Aaon Inc (AAON) 2018 Q2 法說會逐字稿

Good afternoon, ladies and gentlemen.

Welcome to the AAON, Inc.

second quarter sales and earnings call.

(Operator Instructions) 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.

Before we get underway, I'd like to read the 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 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.

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

Welcome to our conference call.

I'd like to begin by discussing the comparative results of the 3 months ended June 30, 2018, versus June 30, 2017.

Net sales were up 8.2% to $109.6 million from $101.3 million.

New sales for the quarter are mainly due to the increases in our air handlers and water-source heat pump products.

Our gross profit decreased 12.9% to $27.6 million from $31.7 million.

As a percentage of sales, gross profit was 25.2% in the quarter just ended compared to 31.3% in 2017.

The company is closely monitoring its staffing levels to improve its production efficiency.

Over time, freight costs have also been increased due to the price of fuel and the shortage of drivers.

The company is actively negotiating freight rates to help control these costs.

Additionally, as the company's research and development lab approaches completion, the company is incurring costs getting the lab running.

These are not necessarily offset by increases in production.

Selling, general and administrative expenses increased 9.3% to $13.1 million from $12.0 million in 2017.

As a percentage of sales, SG&A increased to 11.9% of total sales in the quarter just ended from 11.8% in 2017.

Income from operations decreased 26.2% to $14.5 million or 13.2% of sales from $19.7 million or 19.4% of sales.

Our effective tax rate decreased to 19.8% from 30.2%.

The company's estimated annual 2018 effective tax rate, excluding discrete events, is expected to be approximately 27%.

The decrease in our effective rate was due to the Tax Cuts and Jobs Act that was enacted on December 22, 2017, lowering the federal corporate tax rate to 21%.

Net income decreased to $11.7 million or 10.7% of sales compared to $13.8 million or 13.6% of sales in 2017.

Diluted earnings per share decreased by 15.4% to $0.22 per share from $0.26 per share.

Diluted earnings per share were based on 52,718,000 shares versus 53,151,000 shares in the same quarter a year ago.

The results of the 6 months ended June 30, 2018, versus June 30, 2017.

Net sales were up 11.3% to $208.7 million from $187.4 million.

New sales for the quarter are mainly due to the increase -- increases in our rooftop units and water-source heat pump products.

Our gross profit decreased 24.2% to $43.0 million from $56.7 million.

As a percentage of sales, gross profit was 20.6% as compared to 30.2% in 2017.

In January 2018, the company paid all employees a onetime bonus of $1,000 per employee as a result of the Tax Cuts and Jobs Act, the act which lowered the federal corporate tax rate from 35% to 21%.

This bonus increased cost of sales by $1.9 million, excluding taxes and benefits.

Additionally, the company typically has seasonality in its sales and workforce, with the fourth quarter and first quarters being lower in production.

The company maintained a higher level of workforce through the end of 2017 and beginning of 2018 in anticipation of our growing business.

The company's water-source heat pump business is still in the early stages of production and is not, as yet, as profitable as our other products.

Selling, general and administrative expenses increased 3.6% to $23.3 million from $22.5 million in 2017.

As a percentage of sales, SG&A decreased to 11.2% of total sales as compared to 12.0% in 2017.

The overall decrease as a percentage of sales in SG&A was primarily due to the decrease in advertising expense and profit sharing.

Income from operations decreased 42.3% to $19.7 million or 9.4% of sales from $34.1 million or 18.2% of sales.

Our effective tax rate decreased to 19.5% from 30.0%.

The company's estimated annual 2018 effective tax rate, excluding discrete events, is expected to be approximately 27%.

The decrease in our effective rate was due to the Tax Cuts and Jobs Act that was enacted on December 22, 2017, lowering the federal corporate tax rate to 21%.

Net income decreased to $16.0 million or 7.6% of sales compared to $24.0 million or 12.8% of sales in 2017.

Diluted earnings per share decreased by 15.0% to $0.30 per share from $0.45 per share.

Diluted earnings per share were based on 52,754,000 shares versus 53,176,000 shares in the same period a year ago.

I'll now turn things over to Rebecca Thompson, our Chief Accounting Officer and Treasurer.

Looking at the balance sheet, you'll see that we had a working capital balance of $83 million versus $103.7 million at December 31, 2017.

Cash and investments totaled $24.3 million at June 30, 2018, the investments and maturities ranging from 1 month to 5 months.

Our current ratio is approximately 2.2:1.

Our capital expenditures were $25.9 million.

We expect capital expenditures for the year to be approximately $53.2 million.

We purchased substantially all the operations and assets of WattMaster for $6 million.

The company had stock repurchases of $12.3 million year-to-date.

Shareholder's equity per diluted share is $4.50 at June 30, 2018, compared to $4.49 at December 31, 2017.

We continue to remain debt-free.

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

So net sales increased 8.2% for the quarter.

This was just higher volume that we were able move through the plant.

Water-source heat pumps are coming along nicely.

This quarter, we built fewer units than we did in the first quarter, due to -- in the first quarter, the units we built were a very simple version of the units.

And in the second quarter, we had turned on some very complex options.

And so it was a first-time run-through for some of these more complex units.

We're working on updating the design on several of what we would consider our legacy products for improved efficiencies in operating efficiencies, but also some of these will be improved manufacturing efficiencies.

Our markets, as a whole, remained at about 50-50 between replacement and new construction.

However, in the second and third quarters, we've typically seen that tilt more towards 60-40 for those 2 quarters in that we have a considerable presence in the K-12 school market and a lot of that replacement occurs in the second and third quarters.

We've seen substantial growth in a couple of particular models of our equipment, and we're very fortunate that these are more profitable than the ones that aren't growing as quickly.

So I think we're going to see continued improvement because of an improved mix.

So as I said, the replacement market, new construction on an annual basis is about 50-50.

The one thing I would want to point out is for the trailing 10 months, the architectural billing index has remained above 50, which is the benchmark for growth.

It cooled off just a little to 51 and change this past month, as opposed to the month before it was 52, nearly 53.

But the bottom line is that, that gives us a forecast of what kind of opportunities we'll see out about 9 months to 10 months from that published data.

And things are quite strong right now, with orders coming in the door and look to remain promising going forward.

So the individual markets themselves have not changed appreciably for us.

We'll continue to increase our market share in some of these areas.

The backlog at June 30 was $156.6 million versus $83.5 million a year ago.

I'd like to point out that we had a price increase on June 15, which pulled forward some of that.

And we expect that it pulled forward maybe up until right about today.

However, from June 16 through today, bookings have not been near as soft as I would have originally anticipated with as much pull-forward as we got.

So summarized another way, orders are coming in the door stronger than we anticipated.

They more than made up for the first quarter, which we were short of forecast.

So in the first quarter, as a summation of the first quarter, I think we were somewhere in the 20% short of forecast on orders coming in the door.

And at the end of the second quarter, we were plus 8% for that whole 6-month period of time.

So the remainder of the year, we're looking at water-source heat pumps production ramping up, orders are in the door.

We've got to get them built and turn that into revenue or sales, but we have seen a marked increase in orders coming in the door for water-source heat pumps.

I know that many of you are interested in the status of the AHRI approvals, so I'll give you an update on that as well.

AHRI selected 7 individual products from our entire portfolio of water-source heat pump offerings in order to test for the certification.

Six of those products have been tested and passed.

The seventh and final product goes in the laboratory for AHRI for testing and certification on Monday, August 6.

If things hold true to form, by middle to end of the week, next week, we'll have a pass or fail, thumbs up or thumbs down.

However, since we've passed 6 out of 6, I'm quite confident that we'll pass the seventh one as well.

So we're looking at prospects of having all of the testing completed next week, having all 7 of those tests passed.

Then historically, it is taken AHRI in the range of 2 to 3 more weeks to publish that on their website, so the final transaction is very likely to occur in August.

Our R&D lab, we will not have total completion of the very last chamber until early 2019.

Schedule currently shows that we're in '19.

However, the first segment of the laboratory became available to us to utilize 3 weeks ago.

We began using the acoustic testing chamber.

About each month from now through completion, we gain the use of an additional either environmental chamber or more acoustic capabilities.

So the lab is coming along well, and we're just now beginning to utilize it.

And what we're doing right now with it is testing products and developing better acoustical signatures for products.

Our gross profit improved considerably first quarter to second quarter.

And 25.2%, I believe, was the number for the gross profit for this quarter.

I look for that to stay in that range, but with greater volume.

So we're pushing hard to get more out the door.

So if we can keep that gross profit in that range of 25%, or maybe a little bit better even, because we should have a little improvement in efficiencies by dilution of some fixed overhead, those could, however, be offset by some inefficiencies in our growing labor force.

We're in a market of 3% unemployment.

We have been able to onboard people, but they're not the same quality as our core force.

It's taking a little longer to get productivity from these people.

So that could put just a little pressure on it.

And then with this huge backlog we have, people are anxious to get their equipment.

So we're also utilizing some overtime to make that happen.

And so whatever improvement we get from dilution of overhead could possibly be offset by the inefficiencies in the labor for these factors that I just mentioned to you.

So Rebecca already mentioned to you the CapEx was -- it was budgeted to be $53.2 million.

We've spent $25.9 million right now.

The lab, we have a $32 million and change budget for the lab, and we have expended $27 million of that.

The balance is allocated predominantly on contracts that are yet to be completed.

So the lab is going to be on budget at the $32 million and change.

So that money will, by and large, be spent in 2018.

Obviously, with some of the completion going out into '19, there could be a few dollars that go over into '19 for that CapEx.

Another CapEx situation that we've already taken care of this year was with water-source heat pump manufacturing facility.

We've built that in 3 segments, 6A, 6B and 6C.

6A has been fully utilized in excess of what, 18, 20 months now I think it would be.

And 6B came to utilization about 1 month ago, and 6C will be coming to utilization in the next month to 6 weeks.

And so all of the equipment is there and has now been paid for.

We have a few other items on our CapEx budget this year that some of them will be dependent on those manufacturers' capability of delivering the equipment.

We have some additional Salvagnini machines going into the Longview facility, various things like that, that it could be, what we spend this year, contingent on deliveries.

And some of these manufacturers are running a bit behind.

We had talked about possibly a new site to build more air handlers.

As I stated in the past, we have a business that runs around $25 million, $28 million currently on air-handling units.

That total market is over $1 billion, so we're just barely scratching the surface.

We still have aspirations for that but have slowed the pace down on it just a little bit.

The reason being, with this huge backlog, we've got to keep our focus on producing that equipment and producing it efficiently.

As I said, the orders have not -- the orders coming in the door are not falling off as much as we thought they would after that price increase.

So all of this being said, it told me to hit the pause button on the air-handling unit building opportunity for a few months.

So we'll probably resume our thought process on that when we get past this influx of the huge backlog.

With that, I'll open it up to questions.

Kevin?

And your first question comes from the line of Joe Mondillo.

So I wanted to see what your thoughts are in terms of the demand that you're seeing.

I mean, the backlog was up tremendously, much higher than -- I don't even remember a quarter in the last 9 years where we've seen this kind of growth.

I know there's probably some pull-forward before the price increase, but even considering that, it seems like it's just very strong.

So I'm just wondering what your thoughts are in terms of customers, the end markets that you sell to, the economy.

And if you think this -- I know that kind of growth is not going to be sustainable, but if you think at these levels, you think that's somewhat sustainable?

Well, let's kind of go back to the beginning of the company.

When we first started out, we had a business plan and a plan for products, and we didn't really have any problem obtaining orders.

We had problems producing orders, and that was our lifestyle for about 20 years.

And then about 10 years ago, we started catching up with all of our in-house problems and getting ahead of that a little bit, and we started running into the necessity to do something more to get orders.

And that eventually led to the appointment of Gary Fields, who has, in my opinion, perhaps the most outstanding record in this industry of being able to get orders in the heating and air conditioning field.

So we brought in an extraordinarily strong individual as President and turned him loose and told him to stay after -- we were doing okay in running the business.

Stay after -- straighten out the problems that we needed to get straightened out in getting orders, and you can see the results.

He totally overwhelmed us.

We didn't anticipate it being that much.

We thought normally, pull-forward would pull forward somewhere in the 20% to 40% more business.

We pulled forward 100% more business.

We weren't expecting that, and that put us over there.

So now he is getting a rush education in the inside part of the business of how to run the business on the inside.

He's shown his mettle in the outside world.

Now he's got his challenges sitting in front of him.

So my job for the past couple of years, or 1.5 years now, has been one of letting him go just as far so -- as I thought was reasonable, even when it was a different way than I would have gone, as long as it had a reasonable chance of expectation.

And I'd have to tell you that we made a couple of little errors along the way, both of us did, that has led us into having a little less profitability than we have now.

But all things to correct that are already put in place, and now we've got to dig ourselves out of this backlog.

And I'll turn it over to Gary, and I'll let him tell you how he's going to do that.

Well, as Norm said, when I came here, sales were in my -- dead center in my wheelhouse.

So I accomplished a decent amount over my 32-year career.

So I wasn't terribly challenged on how to get started with that.

So a bit over a year ago, I started digging into the operations side of the business, restructured some folks in our engineering function that supported production, started seeing some merit to what we were doing there.

Then, as we've talked about many times, we've had some rather senior people from the manufacturing processes retire.

So a lot of it is been coaching along some younger people and reassuring them of how things were going.

I probably have dug into the operations deeper than I ever would have imagined that I would be capable of doing at this point.

One of our members of the senior leadership team, I thought he was rather humorous, he told me that the first quarter of 2018 was the best thing that ever happened to me.

And I said, "Oh my gosh, how do you figure that?" This was just awful.

And he said, "Well, you've been going along peeling the onion layer, back a layer or 2 at a time, and you're fixing things and all that's working." He said, "This made you dice up the onion and look at the whole thing at once." So as we talked about before in last quarter's call, there was really about 5 significant contributors to that poor performance financially in the first quarter.

And so we did dice that onion up, we did look at all of that and, as you can see, we corrected a good bit of it.

Now there's still some more to go, but I feel very confident that we're going to be able to achieve the same level of performance at bottom line financials as we have at top line.

So over the next coming quarters, I see improvement in our future, and it's very planned and it's very recognized as what it takes to make that happen.

So I wanted to ask -- to follow-up on that.

How challenging do you foresee getting this kind of volume out of the door as efficient as possible?

You've already mentioned that you anticipate some productivity issues, whether it's having to pay some overtime or whatnot.

But could you just go into maybe sort of some detail on how you're thinking about the challenges related to that?

Yes.

July over June, on a daily basis shipping out the door, we've made significant strides in getting that equipment out the door.

I don't have July figures yet to know how efficiently we did that.

I looked a few minutes ago at our population on the floor, and our plant floor population in that 30-day period of time went up in the single-digit percentage, but our manufacturing output in dollars 1 month over the other went up double-digit percentage.

So at least based on number of people, I don't think we did a terrible job in July.

I think we did a decent job.

Now the real challenge is getting enough people in here to get this backlog built in a timely manner so that we don't harm ourselves long term.

If you're sitting there needing your unit and I'm not able to give it to you, you're not going to be real friendly when it comes time to buy another one.

So I think our biggest challenge right now is getting it out the door and our second-biggest challenge is getting it out there efficiently.

At this time, my viewpoint is that for the dilution that we get in fixed overhead because of the higher volume, that there'll be some pressure on those gains from the inefficiencies.

I don't think that they'll overcome -- I don't think the inefficiencies will overwhelm the gain.

In my opinion, at this point, it could just be flush or we could go forward a little.

But if we were to be able to maintain the same gross margin percentage and at a higher dollar volume, then we're going to get more dollars to the bottom, more earnings per share.

All right.

And then I wanted to ask regarding the material headwinds, pricing on the material side of things has continued to increase through the first quarter and then through the second quarter.

So while the November price increase probably offset a little bit maybe by the time of early second quarter, I would think that sort of a little bit of an offset started to turn negative again as we approach the end of the second quarter and probably, in the beginning of the -- probably, some of the -- most of the third quarter.

So my question is, I understand by fourth quarter or first quarter of next year that your June increase will start to push things in the opposite direction, but will we start to see -- will we see any sort of negative, I guess, headwind in the third quarter compared to the second quarter?

Will it get worse in the third quarter before it starts turning better in the fourth quarter?

It's not anticipated to get worse in the third quarter for 2 significant reasons.

If you look at our inventory levels, you'll see that they're a little bit elevated.

So when some of these pricing pressures were appearing, we bought forward on some materials.

Now we've talked about our steel before, that we buy our steel in so many pounds for so long, and I haven't analyzed how many pounds it takes to build this backlog through the third quarter.

But somewhere towards the end of the third quarter, we run out of the steel at, we'll call it, the old price, and we'll start on steel on the new price.

But it will be towards the end of the third quarter before that possibly happens.

The components that we purchased, we've had people in here talking about price increases.

One of our significant compressor suppliers was in here talking about price increases.

He was here last week.

Well, he was talking about not making those price increases go into effect until about September.

So if he does that, then we'll be really close to getting equipment on the floor with that June price increase right about the same time we get increased prices from that particular supplier.

Our motor suppliers, I don't have the exact date on that, but they're talking about price increases as well.

So I guess, Joe, where I'm at on this is, if there were any pressure -- additional pressure in the third quarter on prices, I think it would be not a lot.

Okay.

And last conference call, I believe, it was sort of a wait and see and see how sort of material pricing trends over the next month or 2, in May and June and whatnot, until deciding and figuring out if you need another price increase.

So what are you -- is there any other plans of any increasing of your pricing?

And can you update us on sort of how the industry has been trending in price relative to how you've been dealing with price?

Yes.

All right.

So our June 15 price increase was 5% across the board.

One of our most significant competitors, Daikin, had a 4% to 6% price increase.

Others, I don't know the exact numbers from others, but the bottom line is, we've seen no real pushback from the market on the 5% price increase we put in June 15.

And our sales channel partners have been dealing with that because I give them about a 3-month lead on that.

So it was about mid-March when I announced that 5%.

So they started putting that into their bid documents maybe late March, 1st of April, and there's been essentially no pushback from that whatsoever.

Fact is some of them have said, hey, we're anticipating that you're going to have more price increases because everything we hear in the market.

So we will be gathering data this week and next week from our major suppliers, and we'll be evaluating our gross margin reports here, our actual cost reports to see, because we have third quarter, everything that we built was at the November price increase, the 3%.

So we now have a complete quarter with no mixed pricing strategies.

So we'll look at that and see where we're at.

We'll look at the price increase information that we've gotten from major vendors.

The other good thing is, and Norm advised me on this, on steel, for instance, the tariff was announced back earlier in the year and it was to be 25% on steel and 10% on aluminum.

Well, almost immediately, within days, we had steel and aluminum suppliers in here talking about new pricing, and they were in the range of 56% elevated, not 25% and 10%.

And Norm says, "Well, it's a good thing we had all that steel bought forward.

We'll weather this storm, there is always a surge on this kind of news and announcement." He said, "You just sit here and watch with me, and that will retreat before we have to go into the market to buy." Well, we were paying on, we'll call it, an aggregate price for steel -- because different gauges, different coatings are slightly different.

But on an aggregate basis, we were paying around $0.48 prior to the announcement.

And they were coming in here, and again that same aggregate thought process, they were asking $0.70.

I talked to our supply chain manager in our Longview operation on Tuesday this week, and he said that he was getting prices now that were in the high $0.50 range, $0.56, $0.58.

So they've definitely retreated a lot.

But the price that he was talking about was about a 20% to 22% increase, more in line with what the announced tariff was.

I didn't get an update on aluminum, but presumably, it would have retreated in the same manner.

So just because of the foresight of the way our purchasing department does business, they actually shielded us from the worst surge in those raw material prices.

Okay.

Great.

Last question for me, real quick, are just on terms of the water-source heat pump.

In the Q, it looks like -- it shows you guys did about 1,000 units there.

You did about 1,600 units in the first quarter.

Just wondering if you could update us on that, why we saw a sort of a pause or a pullback in volumes in the second quarter.

With the optimism with the certification hopefully coming later this month, sort of what you're thinking is in terms of volume and demand with that?

All right.

So the reason that we built 1,000 versus 1,600 is relatively easy to define.

The 1,600 were rather simple units with few to no options on them, and they were smaller-sized units.

The 1,000 that we built in this quarter were some of the very most complex units that we ever anticipate building, with just a whole myriad of options on them.

They were higher-priced units as well due to that.

So the scenario was, your first time to build through some of these complex units, you're developing fixtures for building them, and it's the first time that the workforce has built those options, so there is no efficiency.

We were obviously running at about half the number of units per day as we did in the first quarter, but it was very definable as to why that was occurring.

Now once you've built a few of those units in those complex strategies, then the next time you build them you'll build them much more efficiently, because you have fixtures that have all been worked out.

You have people's knowledge base already maturing somewhat on that.

So we're -- in fact, our very most complex unit, we have doubled the production rate per day on that very most complex unit in the last month.

So there was just a lot of things to work out as we expanded the product offering.

And the reason these options occurred the second quarter was, we had them not available for them to purchase at one time.

Then we turned on the availability and the market demand was there for them, we got orders for them in the door.

They worked their way through the backlog and it just so happens that we built the majority of those in this second quarter.

Now going forward, the backlog right now is quite elevated on water-source heat pumps.

Just an hour or 2 ago, we had our production control Vice President in here, and we were talking about all the strategies to get the production rate up on those water-source heat pumps so that we make lead time.

So there's 2 different things that are occurring here.

We had built this manufacturing process line in 3 phases.

We call it Line 6, and it was A, B and C. Well, 6A has been in operation for 20 to 24 months, 6B only came on a month ago and 6C is going to come on in a few weeks.

Well, 6B is to build the very most complex units we build and larger sizes.

So that satisfied one particular customer that we have that has this need and demand for this extremely complex unit.

So we got 6B going a month ago.

6C, like I said, when it comes onboard, which we'll start utilizing at the end of this month, but we'll have bugs to work out.

So we'll probably, about half of this quarter, have nice utilization of 6C.

So we have the orders in the door that we can build, and now we have facilities coming alive to where we can build them at a faster pace.

So my anticipation for third quarter number of units is going to be very much elevated over second quarter.

I don't yet know exactly what that number is going to be.

And getting people on those lines and getting them trained is also the other opportunity for us.

(Operator Instructions) And your next question comes from the line of Zane Karimi.

Zane on for Brent Thielman today.

First question comes back to the backlog.

Is there any significant orders in backlog that would turn to revenue beyond the usual period you tend to recognize sales in backlog, like beyond the 3 months?

Yes.

Our lead time on the majority of the backlog is around 12 to 14 weeks right now.

There is a segment of the backlog, probably 10% to 15% of that backlog, that's as much as 26 weeks.

So you would not -- the $156 million, in a normal scenario, we would build that entire backlog in the following quarter.

This time, it's going to spill over into the -- beyond that 1 quarter.

Is that answer what you were looking for?

Yes.

And then it also seems your SG&A is running higher than anticipated, particularly with warranty expenses.

Should we be considering this $3.2 million expense going forward?

And is this related to some product line through the last year?

Well, I'll let Scott address to you the warranty, because it's -- that's the accrual that you're looking at.

So I'll let Scott talk to you about that real quick.

Yes.

We did see an increase in the warranty expense.

What's going on at the moment is we've got a calculation that looks historically at the expenses we've incurred and then tries to project how much we anticipate needing.

And that is incorporating some of the elevated -- the claims that we paid out last year, because there is lag time in those claims becoming a factor in the calculation.

So that is beginning to appear at this time, along with the increase in overall sales volume driving it up.

And then on the offset side is we've got our actual expenditures, which for the 3 months went from $2.3 million to $2.5 million.

So those also increased somewhat, due in part to some lingering paint charges that we have been dealing with from our paint problems in terms of the new personnel moving into our paint department and implementing the procedures of painting our equipment.

So that -- I'm going to add a little clarification to that.

The vast majority of the issue with paint occurred early to mid-year, last year.

And we discovered it, and we about 98% rectified the problem.

And I'll give clarity on the 98% rather than 100%.

So we rectified the problem by and large, but some of these units that have paint issues, and this was paint bubbling up and peeling off, we didn't have the ability because of weather and timing and so forth to get those resolved in 2017.

So they were still being resolved this year even though they were discovered last year as far as what was happening.

So we began to accrue for them.

We got a consolidated list together right at the end of first quarter, and we accrued for those as well and -- because of payments.

And I'll define the 98%.

The vast majority of this occurred in late second quarter, early third quarter last year as far as the failure, and then the implementation of resolution was in the third quarter.

However, we had a stray unit here and there pop up with a paint problem as late as January of this year.

And we've not had any since January.

That was the latest one to pop up.

So we're probably 100% captured on that now.

What we discovered was that the environmental conditions that we painted in, in January, in our paint booth, we got out of the environmental envelope slightly that was allowable.

And we have gauges, meters and things that you look at to see if you're in that envelope.

Well, when we discovered this, we added alarm packages that are strobe lights that essentially, when it gets out of the environmental envelope that it's supposed to be in, it gives a very visual warning as to, hey, stop the painting process and figure out why the environmental envelope's been breached.

So I think we got 100% cured now.

But as it turns out, we were only at about 98% prior to finding this out in January.

Okay.

And then one final question.

Earlier you mentioned some inefficiencies with regard to labor and your gross profit margin.

Do you think there is a trough in the gross margin?

And should we see continued improvement quarter-over-quarter through year-end?

Well, I expect third quarter, as I've said earlier, from a gross profit percentage, my expectation is that it could very well be the same percentage as second quarter.

As we have higher production rates, sales going out the door, then that will dilute the fixed overhead.

And then that very well could be offset by the inefficiency of either using some overtime or some newer workers that have not yet got much experience.

So from a percentage standpoint, I'm thinking that we would be -- do well to hold the margin at the 25 and change that we are now, but have a higher revenue rate so that we generate more dollars to the bottom line.

And your next question comes from the line of Jon Braatz.

A couple of questions.

When you look at the backlog number, how much of the backlog is represented by the water-source heat pump?

How significant a piece of business is that?

I didn't carve that out by itself.

Does anybody else in the room got that?

It's not going to be a real large one, Jon.

It's probably going to be down 1% to 2%.

Okay.

Okay.

So not significant.

Okay.

That's fine.

And then secondly, when you look at some of the -- well, when I was down there last year at this time, you were working mostly on the standard water-source heat pump line.

Is that now -- that line now operating sort of at capacity at maximum efficiency?

Or are there still bugs being worked out in the -- I think it's the 6A line, I think you call it that, Gary?

Yes.

The bugs have, by and large, been worked out.

Where we're at right now is we're not fully staffed on every station because we're -- again, we're having a lot of pressure on the legacy products to get them produced.

So when we do add people, we're adding them in other parts of the plant.

So we remained, at this point, relatively constant at the number of people working on that function.

We are beginning to increase that a bit right now.

But up until now, we've not done that.

And the other thing is we were only running 40 hours a week on that manufacturing system.

And of course, everything else in the plant runs 168 hours a week.

So we do have the opportunity to run it more hours.

So the facility itself is not tapped out, it's a matter of getting more people and getting them qualified to build product on that line.

Okay.

So is -- with the production or productivity issues in the sort of the legacy plant, legacy product lines, is the real emphasis going to be placed on returning profitability to that piece of -- that part of the business rather than so much to the water-source heat pump?

Because obviously, the legacy business pays the biggest portion of the bills.

And I guess, from my perspective, how much of a -- how much below the optimal level are the -- you've been operating at around gross margin of 31% for a long time.

And how much pressure is there on the legacy business?

How much of a decline in -- are you seeing in the margins in that piece of the business?

And then how quick we can -- can you get that back up to a level where you once were?

Well, the overall gross margin where we once were -- well, we'll stay in the 2013 to 2016 time frame -- was assisted by the fact that we had gotten some price increases.

We had gotten some price increases that we were able to hold in that period of time, but actually have some decline in materials prices that helped.

And then the other thing was that the top line wasn't growing at the same rate as it is now.

So you were able to add people more methodically, and then factor in that you had a guy that had been here for -- in those years, 35 years.

VP of Manufacturing and the Director of Manufacturing or Manager of Manufacturing had been here 14, 15 years in that position in those years.

So you had a very veteran leadership group along with some very stable situation, that those margin percentages of that '13 to '16 time frame were extraordinary.

My expectation is that, that would be, I won't say impossible to revive, but it's really going to be difficult to think in those terms.

Now what we are -- and we've stated this for quite a while now.

Our goal is to get more dollars to the bottom line and that still remains our goal.

And I believe that that's very achievable.

So that being the case, in order to get the dollars to the bottom line, if I've got a limited workforce, I am motivated, highly motivated to put them towards my most efficient dollar-producing lines.

You feed the golden goose, and the one that's laying the regular eggs, you kind of let it scratch around free range.

So we have definitely biased our labor force towards our more profitable lines so that we can get more dollars to the bottom line.

The line that had the most pressure on our first quarter financials, we had led the lead time go out to as much as 26 weeks on that product.

I refuse to build it faster than that or give it any substantial effort until I can improve the profit margin on it.

And we're working on improving the profit margin on it, but we're probably -- I bet we're 3 quarters away -- 2 to 3 quarters away from being able to get it.

Because right now, that particular manufacturing line, we call it Line 5, is booked all the way to the end of 2018 at the November price.

The June price, I won't build the first unit on that line until January 1 of 2019 as it's currently scheduled.

Whereas all the other manufacturing lines in the plant, somewhere between mid-September and the 1st of October, I start building them on the new June price.

So obviously, I'm motivated to bias my workforce towards those lines that not only have the ability to get me quicker to the 5%, but they're more profitable anyhow.

Jon, let me back up and give you something.

Scott gave me the backlog on the water-source heat pumps.

About 1%.

Yes.

It was about 1%.

No, it was more than that.

$1.3 million at the end of June.

So 1% of the total.

As I said, Jon, about 1% to 2%.

Yes.

Yes.

Okay.

Okay.

Given you're -- the expanding lead times and the backlog, have you lost any orders, do you think?

I know for certain we have not, and this is what's been really -- well, I wasn't sleeping well for a few nights when this thing blew up on this backlog.

And then I began to sleep better because our regional sales managers are a diverse bunch that have worked for some of the competitors, still maintain a lot of contact with their former employers, some of which are considerable competitors to us, and found out that they're all in the same boat we are with lead times, or the vast majority of them are.

So what we have done is we've done a very good job, in my opinion, of messaging to our people what the lead times are, so it's allowed them to plan better.

A lot of times, these people get lackadaisical about getting orders in here.

If they think you're 10 weeks delivery and they don't need it for 20 weeks, then they wait 10 weeks to order it, even though they had it -- had all full ability to get it in to you earlier.

I mean, I live that way, I know for sure it happens that way.

So when you give them the lead times, you say, "Hey, this stuff is 16 weeks." They go, "Uh-oh, I better get off my duff and get that order in there." And then the other thing is with everybody having further questions about price increases, July 6 is when a good many of these tariffs actually went into effect.

And at that point in time, people started feeling it real.

And there's things that a lot of folks didn't anticipate.

They heard there was a tariff on steel, they heard there was tariff on aluminum.

Well, for instance, one of our major compressing manufacturers is Emerson.

They manufacture the vast majority of the compressors we buy here in the United States, either in Ohio or in Lebanon, Missouri.

So I'm thinking, well, there's no tariff on those, Aha!

They have parts that they manufacture in China, parts like a crankshaft, for instance.

And then they had a Teflon seal and this, that and the other.

Those parts made the tariff list.

So I think -- so all of this is beginning to become real to a lot of people out there right now, and they're saying, hey, these -- there's things costing more now.

So while we're in this environment, right now people are not giving us a lot of pushback on pricing.

So I don't know that I ever finished answering the question earlier about future price increases.

Maybe I did.

Okay, I did not.

Scott says I did not.

We will be analyzing thoroughly all of the factors regarding our anticipated cost on a go-forward basis, and we will be crafting a notice of another price increase probably in the next 30 days.

The calculation will be done in the next couple of weeks.

Jon, there's something that this -- and this is true for our whole society.

Generally speaking, most people do a very methodical method of increasing prices, analyzing stuff and going forward.

We have a President who made his life doing it the opposite way, creating chaos, and he just learned how to manage chaos.

That's not the way that most people manage, and you can see, reading the paper, listening to television and whatever, all the people who are just in the state of wondering what's going to happen next because it's not the way most people work, but he does work that way.

The net result is, he'll let you think that it's going way up, and it doesn't always go way up.

So then you say, well, what do I count on?

And it's hard for a lot of us to adjust our thinking.

I think we've got our -- I think we understand it pretty well because in the world we live in and where we negotiate for every order and everything, that is kind of the way life works in the construction industry.

There is a lot of give and take and go forward and go backwards.

So it's not something that we're unaccustomed to.

We're unaccustomed to it on a national basis, but we in the construction industry do live in that environment that the President has lived in all his life.

And so we kind of understand where he's going.

And it's difficult to project and know where it's going, but in the long term, you can pretty well figure out where it's going.

We got caught a little bit short when it first started happening.

But after we adjusted our thinking, I think we picked it up, and we're managing it well now.

Okay.

One final question.

In a perfect world, Gary or Norm, where would you like to see the backlog at the end of the third quarter, at the end of the fourth quarter?

How much would you like it to have been worked on?

If I had backlog at the end of the third quarter in the range of $100 million, I would be real happy with that.

If I had it in the range of $75 million at end of the fourth quarter, I'd be real happy with that.

Okay.

And what kind of shortening of lead times would that imply?

Right now, I've got the vast majority of the plant on 16 weeks.

I would like to be back to 10.

That's really where I'd like to be back to, yes.

There are specific products that I'd like to shorten up even more than that, but that's the vast majority.

And you do have a follow-up question from the line of Joe Mondillo.

Just 2 quick questions.

I was just wondering how much of a drag -- it sounds like water-source heat pump was a drag on the bottom line for the first half of the year.

I was wondering if you could quantify, if that's the case.

Joe, we haven't tried to carve out that metric to see.

And there are so many things that are intangible.

When you got an engineering department that is spending a considerable amount of its effort trying to root out bugs and problems in software and manufacturing processes, how do you quantify that, because you apply that overhead evenly over the whole thing.

But there's concentrating their efforts on that so they're not looking at something else.

When you look at actual product that went out the door, when you look at material and labor that goes on that work order, then it is contributing towards paying that overhead, but it's just not contributing beyond that at the point -- like we have the other equipment.

Joe, the one thing that we did differently than we would do sometimes, is because this is such an unusual way in which it's very software dependent that -- this new process we're doing, we're way out ahead of the normal manufacturing methods.

We recognized we were going to have a lot of those kinds of problems.

So we did not go out there with a price that was very low to try and get our volume moving and moving fast.

So we went out with a fairly high price, and that result of it is that we didn't underprice the product to start with, like you would if you knew exactly how to put it into production and you didn't anticipate any problems.

We thought exactly the opposite.

We don't know everything we know.

We know we're going to have problems.

So let's price it high, don't pull too much orders in because all we're going to do is upset customers because we have these probable problems, and we're not going to deliver.

And the net volume of the water-source heat pump relative to our total volume was very small.

So even though we didn't go out there with a cheap price, so we didn't have ourselves underpriced, we still had the problems.

And like Gary says, trying to trace down the problems, they are what they are, and knowing that they are and spending a lot of money running down and saying, hey, we got problems, that's kind of a fruitless thing.

You better do something that you can actually do something with once you find out you've got it.

We knew we were going to have problems, we had problems.

We didn't go running around trying to quantify them because it wasn't going to put any money on the bottom line.

So we just work them out and go on about it, and we -- they work themselves out, and that's what we've done.

And because it was a small part of our overall running, it really didn't have a big effect on it.

Okay.

Last question that I have is, with all this demand that you're going to see or shipments that you're going to see in the back half of the year, I would imagine your working capital is going to be a big source of -- use of cash.

You have a lot of CapEx in the back half of the year.

Do you think you'll have to cap your revolver, at least temporarily for a couple of quarters, given all this cash going out the door?

Well, that's a very good question.

We are working very diligently to free up cash wherever we can.

We renegotiated our revolver or our bank agreement to be able to lower the amount of cash we have to keep on hand at the bank to make sure we have additional flexibility.

And as we had said last year, we have been prepaying some vendors, or I shouldn't say prepay, but paying them as quickly as we got the invoices.

Well, we have been stretching those back out to full terms.

And if need be, we can always extend terms a little bit further with some of our vendors.

So we're hoping we can avoid having to carry any real balance on the revolver, but it -- from day to day, there's a possibility that we could hit it.

It's just going to be a balancing act between now and the end of the year.

And there are no further questions at this time.

Well, if there are no further questions, we'd like to thank you.

Well, we used up just a little bit over an hour, pretty much on our estimated time.

And look forward to talking to you at the end of next quarter, and we expect to have a very good remainder of the year, a little troubling because of personnel and the growth that we have to get.

We're getting growth with a very low unemployment rate in Tulsa.

So it's a trial, and that's really the big issue that we got is managing our personnel for the balance of the year and not hurting our customers.

So we believe we know how to do that, but it is going to be challenging.

And everything going forward looks very good to us.

So we're very pleased to be where we are right now, and I want to thank you for your being with us and look forward to talking to you at the end of the next quarter.

Bye.

And this does conclude today's conference.

You may now disconnect.