Generac Holdings Inc (GNRC) 2011 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 Generac Holdings Inc.

Earnings Conference Call.

My name is Katina, and I'll be your coordinator for today.

At this time, all participants are in a listen-only mode.

(Operator Instructions).

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr.

York Ragen, Chief Financial Officer.

Please proceed.

Good morning and welcome to our second quarter 2011 earnings call.

I'd like to thank everyone for joining us this morning.

With me today is Aaron Jagdfeld, our President and Chief Executive Officer.

We will begin by stating that we will make a number of forward-looking statements on our call today.

Certain statements made during this presentation as well as other information provided from time to time by Generac or its employees may contain forward-looking statements and involve risks and uncertainties that could cause actual results to differ materially from those in these forward-looking statements.

Please see our earnings release or our SEC filings for a list of words or expressions that identify such statements and the associated risk factors.

In addition, we will make reference to certain non-GAAP measures during today's call.

Additional information regarding these measures, including a reconciliation to comparable US GAAP measures, is available in our earnings release and SEC filings.

I will now turn the call over to Aaron Jagdfeld.

Aaron?

Thanks, York.

Good morning, everyone.

Overall, we are pleased with our second quarter 2011 results delivering solid year-over-year net sales and net income growth.

Total net sales increased approximately 15% during the quarter compared to the second quarter of 2010, and sequentially sales are up 30% over the first quarter of this year.

Residential product sales were up approximately 5% compared to second quarter 2010 and rebounded from first quarter 2011 results increasing 33% sequentially.

Our commercial industrial product sales continued to deliver significant growth during the quarter, growing 32% year-over-year as key end markets accelerated, and we improve our quote-to-order conversion rates.

During the second quarter, residential product sales improved and experienced positive growth due to a number of factors related to our Powering Ahead strategic initiatives.

As discussed last quarter, our residential sales in the first quarter of 2011 were negatively impacted by a number of temporary factors including higher channel inventory levels coming into the year and a below-average level of outage events.

In the second quarter of 2011, we have seen improving sales trends from our distribution channels.

We continued to execute on our strategic initiatives and, as a result, we have seen positive results from our continuing efforts to increase awareness of home standby generators, increase the availability of our products through expanded distribution, and in diversifying our end markets through the introduction of new products.

In the second quarter we witnessed an increase in number of outage events relative to the same period last year, and as a result we expanded our direct marketing efforts to help increase awareness of home standby generators.

In addition to increasing awareness, we continue to focus on making our products more available by further building out our distribution.

We remain on target to add on a net basis between 300 and 400 new dealers again this year.

In addition, with regard to adding new distribution, you may recall we have previously discussed the launch of our Honeywell branded generator line targeting the HVAC distribution channel.

This, as well as the launch of our new power washer product line late in the first quarter, had a modest contribution towards our improved residential product sales growth in the second quarter of 2011.

Now turning the discussion to our Commercial and Industrial products, over the past four quarters we have achieved double-digit year-over-year growth with shipments of C&I products increasing 32% over the second quarter of 2010.

We have previously discussed the growth drivers for our C&I products, and those same drivers continued into the second quarter.

In particular, our telecom national account customers remain committed to increasing their capital spending as they work to improve the reliability of their wireless networks and central office switching applications.

Our high level of corporate and field level support to these customers on a national basis as well as our ability to engineer solutions tailored to each individual carrier has played an important role in positioning Generac as a leading provider for these applications.

Outside of the telecom market, we are seeing solid growth in other end market verticals such has health care and data centers.

Our quote-to-order conversion rates have improved year-over-year as our dealers are winning more business as a result of our innovative and competitive product offering.

We have worked very hard over the last several years to educate specifying engineers and contractors on the value innovation that Generac's product offering can bring to their project.

Our modular power system technology, our Gemini Twin Pack generator solutions, and our Bi-Fuel generators are just a few of our industry leading innovative products that continue to set us apart from our competition.

In addition, our value engineering focus, global sourcing relationships, and lean production capabilities are all critical elements that allow us to maintain our position as the value leader in the market for standby power generation.

With that, I will turn the call back over to York to discuss second quarter results in more detail.

York.

Thanks, Aaron.

As Aaron previously mentioned, net sales for the second quarter 2011 were $161.4 million, a 14.9% increase compared to $140.5 million in the second quarter 2010.

Looking at net sales by product class, residential product sales increased 4.9% to $92.9 million in the second quarter of 2011 from net sales of $87.9 million in the second quarter of 2010.

As Aaron noted, our residential results were driven by increased awareness for our products, expanded points of distribution, and several new product introductions.

An increased frequency of power outages relative to last year coupled with additional direct marketing campaigns helped to drive increased awareness for our home standby generators.

We continue to expand the number of distribution points during the quarter as we signed up new residential dealers around the country, added new shelf space at retail, and penetrated into HVAC distribution through our new Honeywell brand licensing program.

Lastly, our new power washer product line, which was launched late in the first quarter of 2011 contributed modestly to our second quarter year-over-year sales growth.

Partially offsetting these increases was a slight year-over-year decline in sales for our lower kilowatt portable generators due to elevated channel inventory levels as a result of fewer outage events in the second half of 2010 and the first quarter of 2011.

Looking at our commercial industrial products, net sales increased 32.4% to $57.3 million in the second quarter of 2011 from $43.3 million in the second quarter of 2010 driven by continued growth within our national account customers.

In particular, our telecom national account customers have increased capital spending on backup generators in 2011 as they worked towards improving the reliability of their networks.

Additionally, as Aaron mentioned, improved quote-to-order conversion rates by our industrial dealers and the continued recovery in certain end market verticals were other factors that contributed to our significant year-over-year C&I product sales growth.

Our other product sales category improved $11.8 million in the second quarter of 2011, an increase of 27.5% from prior-year second quarter.

This product category is comprised of the sales of after-market services parts, loose engines to lawn and garden OEMs and shipments of RV generators to OEM (audio break) manufacturers, each of which experienced growth on a year-over-year basis.

Gross margins in the second quarter of 2011 were 37.4% of net sales, a 160 basis point reduction compared to 39% in the same period last year.

This decline was attributable to both rising commodity and material costs compared to prior year as well as the continuing sales mix shift towards more commercial and industrial products, which had lower gross margins, on average, compared to residential products.

The selective price increases that we implemented in the first quarter of 2011 began to realize during the latter half of the second quarter helping to partially offset these inflationary and mixed pressures on gross margin.

Operating expenses for the second quarter of 2011 were $38.6 million versus $35.9 million on the second quarter 2010.

This increase was driven by higher variable operating expenses on higher net sales during the quarter compared to prior year, coupled with increased sales, marketing, and engineering costs in support of our Powering Ahead strategic plan.

The increase in operating expenses was partially offset by a $1.1 million reduction in amortization of intangibles as certain definite live intangible assets became fully amortized since the prior-year second quarter.

Adjusted EBITDA of $37.6 million in the second quarter of 2011 increased 4.6% from $36 million in the same period last year.

As previously mentioned, increased sales volume was partially offset by reduced gross margins and increased operating expenses resulting in increased EBITDA dollars versus the prior year.

Net income for the second quarter of 2011 increased 19.1% to $15.3 million compared to $12.8 million in the second quarter of 2010.

Adjusted net income, as defined in our earnings release, increased 5.8% to $27.7 million versus $26.1 million in the prior year.

The improvement in adjusted net income is attributable to improved adjusted EBITDA during the quarter, partially offset by slightly higher interest expense.

Interest expense increased in the second quarter of 2011 to $5.9 million compared to $5.7 million in the same period last year.

This increase was attributable to the Company entering into certain interest rate swap agreements effective the third and fourth quarters of 2010, partially offset by lower interest expense as a result of the nearly $100 million of debt prepayments we've made over the last 12 months.

Diluted net income per share for the quarter was $0.23 per share compared to $0.19 per share in the second quarter of 2010.

Adjusted diluted net income per share is reconciled in our earnings release with $0.41 per share for the current year quarter compared to $0.39 per share in the prior-year quarter.

Free cash flow defined as net cash provided by operating activities less capital expenditures was $13.5 million in the second quarter of 2011, a decrease from $26.7 million in the same period last year.

This reduction in free cash flow was the result of increased networking capital levels, which were primarily related to a temporary increase in inventory levels versus the prior year.

The increased inventory levels as of June 30, 2011, are timing related and should normalize in the second half of 2011 generating additional free cash flow toward the back end of the fiscal year.

With regards to our capital structure, as of June 30, 2011, we had $632.5 million of term loan debt outstanding, and $78.7 million of consolidated cash and cash equivalents resulting in consolidated net debt of $553.8 million.

The last 12 months adjusted EBITDA through the end of second quarter of 2011 was $153.6 million.

As a result, our consolidated net debt to LTM-adjusted EBITDA leverage ratio was 3.6 times at June 30, 2011.

This compares to a 4.0 times net debt leverage ratio at June 30, 2010.

As previously discussed, in April 2011, we used $24.7 million of cash on hand to make a voluntary debt prepayment on our first lien credit facility.

We remain committed to reducing our leverage, over time, and with nearly $100 million of debt prepayments over the last 12 months, we believe we are making progress towards that end.

From a capital availability standpoint, we have no borrowings outstanding under our revolver, which has approximately $145.8 million of availability net of outstanding letters of credit.

I'd now like to turn the call back over to Aaron to provide additional comments on our 2011 outlook.

Thanks, York.

Given our performance to date, we are reaffirming our outlook for moderate sales growth overall in fiscal 2011 versus fiscal 2010 as Commercial and Industrial markets have continued to accelerate, and we've seen the stabilization of a challenging residential investment environment.

We see positive signs for our C&I products, as backlog has increased during the quarter.

However, we are expecting more difficult prior-year comparables as we enter the second half of the year.

As a result, we are not anticipating year-over-year second half growth rates for C&I products to be at the same levels as we experienced in the second quarter.

However, we believe that Commercial and Industrial product sales will experience solid double-digit growth rates for full year 2011.

We are also reaffirming our sales outlook on residential products.

Assuming no major power outages for the balance of the year, we expect residential sales in the second half of 2011 to be roughly flat with prior year.

Despite seeing modest growth rates for these products in the second quarter, we remain cautious, overall, in our views on the continuing negative environment for residential investment and, as a result, we are expecting to see challenging growth rates for residential products in the second half of 2011.

In spite of this relatively poor macro environment, we believe we are executing on the right initiatives to drive future growth for our residential products, and we are confident that we are well positioned to capitalize on a market recovery when it does occur.

With regards to gross margins, we are expecting to see sequential improvement in the second half of 2011 as we fully realize price increases and begin to realize cost reductions and improved overhead absorption on higher expected sales volumes.

We see commodity costs continuing to rise compared to prior-year, and many of the basic inputs we consume such as steel, copper, and aluminum.

Based on our realization [lags] and today's prices for these materials, we should experience peak commodity levels sometime during the third quarter of 2011.

We expect these commodity pressures to be mostly offset with the previously discussed price increases that we implemented across most of our products midway through the first quarter of 2011.

Those price increases did not become fully realized until late in the second quarter and, as a result, we should benefit from a full quarter of price realization into the third quarter.

We are also executing on certain cost reduction projects focused around automation and material substitution that should generate material cost savings beginning in the third quarter of 2011 with full realization expected by the end of the fourth quarter.

While we expect our pricing actions and cost reductions to mostly offset commodity increases, and we anticipate improved margins in the second half of the year sequentially versus the first half of 2011, we do expect that the continuing shift in our sales mix towards more commercial industrial products into the second half of 2011 will result in lower gross margins, overall, year-over-year with those margin trends improving towards the back half of the year.

We remain confident that the growth drivers, which have propelled our business recently, will continue to carry us forward.

We have aligned our Company's goals and initiatives to be able to grow successfully through the execution of our Powering Ahead strategic plan.

Powering Ahead provides us with a roadmap to focus our efforts on growing the residential market, improving our industrial market share, diversifying the end markets we serve with new products, and growth outside of North America.

We also remain highly focused on the generation of strong margins and free cash flow, as they provide us with the flexibility needed to execute on our initiatives and to drive shareholder value.

This concludes our prepared remarks.

Thank you again for joining on the call today, and at this time we're like to open the call to questions.

Operator?

(Operator Instructions) Mike Halloran, Robert W.

Baird.

First, let's talk about the revenue side of things.

Maybe you could talk a little bit about the residential side and what normal sequential trends would look like 2Q to 3Q, 3Q to 4Q.

I know it's not always that clear of a picture given the portable side of the business and given the weak market.

But what would a normal trend look like through the back part of the year?

Hey, Mike, this is Aaron.

Typically, as you guys have been following the Company, I mean, the seasonality in our products is more pronounced when you talk about residential than it is for industrial.

So if we just focus on the residential to get to your question.

The back half of the year is generally going from Q2 to Q3.

Q4 is a little bit dicey depending on what happened in Q2 and Q3.

So, again, I know that some of this can be a little bit choppy, although I would argue that we haven't really had any major events over the last couple of years, and we continue to see some of the same seasonality as people -- you know, it runs pretty -- not only seasonal but geographically driven, right?

So in Q2 people in the South and Southeast are planning for weather events and other outage-related events that occur generally in Q3, right?

And then in Q3, back half of Q3, and into Q4, you start to see that trend shift to the Midwest and to the Northeast and other parts of the country where winter weather tends to be more of the concern relative to losing power.

So there is seasonality, and there is also a bit of a geographic driver underneath that as well.

So it sounds like you're still expecting seasonality all else equal through the year.

This might be a touch muted depending on how the environment plays out.

That's the right way to think of it.

The second half is always larger than first half.

Right.

From a seasonality perspective.

2H is always better than 1H when it comes to residential.

Okay.

And then on the -- could you talk a little bit about the inventory levels, then, on your lower-kilowatt products.

Mm-hmm.

So as we said, we came into the year with more inventory in the channel, a little more inventory in our coffers, as well, relative to -- in particular, when you start talking about portable generators, in particular, which is what we refer to as the bulk of the lower-kilowatt stuff that we're talking about.

Those levels have really kind of -- because we didn't have a real strong season last year in terms of not having a landed storm anywhere in the US and then not really having any major winter-related outages, those -- as we've indicated, those levels remain high.

They continue to work down, and what we're seeing now, particularly, Q2 is more active in terms of seeing events that drive the demand for those products.

And then as we started off here in July, there's been some weather events in the upper Midwest here that have, again, created situations where those products are coming down.

They're coming more in line with where we'd see them this time of year as how we're feeling about it when we look at both channel inventory and our own inventories.

It may be a tad high still, but they're getting in line more with where seasonal norms should be at this point.

Okay.

And then, lastly, you talked about the new product introductions as well as the Honeywell agreement as an aid to the growth patterns on the resi side.

I'm curious, when you think about that flattish outlook, how that adds to it.

And if you strip those out, it sounds like you're talking about a little bit worse trends underlying the business than maybe normal sequentially.

I think what's underlying that is if you look at the lower-kilowatt stuff, products that we just talked about, those products are the wild card in that.

And so when we look at the Honeywell program, we look at our power washer launch, both modest contributors to Q2.

Really, both of them very new.

They're kind of in their infancy.

So not huge contributors, by any means.

Growing contributors, as we go forward.

As we've said with power washers, we've set kind of low expectations on that for 2011 year because you've got to get through the line review cycles for the retailers and look for -- we're really up to looking for a shelf placement for 2012 at this point in a lot of cases there.

The Honeywell program is building out distribution and building awareness for that brand in this category, and that takes time as well.

But, again, we've built into our forecasts here pretty modest contributions from both of those segments, going forward, through the balance of the year.

And, really, the balance of residential really comes down to the lower-kilowatt portables maybe being the piece of that that would be lower there in the forecast than the standby products.

Good.

Yes, because it certainly sounds like you're building some momentum in the core residential standby unit.

Maybe you could talk about where the areas of strength you're seeing from a distributor standpoint and a couple of the newer strategies that seem to be working a little bit better than some of the other things you're doing.

Yes, as we've talked in the past, we've really gotten focused on direct marketing efforts, really trying to hone our targets in to be a lot more laser-focused instead of trying to shoot with a shotgun.

As a company our size, and you can imagine, we don't have marketing budgets that allow us to go out and buy time in large mass like a Super Bowl ad or something like that.

We'd be hitting a lot of eyeballs that just wouldn't make a lot of sense.

So we have to be a lot more targeted in our advertising.

I think we've gotten a lot better.

The data stream that allows us to do that is really the difference, I think, from a year ago.

We've got, just, some much better data around who the current customers are buying products.

And what you start to do, is if you lay all that out, and you put pushpins on a map, it really starts to highlight for us where we need to be with advertising, with marketing, with messaging, about the awareness of the category in a lot more discrete fashion as opposed to doing it en masse.

I would you tell you, Mike, that's probably the biggest change for us.

I think we continue to build the Generac brand in this category, but right now what we're really focused on is building the awareness for the category.

It's still a very small category relative to household penetration at only 2%.

And our brand -- we've got a great distribution channel.

We've got the broadest product line, great positioning of product, but it's really going to come down to reaching more people with the message.

And that's really what we're -- I think we're much more focused on that through PR and through direct marketing efforts over the last 12 months.

We believe that that's really having an impact.

We're hearing that from our channel partners, and we're hearing it from consumers.

Zach Larkin, Stephens, Inc.

Hey, gentlemen, congratulations on the quarter.

Thanks for taking the call.

Hey, the first question I wanted to kind of hit on the gross margin and the decline that you've seen there.

I wondered if you could give us a little bit more detail on how much of that decline was related to the change in mix versus the commodity impact.

Yes, I'd say, of the 1.6% decline, we're talking year-over-year now, I'd say about 1% of that was mix-related.

And, again, as industrial products, on average, tend to have lower margins than residential products, you should see that sales mix shift as that occurs on a year-over-year basis.

Really, the rest of that is then just the price cost impact in terms of commodities getting offset by our price increases.

So I think that's probably how I'd break it out.

Okay, thanks, York, that's helpful.

And then I also wondered if we could talk about the new dealers that you're adding.

It's great to hear that you're on track to hit that goal.

I wondered if you could give us a sense, more geographically, where have you been adding them and getting the most traction?

And then other areas that you might be looking to add from a geographic standpoint as we go into the second half of the year?

This is Aaron, Zach.

The new dealer acquisition program is a program we've been very focused on over, really, the last decade.

It's a far-reaching program and, obviously, over the last 10 years, we've really refined our efforts there.

And what we tended to do is -- in terms of where those geographic adds are coming, just to kind of answer your question, it's very interesting.

We actually go after new dealers in markets where it's clear that our penetration rates are lower than they are in the average, right, in the aggregate.

And where we believe that -- again, I go back to where we're seeing new products being installed where we feel we just don't have the kind of coverage versus the population base and, of course, where power quality is an issue.

So -- as an example -- you take the northern Illinois market right now.

Now, we actually have very good distribution in northern Illinois because the power grid there has had some issues over, really, the last 10 years.

It's been exacerbated here recently but, normally, we go into a market like that with advertising to consumers to educate them on the awareness of products but, at the same time, we'll also go into that market looking to add additional dealers.

So we kind of refined our distribution acquisition efforts around where we're targeting and through our direct marketing efforts directly to consumers.

Because if we're going to try and light consumers up in a particular market, but we don't have the kind of distribution we need, obviously, that's going to result in a potentially poor experience for a consumer either because they can't get what they need right away, or they can't get what they need at all.

And we don't want that to happen.

So we've very quick to make sure that when we go into a market, if we feel that coverage is not where it needs to be, we add those dealers.

But it's very widespread.

It's because power outages are widespread, the dealer acquisition program ends up being widespread as well.

Thanks for the color on that.

And, also, just one final question -- if you could talk about the inventory, kind of, the working capital increase this quarter.

I wondered if that was primarily focused on C&I versus residential?

And then also if it was building up an anticipation of firm future orders or just based on the demand that you're seeing?

Zach, this is York.

I think there was -- some of it was the industrial build, as we talked about backlog building, and we see some good things out of C&I side the second half of the year.

Some of that was our power washer launch, but a large percentage of it was what we talked about.

In fact, with there just not being basically major events in the second half of 2010 and, really, the first quarter of 2011.

Year-over-year we came into the second quarter and ended the second quarter with more residential inventory than the previous year.

All right.

Thanks very much.

Congrats on the quarter again.

Christopher Glynn, Oppenheimer.

You called out a few verticals in the C&I side -- health care, telecom, and another one there.

But I was just wondering, for each of those, if you could qualify what you think is your penetration execution impact versus a cyclical lift?

That's a great question.

I would tell you -- let's just kind of piece that apart.

I mean, there are so many end-market verticals -- from manufacturing to health care to government, and then you break government into municipal installations versus education.

But if we just take the ones that we've mentioned, Chris, to be efficient with the time here, the telecom market, I would tell you that we've always had great penetration there.

We deliver engineering solutions to those customers, we're the recognized leader, by and large, in that industry with our expertise and, really, the way we service those accounts on a national basis.

I would think that's a little bit more of a rising tide, raising all boats, to a degree.

I mean, that's more market rebound, if you will.

These guys can be a bit lumpy with their CapEx decisions not only from year-to-year but a little bit quarter-to-quarter relative to just the buildout and the speed of which they're building out networks and the decision processes to go after tackling power quality issues in certain regions of the country.

They execute at a regional level, which can lead to a little bit of choppiness with what we see.

I would tell you that on the data center side, which we've called out a couple of times -- and the health care side.

We feel that's a bit more of our improvement in penetration into those markets.

So, i.e., market share gains at the expense of our competitors.

And it really comes down to some of the innovation that we bring to the market that others don't, as well as our focus on a couple of key things that are really important to guys in just those two markets -- health care and data centers -- redundancy being just a key thing with reliability.

Obviously, you have a hospital, you have data center, up time on your networks or your power quality is absolutely critical, it's mission critical, both life safety and data safety and security, if you will.

And our systems have a level of redundancy, our modular power systems have a level of redundancy that is built into those systems, it's absolutely built into them.

And that's a technology that we deploy that's really independent from -- it's proprietary, it's something that our competitors don't do it quite the same way, and we believe that's a big driver in why we've been successful in these markets along with some other things we do with biofuel, which is a combination, as I said, we started an engine on diesel, and we switched the engine over to natural gas operating.

What that does is it really allows for much longer run times, in particular, where fuel storage is an issue in terms of being able to store a lot of fuel or if you're concerned about long-term outages, the ability to run a system 70% off of natural gas, 30% off of diesel gives you a run time that's dramatically longer than it would be were it just running on diesel fuel.

So it's things like that, and not to get too technical but, from an innovation standpoint, we think that's what sets us apart, in particular, in those end market verticals that we've talked about.

Yes, I appreciate that.

And then on the power washer launch -- we expect any disruptive trends there either from significant stocking expense or maybe an initial bubble from stocking on shelf space.

No, I think that's consistent with how we viewed 2011 here with power washers.

It's a new product for us.

We launched it late in Q1.

Really, it's all about shelf placement at this point.

And the way it works is you've really got the retailers on their annual cadence.

Sometimes bi-annually, they do it every two years -- they do line reviews, product line reviews, PLRs they're known in the industry.

And those line reviews, they're basically set with who they're going to go with here for 2011 already based on what they did in 2010.

So what we're in right now are the PLRs for 2012.

And so we're actively pursuing shelf space.

So you won't see any disruptive forces from inventory build or anything like that here in 2011.

You could see it in 2012 as we work through these line reviews.

If we're successful at placing it, you know, what we would refer to as kind of a tier 1 retailer, which would be a Home Depot, a Lowe's, a Sears, somebody of that caliber that has the opportunity to move a lot of product.

That certainly will have an impact, and we would have to plan accordingly and could have some influence on our inventory numbers and top line as well.

But we would certainly talk about that, moving towards it, if it happened.

Jerry Revich, Goldman Sachs.

Aaron, just on that last point, can you say more about how the line reviews are going for 2012?

Any early signals or results yet that you can share?

I can't, Jerry, because they haven't all been completed yet.

We have gotten some news on one or two of them, and we're working through is there an opportunity for us?

I don't think we've ever thought that we would go in and -- you're not going to get Home Depot to pick one supplier for a category like this that's so major for them.

So it's a multiple supplier approach in a lot of cases.

So we're working with these guys to figure out where is the best place to put Generac on the shelf there.

We've had to do some educating.

The buyers for power washers generally are not the same as the buyers for portable gens and stationary gens, so we're building new relationships in some cases, which we have to appreciate takes time to do.

But at this point, we've not -- I don't have any new news to give you relative to any major wins there.

Just to tell you that we continue to work through it and hope to have more to talk about here as we get into the third and fourth quarter.

And in your prepared remarks you mentioned some inventories being at high levels.

It looks like based on your receivables balance uptick, it sounds like that's at your customer base.

Is that primarily on the portable side?

Can you give us more color there?

This is York, Jerry.

On the working capital build you're saying?

Yes, so your receivable is up $18 million sequentially, your inventories were flat to down a little, in your prepared remarks you mentioned.

Do you feel like there is inventory at the channel?

I'm just trying to understand what product declines we should be thinking about there?

Yes, well, we said we think they're getting back to seasonal norms in the channel for inventory levels.

AR build is just tied to the sequential growth, the sequential improvement in the top line sales.

So that's where the receivables are coming in.

But from an inventory standpoint, the channel inventories --.

We think they'll come back into line, Jerry.

We definitely would say coming into Q2 they were at elevated levels --.

Right.

-- and then as we --.

We started Q3 here with some of the events in the upper Midwest and whatnot.

I think that's continuing to clear out some inventories out of channel, and they're maybe still a bit higher, a tad high, but they're starting to approach what we could consider to be both at the channel level and our inventories seasonal norms.

And, lastly, Aaron, can you talk about some milestones we should be thinking about from your HVAC distribution development?

What are the key timeframes that you're targeting?

Can you just step us through the big picture view there?

Yes, the big picture view on the Honeywell HVAC program, the Honeywell licensing program for us, is really around introducing this category of product to a new channel of distribution in those HVAC both distributor partners, right, as well as the individual dealers that are working through it.

So from a milestone perspective, right now, we're very focused on signing new distribution.

So the distribution layer -- we have to get their engagement because the HVAC market is, but for one or two OEMs, is, by and large, a two-step market.

Going through distributors down to dealers.

So it differs a bit in the way that we go to market with residential standby generators with the Generac brand and other brands, that's a much more direct model, a one-step model directly to the contractor.

Because of this two-step model, I would tell you the first milestone is really engaging distributors and that distribution level.

The distribution layer in HVAC plays a pretty important role relative to parts support, the HVAC market is a high replacement market.

So they need to have -- the distribution has got to be close by so the contractors can easily go get a machine when they need one, whether that's a furnace or a new air conditioning unit.

So we're trying to work through with distribution there just how they're going to add value with this category.

So we're focused on training, we're focused on stocking.

So the first milestone is to try and get that distribution layer built up.

That's the focus this year.

As we get the distribution built out, we're going to shift gears as we move forward, the way I see it into 2012, is really shifting down into more direct conversations with the contractors themselves about the sales techniques and the things that they need to do to be effective in communicating the value that exists in owning one of these products.

So milestone-wise it's distribution layer this year and probably more contractor focused layer next year.

Andrew Obin, Merrill Lynch.

Yes, good morning, guys, great quarter.

A follow-up question on margins -- just as I think about underlying residential margins, if we take the mix out in the second half of the year, should we see improvement year-over-year?

If you take the mix out?

Right.

Yes.

We talked about how price realization is kicking in full.

Cost reductions with our automation projects that we're working on and some material substitution projects we're working on.

And just from a seasonal perspective, overhead absorption just improves with the higher volume in the second -- the seasonal higher volume in the second half.

So if you take mix out of the equation, the answer is yes.

But mix will be a big part of that equation.

So from a year-over-year perspective, you should see, still, a decline in gross margins year-over-year.

But as we talked about sequentially, you should see improvement from Q2 going into the second half of the year.

Got you.

And could you just give us a little bit more color on what we're seeing on commercial non-residential side?

Any sign of life?

Maybe you're talking, Andrew, about the retail market -- that end of the commercial.

We call it the light commercial market, which is --.

Right.

-- yes, the retail side.

There's two things at that market that are very interesting.

One is the market that traditionally has not done a lot of power generation the way we look at it.

So these are small footprint retail installations where commercial bank branches, small strip malls, retail, which -- that -- what we're trying to do there is almost similar -- it's analogous to what we're trying to do on the residential side in terms of building awareness, right, for affordable backup power.

So we've got that challenge, which is a challenge that's in and of itself.

And then you couple that with the fact that the retail environment has been tough.

As you guys know, there are a lot of -- I don't think that market is going to fully recover, in our view, until we see some level of recovery in housing.

They're not going to build new strip malls until they start building houses again at the levels that -- you know, in July it was an improvement, but it's got a long way to go.

I would tell you that that's probably one of our areas that we continue to just see weakness in, overall, until that -- and I think it's going to take a housing recovery until that really comes back.

(Operator Instructions) Jeffery Hammond, KeyBanc.

I guess, on the residential, I mean, that seemed to be the big surprise, certainly, versus my model, and I just wanted to get a better sense -- a lot of worries about big-ticket items around the home and just -- it seemed like -- I mean -- what, in your mind, has really been the biggest driver this quarter to the strength?

Or maybe the variance in your model?

Yes, it's a great question/comment, Jeff.

I mean, it's a -- for us, you know, I think it goes back to what we've been saying over the last three or four years, even though housing and residential investment have been down, our residential standby continues to -- that category has continued to really grow.

Albeit slower growth than we experienced back in the last decade, but it's a big-ticket item.

It's an investment in their home.

And when you add all those things up, you think that sounds disastrous.

And you look at other large-ticket consumer durables and their performance in the last couple of quarters, and I think you'd leap to the conclusion that this would be tough for us on the residential side.

It really comes down to the fact that penetration is just so incredibly low in this category still, and only 2% in these households.

I mean, we have conversations every single day with potential -- prospective customers for these products, and it's brand-new to them.

They don't know what it is.

So our biggest challenge continues to be and has been over the better part of the last 10 years, just introducing the category and getting the awareness out there.

And to that end our focus here -- I think we've really tightened it up over the last 12 months, to my previous comments about getting a lot more targeted with our reach in terms of the messaging around standby power being a lot better about knowing where those opportunities are, both on the fact that we track outages at a very local level as well as the targeted direct marketing efforts that we've got based on the just incredible level of detail we're getting on who is buying our products today.

I don't know that we've got the right answer all the way yet, but we're getting a lot closer to it, and I think that's really been very helpful over the last couple of years.

And what you've seen -- and as we said in Q1, the performance in Q1 was exacerbated by a couple of temporary things that we didn't feel were indicative of the long-term run rate here --.

The underlying market.

Yes, the underlying market.

And I think we proved that out with Q2, and we're hopeful that the trends continue here relative to -- and, again, we've said -- we're still thinking that the back half of the year is going to be tougher because it is a challenging environment for big-ticket consumer durables.

We're being cautious about it and, again, we're telling everybody here, and we're planning our year without that big -- any kind of major seasonal events in terms of outages, whether it's hurricanes or elsewise.

So I think it's a lot about just being a lot more focused and targeted on increasing awareness.

Gentlemen, there appear to be no further questions at this time.

You may proceed to closing remarks.

We want to thank everybody for joining us this morning for our Q2 results, and we're looking forward to speaking with you again on our third quarter call.

Appreciate it, thank you.

Thank you.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.