EnerSys (ENS) 2018 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Second Quarter 2018 EnerSys Earnings Conference Call. (Operator Instructions)

As a reminder, this call is being recorded.

I would now like to turn the call over to David Shaffer. You may begin.

Thanks, Michelle.

Good morning, and thank you for joining us. On the call with me this morning is Mike Schmidtlein, our Chief Financial Officer.

Last evening, we posted on our website slides we will be referencing during the call this morning. If you didn't get a chance to see this information, you may want to go to the Webcast tab in the Investors section of our website at www.enersys.com.

I'm going to ask Mike Schmidtlein to cover information regarding forward-looking statements.

Thank you, Dave, and good morning to everyone.

As a reminder, we will be presenting certain forward-looking statements on this call that are based on management's current expectations and are subject to uncertainties and changes in circumstances. Our actual results may differ materially from the forward-looking statements for a number of reasons. Our forward-looking statements are based on management's current views regarding future events and operating performance and are applicable only as of the dates of such statements. For a list of factors which could affect our future results, including our earnings estimates, see forward-looking statements included in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations set forth in our quarterly report on Form 10-Q for the quarter ended October 1, 2017, which was filed with U.S. Securities and Exchange Commission.

In addition, we will also be presenting certain non-GAAP financial measures. For an explanation of the differences between the comparable GAAP financial information and the non-GAAP information, please see our company's Form 8-K, which includes our press release dated November 8, 2017, which is located on our website at www.enersys.com.

Now let me turn it back to you, Dave.

Thanks, Mike.

I will begin on Slide 3.

On Wednesday, we announced our second quarter results with $1.05 per share, which was in the middle of our guidance range of $1.03 to $1.07. On a year-over-year basis, sales were higher by 7%, with organic growth up 1%. Gross profit and operating earnings percentages were both down due primarily to a $10 million headwind from increased commodity costs minus selling price recovery. Our price recovery from rising costs was 80% on lead and in excess of 70% on all commodities. However, we were able to offset some of this increased commodity cost pressure by having our cost savings initiatives outpace the increased spending for Lean, Digital Core installation and new product development.

Please turn to Slide 4.

There were several offsetting factors that impacted our regional operating earnings and percentages in the second fiscal quarter versus last year's second quarter. In the Americas, the second quarter operating earnings percentage was lower by 240 basis points from a record quarterly high of last year and due to sustained commodity cost pressure as well as increased spending for engineering, SAP and human resources information systems, Salesforce.com and Lean Consulting.

Europe, Middle East and Africa's year-over-year operating earnings percentage remained stable at 9% despite commodity headwinds and continued lower volume in reserve power primarily in its aerospace and defense business. In addition, EMEA was able to obtain the highest selling price recovery percentage of any region and, along with their continuous cost reduction programs, were able to almost entirely offset these headwinds. More recently, EMEA's reserve power, and particularly A&D orders, have been up year-over-year. So we anticipate organic volume for these businesses will be positive in our third quarter versus our Q3 last year.

In Asia, the operating earnings percentage increased year over year to 5.4% in spite of increasing commodity costs primarily due to a strong increase in motive power volume.

Please turn to Slide 5. I want to briefly review our global businesses.

In motive power, the Americas volume was essentially flat, but that was compared to last year's record second quarter. We did, once again, raise prices in October to offset the continuing rise in commodity costs. EMEA continues to experience low organic growth, while Asia enjoys strong double-digit growth.

In reserve power's Americas region, one of our large telecom customers recently announced they would raise CapEx levels, which we believe will be positive for our United States enclosure and batteries -- and battery businesses. In addition, we are seeing more quote activity and contracts for increased spending from other telecommunications companies in the U.S.

In the EMEA region, sales in the third quarter should increase due to a large telecom order in the Middle East and Africa region and positive uninterruptible power supply, or UPS, orders.

Orders in Asia have gained momentum from Chinese telecom orders picking up in the second half of fiscal 2018 and from 2 telecom programs in Australia.

The UPS market in the United States and Europe continues to be good. In aerospace and defense, the Americas demand continues to be strong, and demand is picking up in the rest of the world.

We have been monitoring 5G development, and the various types of technologies that will be used is becoming clearer. Regardless of what 5G operators deploy, we believe all methods will need to handle increasing levels of data backhaul, which should require significantly more energy storage. 5G is still a couple years away, but we believe increased battery spending during the deployment will be at least equal to previous data transmission upgrades. Based on the above trends and information, our earnings per share guidance for our third quarter is between $1.12 and $1.16.

Please turn to Slide 6.

We will continue to provide investors with information metrics pertaining to key initiatives and cost assumptions, which we introduced at our Investor Day last February.

Please turn to Slide 7.

This was the second full quarter since our Investor Day. The strategy introduced this past February laid out a new product road map to accelerate our organic growth. These growth initiatives included, one, higher market share in motive power maintenance-free batteries. These products are in the form of modular batteries, which are universally designed around our next-generation TPPL, and lithium-ion chemistries.

Two, dramatically accelerating our position in the behind-the-meter energy storage systems by leveraging these new low-cost modular motive power systems into reserve power.

Three, capturing a higher market share in the transportation sector, specifically over-the-road trucking, with our premium TPPL technology.

And finally, number four, introducing small enclosures with integrated DC power to position us for the 5G networks.

I am pleased to report solid progress on all fronts with no major delays or surprises that deviate from our Investor Day presentation. As noted last quarter, engineering expenses and CapEx investment planning continue to rise as we bring new products forward.

Our new modular batteries were well received in our September European sales meeting. Our launch dates in the fall of 2018 for motive power, with reserve power to follow 2 quarters later, remain on schedule. The new products team has selected our Purcell enclosures business to do the systems integration. This should help absorb overhead expenses in both Spokane and Poland. Also, the samples for the next-generation TPPL are built and under test.

On Slide 8, we highlight our new motive power lithium-ion/TPPL modular product for Class III electric fork trucks and our reserve power modular product and enclosure for energy storage systems. The team is progressing with selecting and securing best-in-class lithium cells for these products.

The Investor Day strategy also noted the potential for above-average growth rates in Asia, specifically China motive power and India Telecom. As we mentioned earlier, I am pleased that our China motive power program is on track with our model of double-digit growth rates, and we continue to see better utilization of our newest factory in Yangzhou. This motive power growth is accelerated by China's heavy focus on electrifying their material handling equipment. However, we continue to struggle in India as common suppliers aggressively price to protect their telecom share from Chinese competitors. I have tasked the team with developing a new plan of attack for India Telecom.

An additional driver for future growth and earnings expansion is investing in automation projects that will dramatically reduce conversion costs and increase manufacturing capacity for our TPPL products. We are proceeding forward with a major capital expenditure, which will significantly increase our manufacturing lines speeds. This equipment should be installed in the second half of fiscal year 2019. With this expanded TPPL capability, we will be able to increase our share in the over-the-road trucking and premium automotive retail markets.

As noted during Investor Day, EnerSys is not a startup. Our investors will not tolerate the cash burns and losses, sometimes a decade-long, that are so common with startups. As such, EnerSys laid out a strategy to finance our product road map by squeezing waste out of our existing rolled-up businesses.

Our Chief Operating Officer and Chief Information Officer are leading our new EnerSys Operating System or EOS. These early quarters are heavy on spending but light on savings. I am pleased to report, though, that Lean has kicked off on schedule in our first 4 factories. The initial value stream assessments, or VSAs, have identified many opportunities for rapid improvement. We're following the Lean n/10 rule: one Rapid Improvement Event, or RIE, for every 10 employees engaged. So far, the initial RIEs in our Richmond, Kentucky facility have yielded improvements above our initial targets. I couldn't be more pleased with the efforts and commitment by which our operations leaders and employees are embracing Lean. For the second quarter, we're reporting $6 million in net operational improvement savings resulting from our increased focus on controlling costs. The operations leaders have also worked very hard to identify new productivity improvements at our Hays, Kansas facilities that are unlocked due to significant investments in SAP. As such, we have approved the SAP team to move on to the next factory for systems integration. In addition, the team has made progress implementing Salesforce.com in the Americas and Europe. The path forward of productivity improvements is clear as we automate and standardize our sales and order processes.

We have also recently introduced our first customer portals trials, which allows customers to order directly with minimal human intervention. Like many companies, we have found ERP implementations are difficult, but we will continue to accelerate our progress as we move up the learning curve.

In summary, the plans laid out at Investor Day are on track, and our transformation is well underway.

And now I'll ask Mike Schmidtlein to provide further information on our results and guidance.

Thanks, Dave.

For those of you following along on our webcast, I am starting with Slide 9.

Our second quarter net sales increased 7% over the prior year to $617 million due to a 1% increase in volume, a 4% increase from pricing and a 2% increase from currency. On a regional basis, our second quarter net sales in the Americas were up 5% to $341 million and Europe's were up 10% to $198 million, while Asia increased 10% in the second quarter to $78 million.

The Americas enjoyed a 2% increase in volume and 3% from pricing. Europe had a 6% pricing increase and 5% in positive currency, offset by a 1% decrease in volume. In Asia, volume increased 6% while pricing increased 4%.

On a product line basis, net sales for motive power were up 9% to $325 million, while reserve power was up 5% to $292 million. Motive power had a 4% increase in price and a 2% volume increase and a 2% currency benefit. Reserve power had a 4% increase in price and 1% increase in foreign currency.

Please now refer to Slide 10.

On a sequential quarterly basis, second quarter net sales were down 1% to the first quarter of fiscal 2018 from a 3% decline in volume, offset by a 2% currency improvement. The Americas region was down 4% and Europe was down 1%, while Asia was up 13%. On a product line basis, motive power was up 2% while reserve power was down 4%.

Now a few comments about our adjusted consolidated earnings performance.

As you know, we utilize certain non-GAAP measures in analyzing our company's operating performance, specifically excluding highlighted items. Accordingly, my following comments concerning operating earnings and my later comments concerning diluted earnings per share exclude all highlighted items. Please refer to our company's Form 8-K, which includes our press release dated November 8, 2017, for details concerning these highlighted items.

Please now turn to Slide 11.

On a year-over-year quarterly basis, adjusted consolidated operating earnings decreased approximately $4 million to $67 million, with the operating margin down 150 basis points. The decrease in operating earnings from the prior year reflects $34 million in higher commodity costs, partially offset by higher volume, pricing and lower manufacturing cost. On a sequential basis, our second quarter operating earnings were down $4 million on lower volume.

Operating expenses when excluding highlighted charges were at 15.1% for the second quarter compared to 16.1% to the prior year. I expect fiscal 2018 full year operating expenses to remain near the rate of prior years of approximately 15%. Excluded from operating expenses recorded on a GAAP basis are net charges of $2.1 million primarily related to EMEA restructuring charges and ERP implementation costs. Excluding those charges, our American (sic) [Americas] business segment achieved an operating earnings percentage of 13.1%, which was 240 bps below the record 15.5% second quarter of last year. Higher volume and pricing did not offset the impact of higher lead costs. On a sequential basis, Americas' second quarter decreased 230 basis points from the 15.4% margin posted in the first quarter due to lower volume.

Europe's operating earnings percentage of 9.0% was down from last year's 9.4% but higher than last quarter's 6.8%. The operating earnings percentage in our Asia business improved 30 basis points in the second quarter this year to 5.4% operating profit from a 5.1% income in the second quarter of last year and was also up from last quarter's 4.7%. Asia's improvement on a year-over-year basis is on higher China motive power.

Please move to Slide 12.

As previously reflected on Slide 11, our second quarter adjusted consolidated operating earnings of $67 million was a decrease of 6% in comparison to the prior year, with the operating margin decreasing 150 basis points to 10.8%. Our adjusted consolidated net earnings of $45.3 million decreased 10% from the prior year or $5 million and declined 140 basis points to 7.3% of sales. This $5 million decrease reflects the higher volume and pricing and cost savings and a lower tax rate, overcome by $34 million in higher commodity costs and FX transactional losses.

Our adjusted effective income tax rate of 22% for the second quarter was higher than the prior quarter of 21% but lower than the prior year's second quarter rate of 24%. Timing on discrete tax items caused most of these variations. We believe our full year tax rate should be in the 22% range. However, this assumption anticipates no significant changes in tax rates or legislation in the countries we operate in.

EPS decreased 9% to $1.05 on lower net earnings and lower shares outstanding. We expect our third fiscal quarter of 2018 to have approximately 42.4 million shares of weighted average shares outstanding, which assumes the full benefit from our second quarter $100 million share buyback.

Please now turn to slides 13 and 14.

As usual, we have provided information on a year-to-year basis, similar to that of our second quarter on the prior pages. These 2 pages are for your reference, and I don't intend to cover the year-to-date results.

Please now turn to Slide 15. Now some brief comments about our financial position and cash flow results.

Our balance sheet remains very strong. We now have $540 million on hand in cash and short-term investments as of October 1, 2017, with over $466 million undrawn from our credit lines around the world. We generated $46 million in cash from operations in our first half of fiscal 2018. Our credit agreement leverage ratio is just above 1.3x.

Capital expenditures were $27 million in the first half of fiscal 2018 compared to $21 million in fiscal 2017.

We expect to generate adjusted diluted net earnings per share of between $1.12 and $1.16 in our third quarter of fiscal 2018, which excludes an expected net charge of $0.04 per share from our continuing restructuring programs and acquisition activities. We anticipate our gross profit rate in our third fiscal quarter will be approximately 25%.

In conclusion, we incurred $34 million in higher commodity costs on a year-over-year basis again in Q2. We recovered nearly 70% of that increase in pricing, with the balance nearly fully recovered by cost savings and higher volumes. Our $5.1 million in lower adjusted net earnings is equally attributable to $2.5 million in FX losses, which was unfavorable to the prior year by $3 million.

At our Investor Day last February, I stated that we expected our 2018 EPS to exceed $5 a share, building off last year's $4.75 per share. That projection assumed the spot rate of lead at that time of approximately $1 per pound would remain stable over fiscal 2018. Instead, lead continued rising, along with most other commodities, and has been nearly 15% higher than $1 per pound rate, putting another $0.50 per share of EPS pressure on F '18 beyond what was assumed at Investor Day and raising the full year-over-year impact of higher costs to be well over $2 a share. As such, our ability to build on last year's results has been abated. However, commodity costs will eventually stabilize, and the progress we have made in fiscal '18 will become more apparent.

Now let me turn the call back to you, Dave.

Thanks, Mike.

Michelle, we will now open the line for questions.

(Operator Instructions) Our first question comes from Noah Kaye of Oppenheimer.

Dave and Mike, it's certainly a nice job on getting that recovery, especially in EMEA. These lead prices have just taken off continually. And I know it's not been easy, but you clearly have managed much better sequentially. You mentioned a major CapEx investment in automation. First, could you quantify that a bit? And second, what did you see incrementally in terms of order or customer activity in trucking or advanced auto that helped you make the decision just so we can better understand that?

Right. Now the -- at Investor Day, we spoke about wanting to take a more aggressive share position in the over-the-road and premium automotive transportation sectors. So we're a little bit behind schedule because the scope of our automation initiative to increase our capacity for that sector actually expanded. So what we initially had approved in the budget for the year with the board was more modest in scope. But there's been some real momentum building in this area, and we're going to be up against some capacity constraints. So we dramatically expanded the dimension of the project to the point where we actually had to get board approval last week. That's been accomplished. And so as we noted in the prepared remarks, it's going to be a while before we have this online, but we think it's going to dramatically reduce our line speeds and put us -- just a much higher number and put us in a much better position with our conversion costs to compete for larger portions of those markets. So behind schedule in a sense but for the right reasons because it's a bigger than we originally thought.

Any way to kind of understand what kind of revenue in auto, trucking might be supported by this expansion?

I think what -- let me get -- I didn't put a number to that, but let me have that and we'll add some color to that in next quarter's prepared remarks to try to dimension that a little bit. We were so focused on getting the capital approved I just didn't even think to bring that with me. But it's going to -- the potential is significant, Noah. It's in the tens and tens of millions of dollars. So -- but let us put a number on that. Mike, anything to add?

All right, we'll -- oh, yes.

Yes, no. No, I was going to say in just -- in 2 years, we've added about another $20 million in revenue from that particular size, the Group 31 size. So with the capability of a high -- higher-speed line that can dramatically increase the output of a singular line, we would anticipate enjoying $20 million to $40 million, obviously, in these market conditions. But the line itself can -- is capable of far more than that, albeit the market won't immediately turn on at that level.

Okay?

Sure. No, that's very helpful. And then on capital allocation, you did the accelerated share repurchase program. So the leverage remains quite manageable with the kind of continuing ample dry powder for acquisitions. But can you comment on the M&A pipeline? And maybe to what extent what you're seeing out there in the M&A environment that factored at all in your decision to focus on repurchases? And I don't know if this is sort of a false dichotomy here, but just want to understand what you're seeing out there.

So as usual, we're very active on this front. And in our most recent meeting with our Board of Directors, we identified, I believe, 7 targets which we were -- we believe are actionable in our -- in some stage. Because of our market share, some of these require some antitrust considerations, which can dramatically slow down the process and make it a little bit aggravating. You might recall last fiscal year we added a Vice President of Business Development, a gentleman who has got 30 years of energy storage experience, with the sole focus of accelerating and making sure we have the resources on this. So we are -- as our heritage suggests, we have been a roll-up entity, and we continue to believe that acquiring companies with the right technology and the right locations, et cetera, is the best way for us to move forward. So that strategy remains intact, and that remains one of the highest priorities for our capital deployment. But having said that, given that we do throw off a significant amount of cash every year in the meantime and we have not had, as you know, a transaction of size in the last 2 to 3 years, share buybacks make a good use of our cash and keeping that leverage ratio in a reasonable time frame and as long as our share price -- the value looks -- on an intrinsic basis looks reasonable in our estimation, we will continue. So as we noted, in addition to the $100 million which we executed in our second quarter, the full benefits of those shares, which should be approximately 1.5 million shares when it's all said and done, that benefit will be in Q3. The board authorized -- although we have not made any movements to execute nor can we until this first ASR is concluded, which won't officially be over until January 5 unless the bank that's handling it notifies us that they conclude on an earlier basis. But there is another one out there if management elects to move forward with it. But again, M&A is still our primary focus, so -- and ASRs are a secondary option.

Our next question comes from Brian Drab of William Blair.

Can I just start with a housekeeping item of the WITS data? Maybe, Mike, do you have the trailing 3 months for us? And can you let us know exactly, if you do have it, which month is the ending month on the period?

All right. So the ending month on the period that I have is September, which is, I believe, the most recent one. And the trailing month would show for the total Americas a decline from some pretty high comps in the year ago of minus 3%. Total Europe, they're up10%. When you include Middle East and Africa from EMEA, it remains at 10% for that region. Asia is up 29% for a worldwide growth, on a trailing 3-month to the prior year, of 12%.

Okay. And just to be clear, all of those numbers were trailing 3 months?

Yes, everything was trailing 3 months. So September, August, July compared to prior year.

Yes. Okay. And then can you talk a little bit about the disparity between those overall, very strong WITS numbers that continue to be very strong? And what are the recent factors that drive the difference between those growth rates and your -- the volume growth that you reported in 2Q in the motive segment?

Brian, we've referenced this in prior calls. The -- it's never been a direct 1-for-1 correlation there. As a reminder, a lot of our sales are replacement in nature. And so the WITS data largely will reference the mix of new trucks to older trucks, in some cases. So the other things we spoke about on prior calls is the longevity of batteries and, most importantly, the number of batteries we sold per truck. With a lot of the premium products in the high-charging and the opportunity-charging and fast-charging systems, there's been a lot of positive things, which has been good for our margins, to sell these better products, but it's slowly over time impacting the ratio of the battery and the correlation between the battery and the truck number. So the -- we participate in some industry associations. We have a fairly good handle of what our market share is. We don't have any major market share issues to report. We think that that's very stable. So it's just not a 1-for-1 correlation. So what we've often said to you in the past is it's just a very good indicator of kind of the overall economic activity in the material handling sector. But the age of the fleet, the replacements, the longevity, the number of batteries, trunk OEMs, rentals -- rental fleets has a big impact on some of these WITS statistics. So it's not a clean shot, but we always provide that as it's just a good indicator of what the various markets are doing.

Yes. And I appreciate that you've talked about that, and I've asked about it on past calls. Obviously, it's just helpful to understand. And here, for example, the -- there's no share shift in your view and some -- the other -- some of the factors are more important in certain periods. So thanks for going through that. And as you look at 5G, you mentioned the backhaul opportunity and that that's becoming -- you're getting some clarity around the opportunity within 5G. Can you talk in a little more detail around how the 5G opportunity would be different for EnerSys relative to the opportunity that you had in 4G or 3G?

Sure. So the biggest difference, as you know, is the transmission radius of the antenna itself is much, much smaller. I don't -- I'm not an expert by any means, but there's going to be -- in a given square kilometer, I'll just use a number, there may be 70 different small 5G antennas within a square kilometer area, whereas in the past, that may have just been 1 4G cell site. So it's a dramatic increase in the points of radio transmission. So it's very difficult for the carriers to envision having a traditional backup power scheme at each and every one of these small antennas. So there's different schemes that they're looking at. Now to get -- when we use backhaul, there's different portions of the backhaul. Getting from the antenna to a node, that's sort of the first leg of the backhaul. And the 2 predominant methods we see of backhauling from the antenna to the nodes, it's either going to be fiberoptics or it's going to be kind of a line-of-sight microwave backhaul? At that node, where that's going to be concentrated, we envision that's -- there's going to be energy storage and battery backup. One of the other schemes we're seeing is that you may have 1 battery box that supports maybe 15 or 20 of these small radios' antenna sites. So again, that makes the battery a little bit bigger, and that gets to what we've been working on in our Purcell group with that integrated DC power system and lithium system. And then there's other considerations where they may not have any battery backup at the sites themselves, but I think that's risky. And we've spoken in the past that given the Internet of Things, the -- what we think is going to be unlocked with 5G, ultimately with IoT and with driverless vehicles and so forth, we don't think there's any way that they can get away from backup power scenarios. So again, everything we've seen so far -- we wanted to be conservative in our prepared remarks. We said that the energy storage spend could be at least as good as prior network build-outs, 3G, 4G. But if some of the numbers we've seen recently come true on 5G, it's just an explosive, a radically explosive potential increase in the amount of 1s and 0s that are going to be transmitted. So it's exciting, and there's nothing about it where we think it's bad news for EnerSys that we've seen so far.

Okay, got it. And then, Dave, I don't know if you could give us even just a rough, very rough range in terms of what you think your cost per kilowatt-hour would be those cells that you mentioned that you're going to be buying for the modules you showed on Slide 8.

Yes, that's fairly confidential. So we don't want to help our competitors at all on that. So I'm going to let that one lie. I can make a general comment about lithium-ion pricing, is that -- and I think there's been a lot of press about this, so I'm not speaking out of school. But the rapid rate of decline in dollar per kilowatt-hour prices we saw maybe a year ago has flattened out and, in fact, started to go the other way. I think there are some scarcity issues to contend with. We've seen some major announcements from the transportation companies and, as such, a lot of the current demand. And there's really a lot of supply out there for poor-quality cells, maybe too much. But for the high-quality cells, there's a limited supply. And we're obviously only going to work with very credible supplier partners, and that limits the playing field. So the prices have started to go back up, but that's okay. And what we've said and we remain committed to, if you see our modular designs, what you should see is that we're going to have one customer experience. So when a customer uses EnerSys products, it's always going to be the same experience, and we're going to let the computer decide what goes inside that module. It can be lead, it can be Thin Plate Pure Lead or it can be lithium. And we're just going to base everything on having a consistent and high-quality customer experience, and we're going to let the computer decide of what is the best and lowest total cost of ownership for that particular customer's needs. And we think that's going to drive incredible economies of scale through the business that we've never seen before, and we're excited about it. And the feedback we've gotten from the customers and from the salespeople has reinforced that we're on the right track. So the new CTO, he's had a great first year. And if anything, we're trying to move faster, not slower.

Got it. And then just quickly, I'm trying to gauge the opportunity that you still have in Europe for premium products as a percentage of sales, and the 40% overall is a great number. I believe that it's a little bit lower than average in Europe. And can you just give any brief comment on the opportunity there?

We've got 2 major expansion initiatives afoot. We're hitting some bottlenecks, so we've got 2 major expansions afoot to increase our ability to push premium product deeper into the motive power sector. And then to build off of the successes we've had in the over-the-road market, we're also starting to tool up new over-the-road trucking solutions that are more the European size. They don't use the same sizes as the Americans do. And so we're tooling up new sizes there. Those should be available later this fiscal year. So those are 2 examples of where we think Europe can start to move the needle faster on premium products.

How much lower are they in terms of a percentage at the moment?

Oh, I don't think I have that number.

Okay.

So I -- yes.

Our next question comes from Michael Gallo of CL King.

Just to delve in a little bit on the third quarter commentary. I think, Mike, I heard you say in your prepared remarks you expect the gross margins to be 25% or so. I was trying to bridge that back. Given, I think, you've realized about $12 million year-to-date on the cost savings, what you're -- because you're -- obviously, you're implying a sequential pickup. So I would assume the revenue will have to be up meaningfully sequentially given that, at least on the OpEx side, it would seem like you've gotten more savings to date than what you would get on average the remaining 2 quarters. But just help me to bridge the sequential improvement given the step-down in gross margins Q3 versus Q2.

So the -- you're correct, we are assuming a higher level of volume in Q3 versus Q2. Q2, as you know, is -- covers a good part of the summer holiday season, particularly for Europe. So it's not unusual for us in the second half of the year to have a higher volume output than we did in the first half. So -- and so volume will be up. The margins will decline, which is a natural result of dilution as lead costs have gone up and will be higher in our third quarter than they were in the second quarter probably by at least $0.05 per pound. So -- and while I think we'll make a little bit of progress on our pricing, I think we will still be looking at metrics that aren't so unsimilar from what we experienced in Q1 and Q2. So we'll still continue to chase a higher price number. But because of the higher volume and a reasonable recovery rate on pricing, that's what's allowing the earnings per share to increase by $0.09 per share from Q2 into Q3.

Got it, that's helpful. And then just a follow-up question for Dave on 5G. Dave, I know you talked in the past about the architecture for type of batteries. Any better feel for whether it likely goes lithium, whether Thin Plate Pure Lead will be an opportunity perhaps? Or just your thoughts on the market opportunity with regards to types of batteries and then, obviously, competitive intensity around that, which may vary depending on chemistry.

Right. So let's look at kind of the 3 layers of where batteries are going to exist. So at the smallest sites, where, let's say, you have a pole-mounted battery box that's supporting, let's say, 15 different 5G antennas, that -- I think that's sort of a coin flip right now as to whether that's going to be lead or lithium. I don't really have a good answer for you, but the -- lithium being lighter weight can maybe help some of the cost reductions on the pole mounting hardware that they use and maybe some of the space in the enclosures. So I don't have a good feel, but we were -- we have a solution we're developing that can be either lead or lithium. So if we go upstream a little bit to one of the nodes, maybe that node's at a microwave site or maybe that's a fiber node. Right now, again, I think that -- I suspect, this is just my opinion, is I don't see a real key driver for weight savings there because we had pretty good success with our Thin Plate Pure Lead at these nodes with good, long life. We had a big build-out, a big fiber build-out a few years ago with Thin Plate Pure Lead, and I -- those products have been out there 10 years now, and the customer's delighted with the performance. So I don't know. And that's one of the big -- one of the real big customers. So I don't know that there's going to be a lot of key drivers because those are ground-mounted typically. I don't know that the weight's going to be there. And then finally, you go upstream to where the big, big batteries are, and those are in some, call them, data centers or central offices or MTSOs. Sometimes, the wireless guys call them MTSOs. And at those sites, it's going to be a mixed bag. I think the traditional central offices, where the battery's on the basement level and all the gear's upstairs, I think they're going to stick with traditional lead acid architecture because all they're going to do is layer in additional capacity to what's already there on site. Interestingly enough, in a lot of these jobs, we've seen an uptick of late because of the Y2K frenzy we saw almost 20 years ago. Those batteries are coming due. Those are typically 20-year batteries. So we've seen an uptick associated with Y2K. So I think that, that can be typically lead. But maybe some of the new data centers or offices that they build or a colo site, where space is more constrained, those guys might opt for the lithium versions. So again, I'm pretty -- I try to be agnostic, and I just want to provide whatever the customer needs and whatever their particular drivers are. Recyclability is still a big issue we've got to solve with a lithium solution. So the -- that's not well defined and well understood, and there's been a lot of dialogue in the industry associations about how are we going to recycle some of the stuff. And I know that some of the lead smelters, when those lithium batteries get inside of the lead recycling stream, it can cause devastating damage to those lead smelters. So the recycling side is still kind of a to be determined and something, frankly, we've got to sort out ourselves. But all that being said, I think that the -- we're going to be in a good position regardless. And then on top of that, one of the advantages we have now for 5G that we didn't have for 4G is our ability to package these solutions with very credible enclosure. These are highly engineered, acoustically, electrically high-quality enclosures that is really going to help us give a nice energy storage solution for these customers.

(Operator Instructions) Our next question comes from John Franzreb of Sidoti & Company.

Yes, just going back to the gross margin profile. Based on current lead costs, how long will it take you to fully recapture the price, higher-cost equilibrium? Are we talking 2 quarters now, all things being equal? What's the time line there?

So John, I guess the first assumption you have to make is if lead is today at $1.13 per pound, I believe, on the spot, is lead going to remain at $1.13? Is it going to rise or is it going to decline? All 3 of which are obviously going to have significantly different outcomes. If it stays at $1.13, then I would tell you in 2-plus quarters, you would see pricing catch up. If lead keeps going, obviously then, we're still going to be looking at continuing pressure on gross margins as a percentage of sales. And if lead starts to decline, you should -- would see an improvement, and you would be back to the kind of rates that we were enjoying in the last 18 months. So if it stabilizes at $1.13, I'm going with about 2 quarters.

Okay, all right. And in EMEA, you had 6% price recovery on a 1% decline. And I know that region has some of the undeveloped areas involved in it, but I guess I'm surprised by the magnitude of the price recovery. Can you just walk through what happened there?

Well, keep in mind this is the region that has the bulk of our pass-through mechanism. So they mechanically work this through. So it's just a matter of protocols. So it's not unusual for them to have it, whereas per se in our Americas region, we typically -- we have none of the -- very little of that type of a pass-through mechanism, and we go through announced price increases, we give a period -- a grace period at which point that price increase will be effective for orders taken typically 3 to 4 weeks after we announced we're about to raise prices, which gives them a chance to load up on the front end. And depending on when they take those orders, there's typically a limit as to how far out those orders can go. But it gives the customer a little chance to push that -- defer that process a little further out. Now -- so in Europe, you tend to get pricing quicker. It tends to recede quicker because if lead goes down, then our price will quickly follow. So each region is a little bit different. But for us, seeing EMEA with the best price recovery in these circumstances is as expected.

Okay. And shifting to China. David, you alluded to the China motive business was good. Last quarter, China Tower, I believe, you called out as -- had pullbacks in their net spending. I thought your expectations were that, that would be a 1-quarter phenomenon. Doesn't seems like that was the case, and if you can just kind of update us what's going on in the China telecommunications market as far as spending overall.

Yes, I'm pleased to report that since our last call, our orders have picked up markedly so that it did seem to be an overall spending slowdown by China Towers, they were sorting out some of their strategy. One of the things that is unique about that situation over there is it's highly, highly transparent. So the way they do things, we have complete visibility as to what our share is of that business. So I can say with a very high degree of certainty that we didn't lose share during that slowdown in our H1, and we're very optimistic that things are improving in our second half as their order rates have recovered markedly.

Great, great. And one last question. In India, it seems like the insurance competitors are circling the wagons. It sounds like you're trying to develop a new strategy there. What kind of strategy can you employ with the 2 competitors that control whatever it is, 66%, 70% of the market?

Yes, so I think it has to be technology based. It has to be systems oriented. I think that to try to -- to go in a straight-up knife fight with traditional products is just a -- it's a hill too steep. So I think we're just going to have to really change up our value proposition, and that's going to make us rethink some of the assets and so forth. But -- and then clearly, M&A and those kind of partnerships and joint ventures is something else we can consider strongly as we move forward with that strategy in India. But the plan we embarked on years ago -- the factory is staying pretty busy right now on motive. That's been good. So -- and we're not -- that's not really the problem in terms of factory absorption. It's really just -- that's an incredibly attractive market from all the battery dynamics in terms of the population growth and the poor power quality. So it's just frustrating. But your assessment was right on. We're trying to rethink how to go about that plan of attack.

Okay. And I guess lastly, on some of the incremental costs incurred in the quarter, the system costs, I guess, is what I'd really like to get some color on. When does that number peak? Or does it stay stable at $2 million? And when does it dissipate?

Okay, in terms of peak, Mike and I have tried to manage this. And Mike, if I say anything wrong, let me know, but we've tried to manage the teams to a certain run rate per quarter, and I don't anticipate that run rate substantially increasing from where we've been the last 2 quarters. Mike, is that correct? Or is there something I'm not remembering?

So the answer is that is essentially correct, that the rate at which we're spending or investing in this year has -- will be fairly stable. But compared to where it was a year ago, it's 3x the amount.

Yes.

So we are [incurring] in any given quarter compared to the prior year period about $4 million of additional investment as we expand our product offerings, expand our Digital Core and make other R&D investments.

Yes. Now the cost reductions have done well so far this year, and it's been essential for us to fight off these commodity pressures. So without it, we'd be in trouble. So in terms of when these pieces start to fall down a little bit, I would say we're going to be at these sorts of rates for at least the next fiscal year. And then I know that the Lean guys start to drop out. That's going to help a little bit the -- some of that -- a lot of the -- a year from now, a lot of the consultants should be out of the building, and we look forward to that. But some of these cloud-based subscription services are going to stick with us. And as such, we have to offset that with the savings. And I'm very optimistic. As I said in my prepared remarks, we're starting to get some things in place, which show a very clear path towards sales and order process cost savings initiatives, including those portals where customers are starting to have the ability to order batteries directly into our system.

There are no further questions. I'd like to turn the call back over to Dave Shaffer for any closing remarks.

All right. Thank you, everyone, for taking your time to attend our call. And please have a great day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.