations and have been developing the product roadmaps, processes and go-to-market tools that will be central to our clean energy efforts. We anticipate launching a full line of Generac-branded storage and energy management products in the fourth quarter of this year, which will be made available to our existing distribution partners, as well as a number of new partners that are already engaged in the renewable energy market. In addition to our focused efforts in the quarter to grow the residential side of our business, our commercial and industrial generator business also continues to have success as we experienced another strong quarter underpinned by a number of important macro drivers which continue to develop. Shipments of generators to telecom customers further accelerated in the second quarter as the major wireless carriers focused on building out and hardening their networks. With the impending deployment of 5G technology on the horizon, the need for continuous supply of power to their network sites has never been more critical. The increased data speeds and stability of 5G connectivity will provide for an important foundational layer that will enable some tremendously impactful future technologies. Ensuring that these networks are able to communicate without interruption even during power outages is essential for the new services and communications that will be dependent on 5G technology. Generac is a key supplier of backup power systems to every Tier 1 carrier in the U.S., which is a result of our ability to develop unique solutions and provide an unmatched level of support through our nationwide distribution network. Additionally, we believe we are in the unique position to benefit from the overall global telecom opportunity that exists. With the acquisition of Selmec in Mexico, we are now also the number one provider of backup power for the telecom market in Latin America. And our Pramac subsidiary has recently began to accelerate their targeted efforts in serving the market as well. We believe that similar to the position we have built in the Americas, we can become a global leader in telecom backup power as this key vertical begins another extended investment cycle in the years ahead. In addition to our focus on serving our telecom customers, we have also worked hard over the last several years to further promote the benefits of natural gas-powered generators as a substitute for the traditional diesel-powered systems that have historically been used in emergency backup applications. The strict regulation of diesel emissions have driven prices for generators that use these engines considerably higher over the past decade. When combined with the inherent drawback of diesel systems due to their refueling requirements as well as additional environmental concerns, an opportunity has developed for natural gas-powered generators as a cleaner and more economical alternative. Leveraging our decades of experience in natural gas power generation along with the expertise from our engineering teams at Motortech, which we acquired in 2017, we are executing on a comprehensive new product introduction road map aimed at bringing a number of larger natural gas power nodes to the market. We believe that natural gas has fundamentally far superior characteristics over diesel in power generation with its abundant supply, low prices, logistical advantages and environmental benefits, all contributing to growth rates for gas generators that are roughly double that of diesel sets in the emergency backup power market. Additionally, we continue to see an opportunity for our natural gas generators to be used in certain situations outside of the traditional standby power spaces as we begin to see a number of projects in the market around using these products for other grid support applications such as demand response programs, which are used to help utilities better balance the supply of power with consumption patterns. A natural gas generator that might otherwise be used only in an emergency could be deployed and managed by the customer, the utility or a third-party aggregator as a decentralized power generation asset. The concept of producing power on site locally and either consuming it or sending it back to the grid is not new. But the economics of using a natural gas generator for this purpose have become much more compelling in recent years as utility rates have continued to rise and natural gas prices have remained low. In response, we are focused on tailoring our product offering to better suit these applications, and we are in the process of adding the sales, engineering and project management resources necessary to effectively develop and participate in these new applications. Although the market for stationary C&I products has remained robust, shipments for our domestic mobile products were lower during the quarter mainly due to the timing of capital spending by certain of our national rental account customers as their fleet utilization rates remain below their internal targets. Softer energy prices and a more difficult financing environment have pressured the oil and gas segment in particular, leading to a reduction in rig counts in 2019, which we believe may be a significant contributor to the pullback in rental CapEx spending. Partially offsetting the lower shipments to national account customers, however, in the quarter, were increased equipment purchases from independent rental businesses who did not refleet as heavily in prior years. Our longer-term views on the need for increased levels of spending on infrastructure projects in the U.S. coupled with an expanding domestic energy industry remain intact, and we believe these macro themes will result in greater demand for mobile products in the years ahead. Outside of the traditional domestic markets, our international business was roughly flat year-over-year as the prior year second quarter included a number of larger projects that have not yet repeated to this point in 2019. When adjusting for the timing of these large projects, we saw solid core growth in several regions outside the U.S. including Brazil, China and parts of Central Europe. Although adjusted EBITDA margins for the International segment were lower year-over-year due to the timing of these large projects, they did increase sequentially from the first quarter, and we remain confident in our ability to continue to improve to continue to improve these margins to our targeted lower double-digit levels over time. Additionally, we continue to see the benefit of our international expansion strategy as interest in home standby and gas used generators for commercial and industrial applications continues to gain traction in many new markets around the world As natural gas infrastructure continues to expand and as these markets become more familiar with our gas product offering, we see the long-term substitution of traditional backup – diesel backup power occurring in similar fashion to what we've experienced over the last 20 years in the U.S. I’d now like to turn the call over to York to provide further details on the second quarter results. York?

Thanks, Aaron. Before discussing second quarter results in more detail, recall that effective January 1, 2018, Generac adopted the new GAAP revenue recognition accounting standard. Upon finalizing our accounting under this new standard, at the end of 2018, we made certain immaterial prior quarter reclassifications to our consolidated statements of comprehensive income related to extended warranties. Therefore, the prior period in our earnings release has been updated accordingly. See our press release for more information related to these reclassifications. Now looking at our second quarter 2019 results in more detail. Net sales for the quarter increased 8.9% to $541.9 million as compared to $497.6 million in the second quarter of 2018. Excluding the $12.4 million of contribution from the Selmec, Captiva, Neurio and Pika acquisitions and the almost $5 million negative impact from foreign currency, core growth rate during the quarter was approximately 7.4%. Looking at our consolidated net sales by product class. Residential product sales during the second quarter increased 8.9% to $268.4 million as compared to $246.4 million in the prior year quarter, with core growth being approximately 8% when excluding the M&A contributions from Neurio and Pika and the slightly unfavorable impact from foreign currency. As Aaron mentioned, home standby generator sales grew significantly once again during the quarter as we continue to execute on the awareness and demand created by baseline power outage activity. Shipments of portable generators were down in the quarters – the current year second quarter as the prior year quarter benefited from retail channel replenishment following elevated outage activity. Looking at our Commercial & Industrial products. Net sales for the second quarter of 2019 increased 6.9% to $230.4 million as compared to $215.6 million in the prior year quarter, with core growth being approximately 6% when excluding the M&A contributions from Selmec and Captiva and the unfavorable impact from foreign currency. Domestically, as Aaron previously discussed, we continue to see very strong growth from our telecom customers as they harden their cell tower networks to improve reliability and prepare them for 5G rollout. In addition, shipments to our domestic industrial distributors also remain very strong as we continue to drive share gains with our natural gas power generation expertise. Partially offsetting this growth in C&I products, shipments of our C&I mobile products declined year-over-year as our national rental account customers deferred CapEx spending during the current year quarter. Internationally, our C&I products were down modestly on a core basis when excluding the impact of the Selmec and Captiva acquisitions and the unfavorable impact from foreign currency. In the prior year quarter, our Pramac subsidiary benefited from certain large product shipments that did not repeat in the current year. In addition, in Latin America, we saw flat core sales growth during the quarter given certain geopolitical headwinds that are impacting that region. Net sales for the Other products category, primarily made up of service parts and extended warranty sales, increased 21.3% to $43.1 million as compared to $35.6 million in the second quarter of 2018, with core growth of approximately 12% when excluding the strong service business from the Selmec acquisition. A larger installed base of our products and higher extended warranty revenue recognition drove this core increase versus prior year. Gross profit margin was 36.1% compared to 35.9% in the prior year second quarter. A favorable sales mix shift towards higher margin home standby generator sales was partially offset by modestly unfavorable price cost dynamics during the quarter. In recent quarters, we have felt the impact of increased regulatory tariffs, logistics costs, labor rates, commodities and currencies. While we have substantially mitigated these higher input costs through cost outs and price increases, we are still experiencing modestly unfavorable price cost due to the lags in realization. Based on current market conditions, we believe certain of these higher input costs to be transitory in nature and should moderate as we enter the second half of 2019. Operating expenses increased $11.9 million or 12.8% as compared to the second quarter of 2018. As a percentage of net sales, operating expenses, excluding intangible amortization, increased 40 basis points versus the prior year primarily due to increased research and development costs associated with our clean energy, connectivity and Lead Gas strategic initiatives. These investments were partially offset by improved operating leverage on the higher organic sales volumes. Adjusted EBITDA, before deducting for non-controlling interest and as defined in our earnings release, was $111.9 million in the second quarter of 2019 as compared to $102.2 million in the same period last year. The corresponding adjusted EBITDA margin was 20.6% in the quarter as compared to 20.5% in the prior year. The previously mentioned favorable sales mix shift towards higher margin home standby products was mostly offset by unfavorable price cost impacts and the increased research and development costs associated with strategic initiatives. I will now briefly discuss financial results for our two reporting segments. Domestic segment sales increased 11% to $425.9 million as compared to $382.7 million in the prior year quarter, which includes $2.3 million of contribution from recent acquisitions. As I previously discussed, this year-over-year increase reflects strong end market conditions for our home standby and C&I stationary generators. This growth was partially offset by lower shipments of portable generators and C&I mobile products compared to prior year. Adjusted EBITDA for this segment during the quarter was $104.5 million or 24.5% of net sales as compared to $90.6 million in the prior year or 23.6% of net sales. International segment sales increased 1.8% to $116 million as compared to $113.9 million in the prior year quarter, including $10 million of contribution from acquisitions offset by an approximate $5 million foreign currency headwind. Core sales declined approximately 3% versus the prior year due to the timing of certain large projects that shipped out of our Pramac subsidiary during the prior year quarter. Adjusted EBITDA for the segment during the quarter before deducting for non-controlling interests was $7.4 million or 6.3% of net sales as compared to $11.6 million or 10.2% of net sales in the prior year. Now switching back to our financial performance for the second quarter of 2019 on a consolidated basis. GAAP net income attributable to the company in the quarter was $62 million as compared to $53.3 million for the second quarter of 2018. GAAP income taxes during the current year second quarter were $18.8 million for an effective tax rate of 23.4%. This compares to GAAP income taxes in Q2 2018 of $18.4 million for an effective tax rate of 25.3%. The year-over-year decline in the GAAP tax rate was driven by a higher mix of domestic pretax income and additional stock compensation deductions in the current year quarter. Diluted net income per share for the company on a GAAP basis was $0.98 in the second quarter of 2019 compared to $0.82 in the prior year. The specific calculations for these earnings per share amounts are included in the reconciliation schedules of our earnings release. Adjusted net income for the company as defined in our earnings release was $74.9 million in the current year quarter or $1.20 per share versus $68.9 million in the prior year or $1.11 per share. This increase in adjusted EPS was driven by the strong sales growth and related improvement in operating earnings previously discussed, partially offset by higher cash income taxes during the quarter. With regards to cash income taxes, the second quarter of 2019 includes the impact of a cash income tax expense of $14.1 million as compared to $11.1 million in the prior year quarter. The current year reflects an expected cash income tax rate of 17% to 18% for the full year of 2019 while the prior year second quarter was based on an expected cash tax rate of 14% for the full year 2018. This increase in cash tax rate is due to a higher level of expected pre-tax earnings in fiscal 2019 versus fiscal 2018 at this point in the year. Recall that every dollar of pre-tax earnings over and beyond our $30 million tax shield is taxed at the expected GAAP tax rate of approximately 26%. Cash flow from operations was $8 million as compared to $50.7 million in the prior year second quarter, and free cash flow as defined in our earnings release was negative $10 million as compared to $46 million in the same quarter last year. Higher operating earnings in the current year quarter were more than offset by $29 million of additional primary working capital investment, as well as timing differences related to $20 million of tax payments and $13 million of capital expenditures. As we enter the second half of 2019, we expect to monetize a significant portion of our primary working capital, in line with normal seasonality, resulting in strong free cash flow conversion for the full year 2019 of approximately 80% to 90%. Taking a look at our balance sheet. On January 1, 2019, we adopted the new GAAP lease accounting standard. This new standard requires that we recognize right-of-use assets and lease liabilities related to operating leases on our balance sheet. As a result, we recognized approximately $40 million of additional other assets and other long-term liabilities on our balance sheet in Q1 to adopt the new standard. As of June 30, 2019, we had a total of $943 million of outstanding debt, net of unamortized original issue discount and deferred financing costs. Our gross debt leverage ratio at the end of the second quarter was 2.1 times on an as-reported basis. Additionally, at the end of the second quarter, we had $110.4 million of cash on hand and there was approximately $273 million available on our ABL revolving credit facility. Both our term loan and ABL facilities mature in the year 2023. With that, I’d now like to turn the call back over to Aaron to provide comments on our updated outlook for 2019.

Thanks, York. As we’ve discussed, end market conditions for our domestic residential and C&I stationary products remain strong and better than expected. As a result, we are raising our guidance for revenue growth for full year 2019 as we now expect net sales to improve approximately 6% to 7% assuming no major power outage events and a baseline power outage level similar to the longer-term average. On a core basis, full year 2019 net sales growth is now expected to be approximately 4% to 5%. Should the outage environment in the second half of 2019 be higher due to an active hurricane season and widespread utility shut-offs in California, we could expect approximately 5% of incremental revenue growth over and beyond our baseline guidance. All of this compares to our previous guidance of 3% to 7% growth on a core basis or 5% to 9% on an as reported basis for the full year. As we discussed last quarter, the high end of the previous range included a major outage event. The comparable range based on our higher guidance this morning is 4% to 10% on a core basis or 6% to 12% on an as reported basis with the high end of the range again, including the potential upside of a major outage activity due to a active hurricane season and widespread utility shut-offs in California. As a result of more favorable sales mix and improved operating leverage compared to previous guidance, we’re also raising our margin expectations for full year 2019. Net income margins before deducting for non-controlling interest are now expected to be approximately 11%, with corresponding adjusted EBITDA margins of approximately 20% for the year, assuming no major power outages and an average baseline outage environment. Should the outage severity in the second half of 2019 include an active hurricane season and widespread utility shut-offs in California, adjusted EBITDA margins before deducting for non-controlling interest could be approximately 21% for the full year of 2019. This updated baseline guidance implies that adjusted EBITDA margins in the second half of the year will improve approximately 100 basis points over the first half of the year. This is largely due to improved operating leverage on higher sales volumes, realized benefits from our profitability enhancement program and favorable trends with input costs as we expect logistics, commodities and currencies to moderate into the back half of the year. Consistent with historical seasonality, our baseline guidance, which assumes no major outage events, anticipates that net sales and adjusted EBITDA margins will build modestly from Q3 to Q4 as we progress through the second half of 2019. Lastly, intangible amortization expense is now expected to be approximately $27 million to $28 million for the year, a $6 million increase from previous expectation primarily as a result of our recent acquisitions. The remaining guidance items provided in previous earnings calls are not expected to change. This concludes our prepared remarks. And at this time, we’d like to open up the call for questions. Operator?

[Operator Instructions] Okay. Our first question is from the line of Ross Gilardi from Bank of America. Your line is open.

Good morning, guys.

Hey, Ross.

Your home standby generator shipments is up 20%, obviously, very strong. And I think that is off of a pretty tough comp a year ago. Is that the case? Can you remind us what that number was? And can you say how much California was up within that number?

Yes, Ross. We don’t break that out. We haven’t historically. I think we added the 20% just to give some additional context this year but – in this quarter. But we can say that it is up strongly as you indicate. And that was without any major outage events. I think – and that’s the think that, when we look at it, and in fact, when we look regionally across the board, we’re seeing strength in a lot of regions. The West obviously, as we’ve talked here as of late, has been very strong. Our teams were wearing out of path to the West here. We haven’t had a tremendous amount of development effort in that market over our history because as we’ve said, there are a lot of reasons for that. But primarily, it’s just been a market that hasn’t experienced a ton of outages, and as such, it just was slower to develop. With the shut-offs and all of the disruption to the grid that’s either been taking place or will be anticipated to take place in the future that the interest level on the product has changed dramatically. And in fact, I would point to just even in the last four weeks, we’ve seen activations and IHCs, again, in-home consultations as we refer to them, we’ve seen just fantastic numbers, which gives us a lot of strength and a lot of confidence in kind of underpinning the updated guidance this morning. So we're really pleased with that business. And I think a lot of us internally, we've all kind of collectively wondered aloud whether we've actually hit a tipping point maybe with home standby where it's kind of moving into more mainstream category and 4.5% penetration, it's may be hard to make that argument. But it sure feels like it's accelerating in the absence of anything major, any type of major catalyst.

And despite some headwinds in C&I and so forth, it seems like you're taking your guide up even though you appear to have some additional growth investment in your numbers. I mean, it seem to show on your cash flow numbers, your R&D as a percentage of sales was up a fair amount. So can you talk about how you're looking at overall growth investment in the various buckets into the second half of the year? And how are you doing on capacity because this has now been an 18-month period where you've had very strong generator shipments, and California which really wasn't that relevant of a market a couple of years ago. So are you contemplating a capacity increase on the West Coast or any place else.

Yes. From a capacity standpoint, I'll deal with that part of the question first. The capacity side of it, obviously, the home standby business has always been an interesting business. When you get events – and really the generator business in general, I shouldn't just put it as home standby. But that residential market in particular is fairly sensitive to when you do get surges in demand, you need to respond. So we've been very careful to build that with flexibility, upside flexibility in mind. And so as we sit here today, and I would say the last kind of major resetting of capacity in that business occurred after Sandy. We worked to expand capacity at that point, both in the supply chain which is oftentimes where we run into some bigger constraints than we do internally. But we refocused our supply chain and our internal capacity after Sandy, so call it 2013, 2014 kind of that next step level change in terms of capacity. We went through that again last year, that exercise, and we made some significant investments both internally, some of which has come online and some of which will come online in the future year. That's some pretty decent CapEx and you've seen our capital spending trend upwards. Some of that is related to some of that growth CapEx around expansion for capacity. But also, we've made some – we continue to grow our supply chain and our sourcing. Some of that is in relation to the tariff environment that we find ourselves in today. We've resourced some components or dual sourced some components to make sure we not only got adequate capacity but also a cost basis for those products and components, which reflects hopefully a lower tariff environment rather than a higher one. But all that being said, to get right to the point, we feel very good about our capacity for home standby, and we're going to continue to add that going forward. Now I'll let York speak to the other.

Yes. I mean in terms of future investments, that's – as you pointed out, you can see it in our R&D numbers, you can see it in our cash flow numbers, the reality is we've been putting in terms of head count, we think of those as investments as well. And when you think about our clean energy initiatives, our connectivity initiatives, our Lead Gas initiatives, those are all things that are going to bear fruit in the future. But you need to resource them upfront, and we believe that with the large opportunities we have in front of us, those are going to be good investments here. But you've got to put them in place beforehand so you can see that impact on margins. And then on the cash flow side, you're right. CapEx, we've had a – from a timing perspective, we front-end loaded our CapEx more this year on…

Some of that around those capacity

Around capacity expansions. So that's a little bit of timing difference there versus prior year. And then working capital, you think of that as an investment as well as you grow and ramp. And as we get ready for the season, not only on the home standby and portable side but on the mobile side of the business with our shore products that we've ramped up those inventories to get ready for the seasonal seasons, so we're ready for that. We've put in working capital in the first half of the year and we expect to monetize that in the second half.

I think all those things just kind of exacerbated the 1H, 2H kind of pacing of our free cash flow, so we're

We feel good about it.

We feel good about it. So that doesn't really change anything fundamentally. It's just – I think it's largely around timing.

Now the California utilities are actually advising their customers to consider buying a generator. And are you seeing a lot of new referrals of business as a result of that?

I mean, the utility companies have – they've all taken an interesting approach, and we've reached out to all of them obviously and we have – we've had plenty of dialogue. They're all reluctant to kind of name an OEM partner, which we find to be a little bit frustrating on our part because we think that we could be all working towards the purposes of helping people in their service areas be better prepared, but look, that's their approach. So we can't sit there and wait for the utility to promote one brand, your brand X over brand Y. And I guess in the end result, that's probably not their responsibility. But we've always taken the angle that our responsibility is to grow the market. As the leader in the market with the kind of share position we have and the effort that we've expended to date over the last 20 years to build this market, what we just – that's our cross to bear. It's our mantle. And so we've got that, and we're going to continue to push hard on that here in the market. And so over the last four weeks, we've put together a plan on the page for that market in particular and a lot of it includes much of the same awareness type of building activities that we would typically have. But I would tell you, what's really unique about this situation is we never get the luxury of getting a map where something might happen, right? We always have to react to an event with very little notice oftentimes. And so I do think we have the opportunity here to be a lot more proactive in our efforts. So that's getting us a little bit outside of how we think about developing markets normally, which I think is a good thing. And it's kind of refreshing that way. So we've got, as I said, we have a lot of people out there in the market working to grow that with our existing distribution partners and we're rapidly adding new distribution partners. That really is our focus. And then education, education for inspectors, for utilities, for the municipalities that issue permits. There's just a lot of – we see this every time. There's a new market development effort. It's just a learning curve for everybody, so we're going to get up that curve. That may act as a bit of a constraint on growth in that market this year for us at least in the short term. But longer term, we see that market has a tremendous amount of potential. I mean, if you just run the raw numbers and even get from the 1% that we're at today to the 4.5% where we're at nationally, there is a lot of room to run – to grow the market in a very short period of time in California.

Thanks very much guys.

Thank you, Ross.

Our next question is from the line of Mike Halloran from Baird. Your line is open.

Hey, good morning guys. So following up on the question or the answer you've just given there, maybe can you give some context on the receptivity from a distribution perspective, the ability to expand that? How rapidly is it expanding? The knowledge base, how much of a constraint it is this year? Just provide a little bit more context there. And then maybe the same on the regulation side from an ability to move that forward a little more proactively?

Yes. It’s a good question, Mike. I mean, from a distribution standpoint purely, your dealer counts there today in California are less than 200, so we have 6,100 nationwide. So obviously, we have – it’s probably appropriate for 1% penetrated market but not for 4.5% or greater penetrated market. So we anticipate as generally is the pattern that is followed in these instances, we anticipate adding a lot of distribution in that market. And we’re going to start with dealers because the dealer base is probably our most efficient way to reach the end consumer. We also have the most developed tools in terms of sales tools, tracking of leads and such in the dealer channel. But beyond that, I think this is where our omnichannel approach to distribution is really going to pay off and generally does pay off. The fact that we distribute products very widely through the electrical wholesale channel. We have the opportunity. Electrical wholesalers are very prevalent as are contractors in California. We can turn those branches on very, very quickly and put products in the hands of those electrical wholesale branches so that the electrical contractors in the market can get access immediately. So they don’t have to go through all of the steps to become a dealer. They can do that alongside of that, but they can get access to the product quickly and get on that learning curve even faster. On top of that, we have retail outlet relationships. All of the DIY retailers that we distribute products through the U.S., they also have California footprints. Some of them more so than others, but we are currently in dialogue with all of those regional markets for those DIY retailers to have some special programs put together, endcap displays, other types of events where we have dealers in aisles talking about the product, educating consumers, basically training or doing that work that’s going to be necessary to grow the market, to create the awareness around the market. And so that’s in place. To your question on regulation, that is a little bit of a slower grind. That’s almost a hand-to-hand combat type of thing. And we’ve seen this in markets before, whether it’s in the Northeast with Sandy or Michael down in or Irma down in the Southeast, whenever there’s an event that happens, we typically have to go into that market and we have to talk one-on-one with inspectors, with the local municipalities, with the gas utilities, getting gas meter upgrades, getting gas infrastructure upgrades to accommodate the installation of a generator, the permitting that needs to get done, sometimes there’s a lot of misconceptions about that. So we work very hard and thankfully, we have the scale in this industry. We have a whole team of people dedicated to that. And so they do nothing more than interface with that layer, that regulatory layer as we kind of refer to it here across the U.S. And right now, as you can imagine, they’re very focused on the California market in particular as we bring those people up the curve. So it’s hand-to-hand combat. We can only make it move as fast as we can. I think, again, we have the benefit of being proactive here because we’re ahead of the outages. What might – may happen later this fall, I think we’re going to have the opportunity to get ahead of it. But I think it is going to still act as a bit of a throttle plate on or a constraint on what we can actually what we can actually achieve here this year at least. So I think the upside guidance we provided kind of contemplates another $25 million to $30 million of upside potentially on top of what we had called out.

That wasn’t in the previous.

That wasn’t in the previous guidance. So that’s kind of the add for this year. But we think in the future, and we’ll quantify this as we build out our models going forward, but we would obviously expect that to be greater in the years ahead.

Yes. That makes a lot of sense. And then on the connected strategy or the power management energy storage strategy, two-fold question here. Just talk about what you’re doing to accelerate some of the penetration opportunities, who you’re partnering with, some of the go-to-market pieces there. And then also how quickly can this be a meaningful contributor to your revenue and earnings beyond what the acquisition has already given you?

Exactly. So – as it relates specifically, I’d kind of put it into two buckets. One is connectivity to the generator, right? remote monitoring of the generator. That is really – there is some ability to monetize that. Clearly, there is a number of levels that we offer customers in terms of the level of monitoring that they want to do with their product. There is a free version of that product that gives people information on a monthly basis. And then on a real-time basis, it’s a product that’s paid for. As a service, it’s paid for annually. So there’s an opportunity to monetize that, but that I would tell you is more about creating customer satisfaction, higher levels of customer satisfaction with customers, making sure we have the highest level of uptime possible with the install base of product that’s out there. So that’s a really good thing. And then also creating additional opportunities for our dealers to connect with customers for preventive maintenance, for repairs, again, all in the interest of uptime, but giving our dealers an opportunity to better monetize within their business model kind of a service and aftermarket support side. That’s on the generator connectivity. Then you’ve got our energy monitoring pieces, the storage and monitoring pieces. That – there, our Neurio acquisition, our Pika acquisition. I think on Neurio specifically as it relates to energy monitoring, we intend to launch a product here in the fourth quarter that will bundle with our existing standby generators. So we’ll have products that will have monitoring capabilities on board. And that’s – the process to do that is in place right now, but we intend to basically build out the value proposition for our homeowner when we think about connectivity. So connecting to the Mobile Link platform will give them more than just a status of their generator in the long term. It’s going to give them ability to see how much power they’re using. It will probably and likely extend to how they may even control the usage of that power. And this is – our vision on this is we think it’s a really important kind of part of thinking of the generator differently than just an emergency standby asset. We think that, that generator could be deployed in a more broadly distributed fashion where that generator is maybe being operated a couple of hours a day for the purposes of avoiding some of the peak rates that utilities charge and in that way could actually be part of the strategy where a homeowner or a business could reduce their overall energy cost. So a lot is developing here, and there’s a lot more to come and we’re going to be able to update people. We actually have an Investor Day coming up on September 4th in New York. And it’s our intent at that point to give people, I think, a better view on where we’re going with not only clean energy but also just the monitoring capabilities, both energy and generator monitoring that we’ve kind of built here.

Our next question is from the line of Jerry Revich from Goldman Sachs. Your line is open.

Yes. Hi, good morning, everyone.

Hey Jerry.

Hey Jerry.

So every time we’ve seen major outage event with national attention like we’re seeing in California, you folks have been able to deliver higher in-home consultations and a higher sales and build a higher baseline. Is that how we should be thinking about California? Is this a Sandy-type awareness event as you see it? How broad-based has the interest been given all the headlines compared to prior major outage event?

Yes, it is interesting, Jerry, because what – there's been a lot of headlines around it but very few shut-offs to date, right? I think there was one notable shut-off in Northern California, but it was a small, it's like 30,000 people and there's a small outage. But I think it definitely created a conversation for people that this is real. And we do believe there is a very high likelihood. If you just look at how the utilities have kind of spelled out under what conditions shut-offs would occur, those conditions present themselves every year, and not just once or twice a year but a number of times a year. And the way the utilities are describing their efforts around the shut- offs is they're going to be extended periods of time. They're not only just going to shut the grid off initially but they're going to keep it off until they can physically inspect every single mile of line. Now that is – for us, when we hear that and we know just kind of the topography of California, we know the vast nature of the service areas that are being discussed there, this is going to be days of outages. And so when it happens, I think today, I wouldn't say it's reached the stage of a major outage. The interest level is very high and which I think is for us, a leading indicator in the possibility. I think we won't probably see the real impact of this until shut-offs occur. And again, we're highly confident that, that is likely to happen based on all the conditions that have been stated today. But that's something that, should it happen, we do think it would reach the status of a major outage, could in fact do that and it's going to depend on exactly how many people for exactly how long. So we'll have to see how it plays out.

How many times…

And how many times they do it. Frequency is oftentimes an important part of that. But I think, Jerry, when we look at this, to set up for it, I mean it's incredible to think that the service area we're talking about here is 5.5 million connected meters, which represents maybe 11 million to 11 million people that could be without power for an extended period of time. And it's a major area, so how that plays out remains to be seen. Should it happen, will definitely qualify in our eyes as a major outage.

And dealer development has been a big part of the way you folks have grown that standby business. Can you just talk about how big that pipeline is? So you spoke about how many dealers you have now, but as you look at the pipeline based on the interest level, what does that California dealer base look like if we fast-forward six to 12 months, how high is the interest level from dealers and how much could the distribution points increase as a result?

So we have roughly a little less than 200 dealers [indiscernible]. We started the year with about 100. So if it tells you the pacing kind of in a six-month timeframe here, we've added. We've almost doubled the number of dealers in that area. Now admittedly, only 100 dealers in our entire network is 6,100. So California is a massive state, fifth largest economy in the world on its own. So it should have more than 100 dealers but I think that's a consequence of just below penetration than it's historically had and the relatively good power quality that California has experienced historically. So we doubled that dealer count already. The interest level is very high. I'm not going to sit here and give you a prediction of where we'll be at the end of year because we have a lot of feet on the ground, lot of boots on the ground and a lot of effort adding distribution. And again, a lot of that distribution expansion, you have to think of it not just in the context of dealers. You have to think of it in the context of our omnichannel approach to it. We have all of these wholesaler branches, this wholesale electrical wholesale branches that we can put product in immediately and our retail outlets we can put product in immediately. Our e-commerce partners are seeing a lot of interest from California residents, shipping product into that market. So I think we're blessed with having this omnichannel approach. I think this is what really serves us well and it's one of the main core tenants of why we've designed it this way is it allows us to expand very quickly into markets where there is a development effort that need to take place. California is going to fall squarely into that. But it's not just signing up the dealers. You have this whole onboarding process, and that takes a while. There's a learning curve with that. We're going to try to accelerate it. We may even have a physical presence in California by year's end because I think we all view this as a unique opportunity where having brick-and-mortar in the state could actually be beneficial to us in terms of accelerating training, accelerating that onboarding process by having our own people housed in California. That's not typical of what we would do in a market. Even after a major event, we might rent a couple of hotel conference rooms or things like that and do some widespread training. But this might end up looking more like a longer-term physical presence in California, given that these power shut-ups are likely to happen over a long period of time and be fairly consistent. So we'll allow that to develop, but we're very bullish on dealer counts are going to go up very dramatically here as we keep going. And we think that, that's something that is going to be an important part of how we grow the market.

Our next question is from the line of Chip Moore from Canaccord. Your line is open.

Good morning. Thanks. Hey guys.

Good morning, Chip.

So curious on you hear that you're going to have sort of Generac-branded energy management storage products by the end of the year. Can you maybe talk a bit more about how you initially? If you call out some new partners, would this be residential solar installers or how do we think about that? And maybe potential for cross-selling of standby generators as well there?

Yes. I am, like very excited about this. This is one where we've made a sizable leap into this market, right? We put a lot of capital behind this. So we believe in this. It's been a great rallying point for our team. I think it's completely coincidental that all the things we just talked about in California from a shut-off standpoint have happened at the same time. I mean it's remarkably ironic to me that here was a market we didn't have a ton of distribution or effort going on to as it relates to standby power and we kind of looked at it as, well, there was a little bit of a heavy lift, right, to set up distribution, for energy storage and energy monitoring. And it's almost fallen on our lap. I mean it's the combination of these two things and being able to go after that market, and not just go after new distribution points talking about power generation but going after those new distribution points and talking about energy storage and energy monitoring, things that are very pertinent, top of mind for those types of distributors and distribution points in California. It's been fantastic. You talk about the opportunity to cross-sell. It's great. It's going to be a major way that we're going to go-to-market in the West and in the Southwest, in the Sun states, is going to be through cross-selling. New distribution partners. We're talking to partners – I've been to visit some of the largest residential solar companies here as of late. I've been there personally with our teams just because we're learning. We're all learning at the same rate here on how best to serve this market, how best to partner, what should these programs look like, what should the partnerships look like, is there a cross-selling opportunities within those solar partners. We do believe we're going to need solar as a channel. We think that's a brand-new channel for us. Especially when you think about the mandates for new construction in California, mandating solar in 2020, that it'd be attached to any dwelling, clearly new installations are going to have to have solar partners with them. The 2 million solar installs that are already in the market, we think we can probably effectively get to maybe without meeting the solar partners. If they want to be a part of that, great. If they don't and they want to focus on new installs, that's fine, too. We can focus on that. But with this new product line we're going to introduce in Q4 is kind of our –I'll call it our first phase, which is essentially a rebranding of the existing products that Pika offers and that Neurio offers win and the combination of those form factors that we can sell it as an all-in-one. That's what's going to happen in Q4 this year. By the time we get around the horn, maybe 12 months from –I'll call it Q3, Q4 of 2020, we'll have a second version of the product that will be a little more advanced. And that, again, we're going to share more of those details at our Investor Day in New York on September 4th. But I think it’s important that I think the market, that it's important that we get into the market and see what's going to happen. As far as adoption rates, I look at the growth rates that are out there, and these are not our numbers. What people are talking about for storage are these are big numbers. There was a recent analyst that issued a report, this is a –these are credible of reports. These aren't kind of from fringe places. These are from mainstream kind of places. And we're talking about a $27 billion market by 2030. We think that there's a lot of room to grow. We think that we're going to have a very unique solution, a differentiated solution. And we've got some pretty cool benefits on our side around the selling techniques, our targeted marketing techniques, our awareness building. We're in the middle of shooting an infomercial for our storage device. Nobody else in that market has anything like that. It's a small step, but I think it's an important step and it's an example of, I think, some of the things that we're going to do that haven't been done yet in this market. So I'm very bullish on this. I think it's going to be –I think it's a home run. It's a hand in glove fit for what we've been doing with home standby and, I think it's just –it's a great extension and a great way to leverage all the things that we do really well in that market.

That’s great. Maybe one follow-up to your point on the potential growth in that market. Over time, do you see yourself sourcing batteries from third-party guys? Or could you go after a lithium ion manufacturer or something like that?

Yes. So – this is how we see it. This is kind of our view of the world there. We're not going to be battery manufacturer and we don't want to own a battery manufacturer. Battery manufacturing takes a ton of scale to be good at it, good from both a cost position but also the level of scale necessary to effect the cost position needed, as well as the continued investment level needed, right? Chemistries are going to continue to change. Automation is going to continue to improve. That's just not where we want to be. We look at the battery itself, the cells, the lithium ion cells that exist today, we look at those as a component ingredient, a commodity ingredient in a battery pack. And so almost as we would look at, you think of an engine today, an internal combustion engine, the aluminum ingot used in an engine casing is a commodity ingredient. We're not in the aluminum ingot business. We design, and in some cases, manufacture the engine itself, and that's where we think the battery packs themselves. We think that that's in our wheelhouse and something that we can do. But we view the battery themselves, the cells as being a commodity ingredient that we're going to continue to source from others. Now today, and in our acquisition of Pika, they use a third-party battery source. We're likely going to continue to build on that relationship. It's a very good relationship today. We want to build on that. But as the market grows, we may find ourselves in a situation where we need to expand source. I do think that there is a possibility, if the market is going to grow according to the projections that are out there, that capacity could end up being a constraint on market growth long term. So we want to make sure we've got enough partners to be able to make sure that doesn't hold us back from a growth standpoint. But we're not going to be in the battery business.

Our next question is from the line of Brian Drab from William Blair. Your line is open.

Hey, good morning. Thanks for taking my questions.

Hey, Brian.

Good morning, Brian.

Hey, good morning. So on the five points of additional growth, that potential, I'm looking at that and thinking maybe that would require a hurricane that generates another like $50 million in revenue and then these outages in California, think about that as a major event, like that's another $40 million, $50. Is that kind of what needs to happen to get those five points? Or am I kind of off track here?

Yes, I think Aaron alluded to it just on an earlier question. I think our previous upside guidance from last quarter that we included that high end of the range that we talked about. That was somewhere in that $75 million range. And so we added another percent on top of that, which is roughly called $25 million to $30 million. So that’s – given, so I think some of the constraints around expanding distribution, I think initially the initial surge if you will, demand, if they were to turn the power off and when they turn the power off to millions of people, there may be a restricted play on that. So but I guess to answer your question, we put $25 million to $30 million on top of that.

This is a combination of a potential hurricane and that potential step-up in demand in California, right?

Correct, that’s the 5%.

Yes. It assumes both situations, Brian.

But I think it's important to note, our guidance today where we came out with this –the guidance we gave is just the baseline guidance assuming no events and an average level of outage activity and then there's upside. And I think where previously, we talked about 3% to 7% core growth, we actually are incrementally positive on that. So we're taking it effectively to 4% to 10% and so –but –as a result of all the positive things we're seeing in the end markets and the additional upside of California.

And in those five points, is that related to California? Is that kind of a knee-jerk reaction to the outage event, people running to get their portable generator in large part? Or is it kind of both, standby and portables?

It’s both. I mean largely, there will be a knee-jerk reaction and largely there's going to be some portables that will go into the market. I think the –but it does include –it does contemplate both, Brian.

Got it. And then the last question. So in California today, what is the penetration of home standby into that market and what percent? And then if that goes to 4.5%, 5% over some period, how long do you think that –how long will that take do you think for you to kind of get to the market average penetration rates in California?

Yes. So today, we’re a little less than 1% penetrated in California. Obviously, there's a lot of single family unattached housing in the state that are greater than $100,000 in value. I think one of the really interesting things I'll point out is we've always said that –what's really important is you have to look at the value of the home in relation to the investment, right, in a home standby. The average investment of home standby is between $8,000 and $10,000 completely installed. And when you look at average house prices, that $8,000 and $10,000 in relation to a $300,000 home which is our median average, it's a fairly decent sized investment. So when you look at the median home prices in California, they're materially higher. So you think about that investment in the context of the value of the home there. And all of a sudden, the home standby doesn't sound like that, it doesn't sound that expensive. And so how quickly could the penetration increase, I think there is a couple of factors that are going to influence that. How quickly can we add distribution and how impactful are the shut-offs, right? How frequent are they? And how long do they last? And unfortunately, I don't have exact answers for you on that, Brian. We're going to have to kind of see how that plays out. But I can only tell you that we're going to be pushing very hard at least on the things that we can control there, which is building out the distribution and how rapidly we onboard them.

All right. Thanks very much.

Great. Thank you.

I’m showing no further questions at this time. I would now like to turn the conference back to Mr. Aaron Jagdfeld. Please go ahead, sir.

Thank you. We want to thank everyone for joining us this morning, and again, we'd like to take this opportunity to remind everybody that we do have an upcoming Investor Day on Wednesday, September 4th in New York. We look forward to providing an overview of our strategies, growth drivers, long-range targets and other key investment highlights during that event. And more details are going to follow as we get closer to the date. So with that, we’ll conclude our presentation this morning. We thank you for joining us.

Ladies and gentlemen, this conclude today's conference. Thank you for your participation, and have a wonderful day. You may all disconnect.