Aaon Inc (AAON) 2017 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen.

Welcome to the AAON Incorporated Second Quarter Sales and Earnings Call.

There will be a question-and-answer period after management's brief presentation.

This call will last approximately 45 minutes to an hour.

I would like to turn the meeting over to Mr. Asbjornson.

Please go ahead, Mr. Asbjornson.

Good afternoon.

Norman Asbjornson here.

I'm hosting the event.

Before we go forward, I'd like to read a forward-looking disclaimer.

To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the safe harbor provisions of the Securities Litigation Reform Act of 1995.

As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated.

Please see the risk factors contained in our most recent SEC filings, including the annual report on Form 10-K and the quarterly report on Form 10-Q.

Thank you.

I'd like to introduce our CFO, Scott Asbjornson.

Good morning I'd like to begin by discussing the comparative results of the 3 months ended June 30, 2017, to June 30, 2016.

Net sales were down 1% to $101.3 million from $102.3 million.

Sales decreased primarily due to changes in product mix, despite increased volume.

Our gross profit decreased 3.3% to $31.7 million from $32.7 million.

As a percentage of sales, gross profit was 31.3% in the quarter just ended, compared to 32.0% in 2016.

The decrease in gross profit is primarily due to increased raw material prices.

Selling, general and administrative expenses increased 13.4% to $12.0 million from $10.6 million in 2016.

As a percentage of sales, SG&A increased to 11.8% of total sales in the quarter just ended from 10.3% in 2016.

The overall increase in SG&A was primarily due to increased warranty expenses.

The company has been working on modifications and refinements to its warranty policy.

These modifications more clearly define what qualifies as a warranty claim and puts a deadline for when claims may be submitted.

This has increased our warranty reserve and increased our warranty expense for the 3 months ended June 30, 2017.

Income from operations decreased 11.4% to $19.7 million or 19.4% of sales from $22.2 million or 21.7% of sales.

Our effective tax rate decreased to 30.2% from 33.9%.

The company's estimated annual 2017 effective tax rate, excluding discrete events is expected to be approximately 36.0%.

The difference between our expected effective rate and our actual effective rate is due to excess tax benefits from stock compensation.

For the 3 months ended June 30, 2017, and 2016, the company recorded $1 million and $0.4 million, respectively, in excess tax benefits as an income tax benefit.

Net income decreased to $13.8 million or 13.6% of sales, compared to $14.7 million or 14.4% of sales in 2016.

And diluted earnings per share decreased by 3.7% to $0.26 per share from $0.27 per share.

Diluted earnings per share were based on 53,151,000 shares versus 53,575,000 shares in the same quarter a year ago.

The results of the 6 months ended June 30, 2017, to June 30, 2016.

Net sales were down 0.2% to $187.4 million from $187.7 million.

Sales decreased primarily due to changes in product mix to smaller and less expensive units.

Our gross profit decreased 3.1% to $56.7 million from $58.5 million.

As a percentage of sales, gross profit was 30.2% in the 6 months just ended, compared to 31.1% in 2016.

The decrease in gross profit is primarily due to increased raw material prices.

Selling, general and administrative expenses increased 15.5% to $22.5 million from $19.5 million in 2016.

As a percentage of sales, SG&A increased to 12.0% of total sales in the 6 months just ended from 10.4% in 2016.

The overall increase in SG&A was primarily due to increased warranty expenses we mentioned earlier.

Income from operations decreased 12.6% to $34.1 million or 18.2% of sales from $39.0 million or 20.8% of sales.

Our effective tax rate decreased to 30.0% from 33.1%.

The company's estimated annual 2017 effective tax rate, excluding discrete events, is expected to be approximately 36.0%.

For the 6 months ended June 30, 2017, and 2016, the company recorded $2.0 million and $1.1 million, respectively, in excess tax benefits as an income tax benefit.

Net income decreased to $24.0 million or 12.8% of sales, compared to $26.3 million or 14.0% of sales in 2016.

Diluted earnings per share decreased by 4.3% to $0.45 per share from $0.47 per share.

Diluted earnings per share were based on 53,176,000 shares versus 53,564,000 shares in the same period a year ago.

Looking at the balance sheet, you will see that we had a working capital balance of $104.5 million versus $101.9 million at December 31, 2016.

Cash and investments totaled $51.8 million at June 30, 2017.

Investments have maturities ranging from 1 month to 12 months.

Our current ratio is approximately 2.9:1.

Our capital expenditures were $16.8 million.

We originally expected capital expenditures for the year to be approximately $42 million, but we have now raised it to $48.5 million to accelerate acquisition of sheet metal equipment.

The company had stock repurchases of $10.4 million year-to-date.

Shareholders' equity per diluted share (inaudible) at June 30, 2017, compared to $3.85 at December 31, 2016.

We continue to remain debt-free.

I'd now like to turn the call back over to our President, Gary Fields, who will discuss our results in further detail, along with the new products and the outlook for the remainder of the year.

Good afternoon.

While net sales were down 1% for the quarter, sales decreased due to changes in product mix despite the increased volume.

Potential on the water source heat pump has come along a bit slower than what we had originally forecast due to getting some industry certifications completed.

We're well on our way to those completions.

It's a 2-step process.

The first step is completed.

The second step is in process now and is imminent.

So the water-source heat pump is probably running a few weeks behind the schedule that we originally intended.

So the tone of business in the various market segments.

Replacement markets versus new construction, we find the ratios remaining very similar to what they were in the first quarter.

And we do quite a lot of replacement business in the K-12 markets at this time of year, and that's been very strong for us.

Commercial and retail.

We don't have very much retail penetration with our products.

We do have some in the commercial market that's reasonably noteworthy.

Office buildings remain steady as they were in the first quarter.

Medical and health care have both picked up a bit for us in recent months.

The good thing about that is medical and health care tends to use our larger tonnage units, so we should see a bit of a shift back towards a few more larger tonnage units.

Education, primarily K-12, that's what's been responsible for the smaller units.

They tend to run in the smaller end of our scale with a high number of quantity of units, but a low dollars per unit, comparatively.

We've still got probably 2 more months of very heavy production at the K-12 markets.

Manufacturing has been steady.

Lodging has been steady.

Municipalities has been steady as well.

A couple of areas that we would categorize as much smaller, more unique niche markets have been what we call mission-critical.

Some may know them as like data centers and this sort of market.

We've made some significant inroads on that with some of our products.

The encouraging thing is the backlog at June 30, 2017, was $83.5 million.

That's up from $69.3 million at the same point a year ago.

So we have the orders in the door, and they're in processing.

And with some of the management changes we've had in the manufacturing, the personnel changes, that transition has moved along quite well, and Norm will speak to that a bit more here.

So I'm going to turn it over to Norm.

Okay.

The outlook for the remainder of 2017.

First of all, I kind of should summarize a little bit what's been occurring within AAON.

We had an enormous amount of things on the table to be managed, and one of the things is management changeover.

There were a lot of us my age that were getting towards the end of our career, and some of those people decided to leave us this past year.

These are very critical people within our organization.

The head of our manufacturing, a gentleman who is 76 years old, had in excess of 40 years’ experience, about 30 of which -- more than 30 of which was here, stayed on from last summer when he wanted to retire until March of this year, simply because of the number of management challenges we had around here with all the things we've got on our plate to get changed and all the changes we're doing.

So he left in March.

Another gentleman who we didn't expect to leave quite so soon is a 58 year old gentleman who was our shop floor supervisor, managed the people on the factory floor in our Tulsa facility for many years and had somewhere around 30 years of experience doing that.

He told us last fall -- late fall, that he wanted to retire, and we asked him to likewise stay around, and he stayed till March.

Both of them were big fishermen, and I think that played a role in what they thought they should do.

At any rate, we brought on our new people to run the overall management of the manufacturing as well as the operation on the day-to-day basis at the floor level.

These -- we made quite a significant shift there.

The one gentleman drops down into low 30s age-wise, and with a limited amount of time.

He is a beneficiary of having an engineering education in conjunction with a Masters in Business Administration.

Very smart, very ambitious, very capable person, but he doesn't have a lot of years of experience.

So this being a very complicated company to run in manufacturing, probably similar to a lot of others, there's a lot that isn't quite so apparent for somebody to pass it off to the new generation.

Things that just happened sort of as a matter of fact, and the person doesn't even realize they are making those decisions.

But when a new person takes over all of a sudden, they find there's more decisions to be made rather than all what they thought were there.

The net result is you'll lose a little efficiency in your management.

A similar thing happened to us in the floor manager position, a similar educational thing, engineer with a Masters in Business Administration took over.

Again, very, very capable individual, very much able to do it, but again, short on industry experience.

So with those 2 things combined, you can see we had some difficulty managing our personnel.

And we further complicated this by the fact that, if you can recall back to the fourth quarter of last year, we had kind of a slowdown in our order input in the fourth quarter, which resulted in a somewhat lower backlog when we came into the year, and therefore, had an effect on our first quarter.

And to compensate for that, when people left, some of whom were good people, left for whatever reason, but then when we got through with the people who were leaving, we decided we were going to take out some of the low performers, and we did that also at just our personnel to our business in the first quarter.

Then business started picking up in the first quarter or the end of the fourth quarter, right in that area.

And finally, it came back up by the end of February, and we were back in the market, starting to replace people.

Well, we've been replacing people in a serious basis ever since, but we're running at about 4% unemployment here in Tulsa, and you don't have a lot of good people to select from, and we have been trying to upgrade our personnel.

And so it's been a slow and torturous path for us to get the type of people we wanted as fast as we could.

And to manage them with 2 new managers, so altogether, it slowed down our growth.

So what happens?

We don't make the volume, and we have a significant increase in our backlog.

That was all okay in that -- for a long time in there, we were starting to get the backlog too high and thereby affect our customers who wanted stuff shipped.

We have arrived at a point or have for the past few couple of weeks anyway been at that point when they want more -- they want it a little faster.

So we're not encumbered by not being able to ship by customers all want their products.

So the burden is on our back to get it out the door.

Well, the latter part of this quarter, our new personnel started coming into their own pretty well as well as the management of the new personnel.

So the last couple of weeks we've had quite good production, but that wasn't sufficient to pick up the whole quarter.

And consequently, we came out as we came out, and we were running real strong now, anticipate running strong for the rest of this quarter.

So it was a necessary change in personnel, just like the bringing in of Gary Fields was necessary change.

We've had a huge reduction in the age level of the management of the company, which is a very positive thing going forward in that we no longer are encumbered by a lot of people my age being in command around here.

It's now being taken over by much younger generation.

Very capable generation.

I admire what they're doing.

I'm still around helping where I can and advising where I can, and I'm just very pleased with what's going on here, management-wise.

So we had, if anything, we've had a little softening of management while the transition was underway.

But it's headed to, I believe, even stronger management then we've had in the past, including myself.

I'll throw myself into that loop, too.

I think Gary is trying to do things that I was not able to do.

So I think the management situation is outstanding.

I think we got a little bump here.

I think things are coming along well in all of that.

Now the one thing that we've been talking about that needs a little further amplification is the water-source heat pump.

Those of you who have been around realize that it was in August of 2015 that we decided, finally, to go into the water-source heat pump business by building our own product.

We've played with purchasing 3 different companies before that over a few years’ time frame before the 15th of August, before 2015, and chose that, that wasn't good, we were going to have to pay too much, and we were going to get some antiquated product and antiquated manufacturing facilities.

And we decided we could improve on all of that.

We could cost the company less money, we could get very current up-to-date product, and we can get a very current up-to-date technical manufacturing.

Now let's talk about that a little bit.

The water-source heat pumps products that we've designed have been widely received very well.

And there's an industry newspaper that is called Air Conditioning News, that has a contest on a variety -- all the different products that are manufactured in our industry, different types of products, and they categorize them by different categories.

And they put them out there, and there a total of 81 different entrants into those.

And I'm not actually sure how many categories there were, but there were a number of categories.

The category that -- we won in 2 different categories, but the one I'm going to talk about right now is the water-source heat pump.

The water-source heat pump got a gold, and there is gold, there is a silver and there is a bronze; the first, second, third so to speak.

We got the gold with the water-source heat pump.

How does that happen?

Well, it happens judged by the information we put out there as to what the product is, but since all these products that are out there are pretty new products and therefore, don't have a lot of history, that is not -- they can't be judged on history because the people voting on them probably haven't seen or used some of them.

So what they do is they survey the various people who are voting on it, which is all, basically -- for the most part it's a contracting trade, doing the mechanical work in the industry (inaudible), other participants too, but contractors dominate it.

And what they do is respond if they have any thoughts as to what various products should win.

Then they choose one of those responses and they publish that on with these entrants so that other people have the advantage of seeing what one of the recipients of the product have to say about the product.

The gentleman who chose to do that for us was in the northeastern part of the United States, a rather small state of up there.

And he sent in a thing saying that he did a renovation on an office building, purchased approximately 1/3 of the units that were in the building and put new units into that.

And his primary thing that he thought was the outstanding feature was one that we weren't even pushing that hard.

We were pushing the feature, but not that hard.

The feature they chose to say was reason that he chose to buy the product was because of its weight.

We built the unit out of aluminum.

We used aluminum in one of the heavy products, which is the evaporator coil, and we have a significant weight advantage over our competition.

And pushing these units up into the ceiling in our replacement job is a little bit of a problem as you can well imagine.

So he bought it based upon the weight and the savings he felt he would incur by having it lightweight.

So that was a nice thing that we heard that, because we thought there were a lot of reasons for them buying, that were stronger than the weight, but he chose to say the weight.

So the unit has been well received.

So why aren't we selling more?

Why isn't it making a big impact on our P&L statement?

As was mentioned by Gary, we're waiting for the AHRI certification.

Now what is that?

That's a certification as to the efficiency of the unit, and that we had anticipated being further along and doing that faster.

But in order to get that done, you have to submit all the electronic information as far as the capacity of the unit under varying conditions, you have to submit a whole lot of information.

And then after you've done that, so that you tied down all the loose ends, you tell them what kind of a compressor you're using, every component in it.

And you have all this multitude of different units to do.

Well, as we have noted before, we had $16 million worth of sales last year in larger tonnage equipment, which were already in our bulk deals, things that we're already doing.

These small units we were bringing in, while they were the dominant volume makers in the industry, we still had $16 million of that.

Well, it so happen that we didn't have to have that registered before.

Once we wanted to register the small tonnage units, we had to also include those which were within the realm of registering on the bigger tonnage.

And so we had to not only get the 2 to 5 tonne that we are introducing right now, but we had to get all the other products out of that $16 million, which were applicable.

So it was a formidable challenge.

We haven't anticipated having quite as much work to do, and we had a little more time to do it.

And then we're at the mercy of the industry, AHRI, to move the ball forward, because we turned it over and it goes into their court.

They didn't respond real fast and tell us what the money was and what units they wanted to check and find out how they work and verify that what we said in our literature was correct.

And finally, they gave us that a little over a week ago, and they gave us 30 days to prepare all that equipment.

They come in then and we have to have multiples of every product they ask for and they check -- they take one out of each of the 3 of the things that we have to build for every size and they test it.

So we're still in that process of it.

We anticipate but, of course, a lot of this is dependent on how fast AHRI moves on the testing, somewhere between 50 and 90 days from now, we should have our certification.

As you might suspect, all of our competition are making a very big thing out of the fact that we don't have certified energy efficiencies.

So that has been somewhat of an encumbered.

The other thing is that about half of our sales force already has a product line, and so they have the choice of either staying with the product line they have or going with us.

We have been given assurance by the vast majority that they're going to go with us, but they're not going to cut their selves down from what they're using right now when we aren't quite up with all of our products ready for them.

We're very, very close right now, but there are a couple places where we're deficient and don't have the new product out.

So they're starting to move over and move their business to us, we're in that transition now.

That has all not been too bad, though in our eyes.

So we haven't pushed this because, as we mentioned, we came up with a new way to manufacture this product.

What we did was we could have come up with a product manufactured in ways that were similar to what we're doing right now and similar to what everybody else is doing, but we're trying to gain an advantage.

So we said, "Let's see how far we can go to automating the manufacturing process."

Towards that end, what we did was went out look for automated equipment all over the world, which would produce some of these automation.

We pretty much bought stuff from all over the world, and 4 of the different processes with fabrication, this heat metal fabrication, copper cutting and forming of insulation and the delivery system to make the availability of product at the assembly line happen.

We bought some very large automated software-driven towers.

All those 4 things had software of their own device.

We had to write a software to read that, we had to write a software to run the unit.

And that took us a lot of effort to get that software up and running and get it debugged.

And we're now at a point where it's debugged and we are now at the point where it is debugged and we are still running into a bugs -- at first, we were running into them every few minutes.

We're down now to run into a bug every second or third day.

And we will probably have bugs for some time to come, but it's now up to where it is a workable situation.

So we've been building units on every size and every voltage, all putting them in stock.

We have approximately 1,700 units in stock right now.

That has been noticed.

I suppose you might have noticed that we have a little higher inventory level than we've had before.

A lot of that is either parts that we bought for the water-source heat pump or else is the actual finished goods water-source heat pumps and a little bit from the fact that we anticipated being able to ramp up our legacy product faster than we were able to, so we have a little more products in that.

All of that will start liquidating down somewhat, but we will continue to have a higher inventory than historical because we have a new product line.

So those are some of the things that need to be talked about there.

Now we have by the fact that we have a backlog increase, if we had cranked that backlog through and pull this down, we'd be about 7.4% greater than we are now if we had pulled our backlog back down to where it was.

So we got a little bit of a slush fund in there to get some growth.

The water-source heat pump is just now starting, too.

As we have been indicating for a long time, it would be latter 2017 before it started really moving forward.

We're still in line to have that start happening.

Maybe it's going to happen a couple months later than we thought, but it is going to start happening in the latter part of this year.

2018, it's going to start moving a little better.

So in addition to our normal legacy products' growth, which have been growing very nicely, whatever number you want to choose out of the backlog and action.

And we anticipate that growth to continue and be modified somewhat as the water-source heat pump comes up to speed during 2018.

Gross profit, of course, is contingent upon our running the place right.

And a lot of the things we've been doing, we've been cleaning up and getting things over.

And you got to recognize that this startup that we're talking about, we're doing that, we're funding that as we go.

So what we would have had to pay for the companies we looked at were somewhere up in the $300 million and $400 million.

We're doing that out of cash flow right now.

We're not damaging our backlog of money hardly at all.

We're in fact doing pretty well on that.

So I think it's -- as the biggest stockholder, which I am, I'm extremely pleased with the way it's affecting me, and I trust most of you see a similar thing, although I'm always disappointed, I'm a very greedy individual and I wish it would would've been better, but it wasn't.

Going forward, however, I think it's going to be very, very good.

Capital expenditures for 2017, we came into the area talking about low $40 million or $42 million.

And because of what we see happening, we thought that it was wise for us to move forward on some of the capital expenditure we have slated for 2018, namely some sheet metal fabrication equipment.

And we have announced previously an increase from the $42 million to about $48.5 million.

And our capital expenditure expectations, even though we're, as Scott mentioned, quite below that for the first half, we anticipate we're going to get quite a lot of capital expenditures in the last half year, getting ourselves ready, both in the manufacturing of product as well as bringing in the new cells, test cells for our new R&D lab, which will be going online approximately this time next year.

Those of you who knew the lab, suffice to say, it's 162,000 square-foot lab, going to cost us right now about $33 million.

And it will be state-of-the-art and leading-edge technology, have capabilities beyond any that we know of any laboratory anywhere in the world.

So AAON goes into last part of 2017 in excellent shape, with a new management, a younger management in place, getting seasoned, looking very optimistic, and I open it for questions.

(Operator Instructions) Your first question comes from the line of Joe Mondillo.

So I wanted to try to get a better idea of exactly what was going on with the management and production disturbances related to that.

What was the timing of all this?

Does this go back a couple of quarters?

Because you mentioned that both these individuals who were going to retire last year, but then it got extended.

So I guess, they were there.

So in that time period, I assume the production of your orders and such weren't that disturbed, so was this just a second quarter issue?

And also, were you turning down orders throughout this time period or was it just a case in point where production was just not as efficient and lead times got extended a little bit more?

Any further color on the timing, the extent of the issue this caused?

Joe, this is Gary Fields.

So the 2 gentleman we spoke of, Bob Fergus and Ed Johnson, both retired in March.

So the transition -- the 2 young men that took their places really began transitioning back in probably November, December, to some extent, shadowing both Bob and Ed.

But the last day for Bob and Ed was the same day, and it was in March.

So the entire quarter, second quarter was produced by the 2 new young men.

So as you can imagine, the first few weeks was a little bit, I like the way you called it, disturbance, that's a good way to categorize it.

And it was like there was a ripple in the water kind of disturbance.

But it wasn't a big splash, it was just a ripple.

Well that's began to smooth out.

And we did extend lead times, to your point, that's why the backlog grew.

We've extended lead times, probably, on average, 2 weeks, in some cases 3 weeks from what we had historically been producing.

Now we're beginning to gain steam on that.

And actually, as Norman mentioned, it's grown much stronger and they are running at a pace that's ahead of anything that we've ever done.

So they had some catching up to do.

They've done that, and they've actually gotten ahead of the curve now to some degree.

And the other thing that they had a little more focus on getting some efficiencies as they saw them.

And so there was some, again, a little disturbance in that in trying to get people to change their culture a bit to some new efficiencies.

And I think they've made great headway.

We get a daily report telling us how we're doing on a year-to-date basis, every morning, and we've been in the green for a little bit now.

It's all about being in the green.

It either flashes red to us that we're not progressing or it flashes a green that we are progressing.

It measures several things about our company and tells us that every morning before we come to work.

So we know how we're doing.

We get a daily report out of the computer telling us how we're doing.

We're in the green, which means we're advancing pretty consistently now.

Yes.

And it compares it to the previous year, which, of course, 2016 was a record year.

Okay.

How would you compare -- or how would you look at the industry, overall?

Because it seems like listening to some of your peers that things have slowed a little bit.

It's tough to tell exactly how you would have done if things were running smoothly, it sounds like you would have done better.

But I don't know if -- I'm not sure if you're talking 200 or 300 basis points of growth or 500 into 1,000 basis points.

It sounds like it's maybe the former.

Do you sense in the first half of the year that, overall, the industry had slowed a bit at all?

Well, I think the industry as a whole has.

There are segments of the industry that are anywhere between flat to very, very slightly up.

Norm and I were just looking at the water-source heat pump report for the first 6 months of this year versus the first 6 months of last year.

And overall, it was up -- I think, it was 1%.

1.4%.

Yes, 1.4%.

So it's -- that's not much.

I haven't examined -- our core products being the rooftop units, I haven't looked at that same report.

But the last time I did look at it, we were either most categories were flat, some of them were slightly behind.

They were very dependent upon the tonnage size.

Some were significantly ahead, some were pretty flat and some were down.

So it depends upon which part of that market, tonnage-wise, you have your strength as to how it was affecting you.

I think the fact that our backlog is up significantly, so you kind of do the math there and say, "Hey, we produced very close to what we did in 2016, so far.

We're just a little bit behind that as far as what's gone out the door, but the backlog has grown." And so you can put the math to that and analyze what might occur as we reduce that backlog.

When you look at your order intake trends, do you feel like throughout the first half of the year, up until now, that things have started to slowly get better in terms of the order trends?

Well, exactly.

Our order intake trended up, beginning with the first month of the year.

It actually started turning around towards the end of the fourth quarter, but we have, again using that green and red scenario, we have stayed in the green virtually every day all year long on order intake I mean, there's some days that we'll be a little behind, but when you start getting enough data points out there, then the trend for order intake, has actually -- it's been up very nicely.

(inaudible) what's been suffering is units out the door, and that's what we've been talking a lot about why that was.

And now, as we've said, we're now running faster than we've ever run.

So all of the troubles which we've had most all of the earlier part of this year for either not having orders from the fourth quarter or from the fact that we diminished our workforce and then had to replenish it, they are pretty much behind us now.

Okay.

And I know it's probably tough to sort of address this, also just in terms of the gross margins.

You mentioned a little bit I think how mix has been a little unfavorable in terms of smaller units, but I also assume that these production issues have weighed on efficiencies.

And now that things are sort of better, and it sounds like mix may even be, you mentioned, health care, maybe sort of transitioning to maybe a little more of a favorable mix.

Do you anticipate gross margins to start to improve on a year-over-year basis again in the back half of the year?

Jeremy (inaudible)?

Scott?

Yes.

The margins are being impacted as well by the commodity costs and the component costs.

And commodity costs are going up with respect to copper.

And so we're trying to offset some of that with getting the efficiencies back up in the actual assembly process.

And hopefully, if commodity costs will stabilize, we'll be able to evaluate what that impact is going to be going forward, and we may be putting in some price increase later in this year.

(Operator Instructions) You have a follow-up from Joe Mondillo.

A couple other questions.

So number one, for the water-source heat pump.

Do you have anything in backlog?

And if so, can you quantify what you have in backlog related to that?

We have very little backlog.

We've been producing about as fast as we get them in, and we've been spending in time putting additional units in stock.

And as I mentioned, our stock is up around 1,700 units right now, which is a real high position for anybody in this industry.

Normally, most people carry very low stock for whatever reason, their own reason.

We have decided to carry a higher stock that we can benefit by having a bigger stock and leveling out our production and doing a number of things that we think will make that make money for us.

So it's not that we're getting -- what we announced early on was we were intending to go up to as much as 2,300 units in stock, we're at about the 1,700 mark.

And now the orders are slowly but surely starting to materialize faster, and we're not going to speed that line up any sooner than we really have to because it allows us to keep our costs down when we do have one of these shutdowns because of a software problem.

We don't have too many people standing around when we fix the software problem.

So it's working out quite well for us to bring it up into speed at a minimum cost.

We're losing a little bit on the revenue line, but we're saving on the bottom line at the same time.

So we're trying to tread that thing so that we get the revenue and bottom line performance working to the best possible way.

Okay.

And I know you were talking that this first production line was -- the goal was in terms of low-hanging fruit within the industry was to achieve $50 million of revenue, give or take, on this production line.

And then later in 2018, you're going to open up for a new -- another second production line, and that will, sort of capacity-wise, will get you the same so that gets you to sort of that $100 million that you've been sort of talking about or targeting.

I'm just wondering, where we're at in terms of that first production line.

And I know, your goal was by the end of this year to get an annualized run rate exiting the year, getting to that sort of $50 million, I think.

Where are we?

Is that still achievable?

Or is that sort of still -- is that pushed into 2018 in terms of the first production line?

Any insight in terms of those target numbers and timing-wise would be helpful?

(inaudible) talk about the production line and turn this order input over to Gary.

Gary has taken over that part of the diet.

One of the things I'm concentrating on is internal issues, including the production.

We're going to have 3 production lines for water-source heat pump.

They're all on what we call Line 6, Line 6 A, B, C. It's A that's running right now.

And that is, as you say, the one to take us up to $50 million or a little -- actually a little more than that.

But one of the features the way we're doing this is quite maybe a little different than everybody else who has set up a line.

A line is for small tonnage units.

B line is going to be a different kind of a line.

It's going to be a line for bigger tonnage units and for taking problem units off from Line A -- off from the A line.

So if we get a problem unit on the line, we're not going to slow the production down, we're just going to let that problem unit slide off and onto the B line and let the B line fix it up because the A line is a high-volume line, the B line is a low volume line, so we will get a more cost-effective method of correcting whatever problem is in that particular unit and will slow the A line down.

So the A line runs from north to south.

B line sits right on the end of it and takes the unit directly off on the underline rather the than going to the test bed and outside they go right onto the B line.

The C line is going to run from south to north and also end at the B line also.

So it will be dumping off on the B line.

So the C line is going to be the very high-volume line.

The B line is going to be this low-volume big units and (inaudible) line.

So assuming (inaudible) approach we're here using it, trying to get productivity up in place.

The B line is under construction right now.

It's about 50% production -- 50% manufactured right now.

The physical portion of it is pretty well done and it's now has to have the equipment put in place and start it up.

So that will probably be done in another couple of months and be active.

So that will speed up the A line by taking off the ones that have problems in them, and it will also give us the ability, as we design out the bigger stuff, which is low-volume stuff, that we will have a place to build it.

And then somewhere around the end of the year, we will start construction on the C line, which will be the high-volume line, running from south to north and ending at the B line also.

So by this time next year or somewhat before this, probably, we will have all 3 lines up and running, which will give us the capability of getting up to somewhere around a couple hundred units a day, at rather modest, hourly.

Understand the way we run our shop here.

Everything else in this place on the sheet metal department for our historical equipment, we run 24 hours a day, 7 days a week to get maximum usage out of the money we've got invested in all that machinery.

The assembly line we run 12 hours a day, 7 days a week.

It's got adequate assembly capability to keep up with that sheet metal operation.

And then at the water-source heat pump, we're running it 5 days a week, 8 hours a day at the present time, and we will, for some time to come, because it's got problems and it needs to have the engineering department, upper management and people like that around here to help it with its problems, and we don't want to run it over the weekend when we don't have all those people available to it.

Ultimately, it will go to probably a 12-hour 7-day a week operation once it's running well and we don't have concerns about needing any of the supported personnel around here on a weekend.

And of course, we can always take it up to -- like we do on the sheet metal, a 23-hour day and 1 hour down for maintenance.

So we've got a lot of latitude in what we do.

Norman, that's very informative and really great color in terms of that.

Gary, could you comment just in terms of the so we got a pretty good idea of what the daily sort of run rate in this production line can do.

Can you sort of give some color on the order intake that you're starting to bring in?

And how your -- are you controlling the speed of that?

Or are the floodgates opened up at this point?

And if so, how that's going?

Okay.

So we have been controlling the speed, and still continue to control it to some extent by turning on only models and options that we have fully vetted out, that we've had test runs of.

So that's really been the throttle.

Approximately each month for the last 3 or 4 months, about once a month, we open that valve just a bit more.

Right now, I'm going to say that we still have some closure to the valve and it's because -- probably 2 or 3 different reasons, one of which, on a product of 2 through 5 tons.

When you go for a project quote, it seems like there's always a handful of 6, 8, 10 ton units in there.

Well those are what we intend to build on 6 B. So we still don't have the ability to turn those on with a cost-effective product.

We have -- in our historic products we have some ability to build those, but it's not cost effective.

So I didn't want to turn that valve open too much.

What we're doing is managing that on a kind of a case-by-case basis.

So let's just say that a project has got preponderance of 2 through 5 ton units that we are prepared to build with 6 A. Then that project has got a very small percentage, handful of units that we intend to build on 6 B to be ideal, but we have another method of building them in our historic product.

Then, we go ahead and open that up and look at that project.

And we've secured a couple of projects doing that.

So we're playing still project by project on those kind of opportunities.

Then, there are some options that are desirable options, market wants options that we're still vetting out in all of our processes, testing and building that we've yet to turn on.

Those are probably like the final, little half turn or 3/4 of a turn left in the valve to turn it, to what you're calling the floodgates open.

So we're running about 90 days behind what I originally thought we would be -- we've been able to open up the floodgates.

Once we get the AHRI certification complete, which as Norm said earlier, we anticipate sometime in the 50 to 90-day time frame.

Once that's complete, we will also have completed some testing and preruns on some of these other desirable options.

So what I'm saying is that I'm about 90 days at the most from turning the valves wide open.

So right now, we still manage the opportunities on a case-by-case basis and we're looking out to make sure that they're not delivery-sensitive because we do not want to commit to delivering something that we're not fully prepared to deliver.

So we have several opportunities that are fourth quarter opportunities that we've already secured, that our reps have secured, of course they haven't sent the orders in to us yet because they're going through their processing but there are several very nice orders that have been secured.

And so to say that the run rate is going to be what we are anticipating in that $50 million annualized run rate, we might possibly hit a run rate like that at the very tail end of the year, but I'm still somewhat skeptical of that.

I think that we're going to have some ramp-up.

But there have been some developments that have been very favorable.

One of the things that we have mentioned many times is half of our reps represent a competing line.

One of our reps on the west coast sent us a letter yesterday or the day before and said that he had dropped that competing line because he felt like we were far enough along to serve his needs and he is 100% on board with us with no conflict.

Well, that's the second one that's done that actually.

The other one was right here in Oklahoma to the west of us, had done the same thing.

So we're going to see these people converting their existing business to us as fast as they feel like we're ready to do it.

And when we prove that we're ready to do it by delivering -- these guys all talk to each other.

So for instance, this West Coast sales channel that just made the conversion that dropped the competitor.

He has brought us an opportunity that we were looking at the right before this conference call that should we capitalize on that opportunity, which we're going to try it very hard to make sure we do.

Should be capitalize on that and deliver that for him, then that news will spread very fast.

So I think this is kind of like firewood stacked up in the fireplace, you got all kindling underneath it and we're just now lighting the match to it.

Okay.

And regarding the sort of reps transitioning from a competitor's line to your line, at this point in time, where the production line is and how much you're willing to sort of go out there and take orders, in terms of that transition of reps to your product line?

Are you -- is that sort of in line with your expectations?

Are you at all disappointed on the speed of that?

Or is this sort of in line and you just need more time of production and getting the certification and you expect that will continue to progress?

I'm going to say the latter.

I'm going to say, while I'm disappointed in the time line as it occurred because of some of the restrictions that we've had with the approval from -- the agency approval and then getting our software vetted out.

We had been probably a little more optimistic -- I certainly was a little more optimistic than what proved to be realistic as far as how long it would take to get some of those preparations vetted out.

So the way I'm looking at it is we probably -- versus the time line that I had in mind, we're probably -- just take everything that we've been saying and move it forward in the range of 90 days.

But it's all occurring, as far their endorsement -- our sales channel's endorsement of our product, I could not be happier about that.

I mean -- they -- they are absolutely endorsing the product, and we've had delivery of a decent number of units and installation of them, and we've gotten feedback from that, and by and large, it's been very favorable feedback.

Of course, like any newer introduction, there's been a few little snags here and there that has given us an opportunity to work them out.

But that's also a good reason to say rather than having open the valve too much, too soon then it might not be so manageable.

But this way, these small, little -- I really call them inconveniences, they've been about the same ripple in the water that the management change was.

It's not tumultuous, but it's a little irritable, and so we've managed to work those out in a very nice pace.

So it's preparing us.

In other words, summarize it this way, we're building a very, very firm, strong foundation under this business.

It's very solid and we've got very solid support.

So I'm as optimistic as I have ever been, and becoming more so every minute, because we accomplished some things that some of them were a bit speculative as far as how we can automate some of the software.

Some of this has never been accomplished before, and so while you're optimistic that you've got all of the right people in place to make this happen, it's never been done before to some extent, and now we've accomplished quite a few of those things, they are now in the rearview mirror.

Just one last question with the WHP.

At this point in time, would you say the overall operations with all the costs that are baked in, whether they are production costs or any other sort of one-time like up, startup type cost, is the business profitable or is it -- I would imagine it would it is probably a drain on the overall company at this point in time, but can you comment on that at all?

At the present time, our volumes are low and you're correct.

It is not adding to our margins.

We aren't quantifying the magnitude of that at this point, but it is a drag on our profitability at the moment but not a major drag because we don't have a whole lot of investment in it in the first place.

It was very low cost to get into it.

It's mainly been intellectual capital, time and resources relative to that.

Okay.

And Scott ...

One thing that should be said here.

When we do start cranking up the volume, what's probably going to happen is we're going to get it to be a profitable entity before very long to where it is moving, but it wouldn't be moving at the same percentage profitability that our historical product will be.

So as it ramps up, it will be a bigger and bigger chunk of volume at a lower -- lower margin.

And so [we'll have] adverse effect on margin for a little bit as it crops up, but it will have a positive effect on our bottom line total dollars of profitability.

But long-term, we do anticipate the margins will be comparable with our legacy product line.

We did a lot of studying early on, and once we get to everything, all the kinks worked out of this, and everything running full blast.

We have every expectation that it will meet this previous profitabilities that we have experienced over the years.

But there will be a time in here when we're cranking it up, we'll probably run the volume up, the revenue will start increasing, and we might suffer a little bit on the percentage of profit, but the profitability will move up also.

So it would transferring dollars, real dollars on the bottom line, but at a lower margin, we are getting some of them at a lower margin.

Right, understandable.

I just have 2 other questions.

Scott, in terms of the SG&A, I may have missed this, but is there any way you can quantify sort of these one-time life warranty expenses?

It seems like that is sort of the behind us and going forward, your SG&A should be sort of more normal as compared to historical levels?

Is there any way you can quantify what was sort of not normal in the second quarter?

Well, I mean, we did have an increase in the reserve from the beginning of this year.

So that's part of what you see within the first 6 months of this year, is an increase in our reserve just due to the general cyclical nature of our sales.

Because when you do have warranties, they tend to be earlier in your shipments.

So as our sales are going up, the warranty reserve that's necessary is going to go up, because you have more recent sales volumes.

So that will, of course, decline as your sales volume goes down generally towards the latter part of the year.

The other part though is the part that you're talking about, the one-time portion, which we think is somewhere round about $1 million worth of that expense is around that onetime increase that we experienced, and most of that is a timing issue, people accelerating some claims, resolving some old outstanding issues and reviewing how we handled some prior situations and getting those all processed through, and we believe that is all behind us at this point.

Okay.

And how did the reserve increase?

$666,000, I believe, it is, since the beginning of the year.

Okay.

And I mean that may trend down but that's not going to fully go away, right?

Well, it follows with what your charges are against that reserve, of course, and also with the volumes.

So if our volume increases further going forward, then we're going to have the reserve going up accordingly.

And this is related to water-source heat pump or other new product?

Product in general.

I mean, it's rooftop primarily.

The warranty incident on water-source heat pump in dollars is not even measurable, it's so low.

But related to that though, as that business ramps up, do you anticipate that to become somewhat of a substantial expense because it is a new product and you're not -- you're going to have to reserve for something, right?

Depends upon what you mean by substantial.

Let us tell you this, because of the nature of the product being a high-volume low-cost product, one of the things which we agree upon around here, which is maybe exaggeration of what we agreed.

We agreed we're going to build a perfect product.

We weren't going to have -- we were not going to have anything, but wear out, just the warranty part would be things that worn out, not for failure and all those kinds of things.

And so we paid a lot of attention to the components that we selected.

We did an enormous amount of work on the manufacturing methodologies.

For instance, when it gets to the end of the production line, we hook on refrigerant sensing devices, we hook on electrical sensing devices, we push a button and the computer run tests it.

If the computer in its a run test, which runs it through all the variations it should run it through to check everything.

Finds that it doesn't pass, the big red sign comes up.

We have some 50 screens, big, large, several-inch television screens around this manufacturing process that we use for communication and it comes up with a big red failure.

And when it comes up with that, in all of our product lines, if we don't allow the computer, the computer generates our nameplate, it prints our nameplate upon the completion of our check.

And all the other things, we have human beings doing this -- these checks.

In this case, we have the computer doing the check.

If the computer fails the unit, it will refuse to print the nameplate.

Without a nameplate, we can't ship the unit.

So human beings are taken out of the picture.

They don't have the ability to override the machinery.

And thus, we will not get something out the door that the computer won't pass.

If it fails, they have to take it, fix it and it has to go through the computer again, and if computer fails it again, it's the same sequence.

They've got to get it to where the computer will pass it and print the nameplate, otherwise it doesn't go out the door.

And the degree of absoluteness that we've put into the system to make sure that the computer doesn't get fooled is the best we know how to do.

So we're very, very confident we're shipping an extremely good product out the door.

Because we recognized with high-volume, making one little mistake on a high-volume item could be an enormously costly thing.

And so to every degree that we know how to eliminate that we've done so.

So no, we don't think we're going to have a big issue on warranty.

Will some stuff that's under warranty wear out?

Yes it will, and those things will be serviced under the warranty cost.

So we're thinking that our warranty cost as a percent of sale is going to be very low.

Okay.

It sounds like any warranty that was to be the reserve, the customer should pay for it, Norm.

It sounds like you have such a good product there?

Well, we think that once people realize what they're getting then we'll be able to get a very nice price for our product, because I think there will be a lot of very satisfied customers.

From the basic concept for the unit the way it's been built together and everything they've already agreed it looks great, everything that they see looked great, well we want the performance to be equal to looks.

It sounds like it.

Just 1 last question for me and I appreciate you guys taking the time here today and bearing with me.

The taxes, Scott.

They were a little on the low side.

I think you even mentioned in your prepared remarks about that.

Going forward though, the back half of the year going into 2018, what can we sort of think about in terms of tax rate?

Well, we can't totally predict that nowadays because we do have to account for that beneficial impact when people exercise stock options.

And we can't control who's going to exercise when and what the impact of that is going to be.

So we have had the lower tax rate because it's reflecting people who have been exercising equity compensation, giving us a beneficial tax situation, and there's really no way for us to project that.

Outside of that is a normalized rate still round 36% or so?

Normalized is 36%.

And so far this year, we've had, I believe, it was $2 million versus $1.1 million last year.

And there are no further questions at this time.

Okay.

All right.

Well, thank you, ladies and gentlemen.

We appreciate your time we've taken to join us with our quarterly report.

Hope that we've answered all your questions.

As you might have believed, we've been in a little bumpy time here, but we're very optimistic about where we're going and feel very comfortable with what is going on.

We don't see any big ripples in the economy yet, even though there is a -- as we all know, a lot of turmoil out there, but doesn't seem to be slowing the economy much.

So we're pretty optimistic.

Thank you.

And that does now conclude today's call.

You may now disconnect your line.