Tennant Co (TNC) 2017 Q2 法說會逐字稿

Good morning. My name is Dan, and I will be your conference operator today. At this time, I would like to welcome everyone to Tennant Company's Second Quarter 2017 Earnings Conference Call. This call is being recorded. (Operator Instructions) Thank you for participating in Tennant Company's Second Quarter 2017 Earnings Call. Beginning today's meeting is Mr. Tom Paulson, Senior Vice President and Chief Financial Officer for Tennant Company. Mr. Paulson, you may begin.

Thanks, Dan. Good morning, everyone and welcome to the Tennant Company's Second Quarter 2017 Earnings Conference Call. I'm Tom Paulson, Senior Vice President and Chief Financial Officer. Joining me today are Chris Killingstad, Tennant's President and CEO; Karen Durant, Vice President and Controller; Jim Stoffel, Vice President of Global Planning and Analysis; and Tom Stueve, Vice President and Treasurer. Today, we will review progress on our core strategies, Tennant's performance during the 2017 second quarter, and our outlook for the full year.

First, Chris will brief you on our operations, and then I'll cover the financials. After that, we'll open up for questions. We're using slides to accompany this conference call. We hope this makes easier for you to review our results. Tape replay of this conference call, along with these slides will be available on our Investor Relations website at investors.tennantco.com for approximately 3 months after this call.

Now before we begin, please be advised our remarks this morning and our answers to questions may contain forward-looking statements regarding the company's expectations or future performance. Such statements are subject to risks and uncertainties, and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today's news release and the documents we file with the Securities and Exchange Commission. We encourage you to review those documents, particularly our safe harbor statement, for a description of the risks and uncertainties that may affect our results.

Additionally, on this conference call, we will discuss non-GAAP measures that include or exclude special or nonrecurring items. For each non-GAAP measure, we will also provide the most directly comparable GAAP measure. There were special non-GAAP items in the second quarter and first half of 2017. There were no special non-GAAP items in 2016. Our 2017 second quarter earnings release includes a reconciliation of those non-GAAP measures to our GAAP results. Our earnings release was issued this morning via Business Wire, and is also posted on our Investor Relations website.

At this point, I'll turn the call over to Chris.

Thank you, Tom, and thanks to all of you for joining us this morning. For the past several quarters, Tennant Company has been pursuing a range of initiatives all focused on a primary goal: reengineering our organization so it is better able to deliver value to our customers and our shareholders in the low growth environment that we continue to experience. Our success means ensuring that we have strength in each aspect of our business, from our product offerings to our market orientation to our ability to operate efficiently.

The following core strategies address these areas: maintaining a new and strong new product and technology pipeline and the R&D commitment needed to fuel it; expanding Tennant's global market coverage in ways that complement our strengths and allow us to improve our scale; building our e-business capabilities to further improve our ability to serve customers and to create additional revenue streams; and leveraging our cost structure and improving operating efficiency.

We are in a period of transition for Tennant, and we are confident that this is the right mix of strategies to continue on the path of profitable growth. We have more work to do as we move through this transition period. Our performance in the second quarter reflects this. We remain committed to our core strategies and reaching important milestones.

As you saw in today's earnings release, Tennant faced a number of factors in our 2017 second quarter that impacted our results. Sales reflected a combination of a challenging year-over-year comparisons such as record sales levels in the Americas region in last year's second quarter as well as the current low growth market environment. Bright spots included our new product launches and strong vitality index, strengthened organic performance in the APAC region, and importantly, a solid year-over-year sales performance for our recently acquired IPC Group.

During the quarter, we also experienced some near-term headwinds that resulted from our first quarter 2017 restructuring, and our manufacturing automation initiatives, and these negatively impacted our gross margin. I will discuss this a bit later in my remarks.

For the 2017 second quarter, consolidated net sales grew 24.9% to $270.8 million, but declined 2.3% organically. It is important to note that our organic sales growth was 5% for the 2017 first quarter and was 1% for the 2017 first half.

Adjusted net earnings were $0.60 per share compared to $0.85 per share in the prior year quarter. Tom will provide more detail on our performance by geography in a moment. I spoke of milestones. Early in the 2017 second quarter, we closed on the acquisition of IPC, the largest deal in Tennant's history. IPC Group, based in Italy, designs and manufactures innovative professional cleaning equipment, tools and other solutions. Our purchase of IPC helps Tennant pursue several of our core strategies, specifically, expanding our geographic presence in key markets, improving and better utilizing scale, efficiencies and addressing the needs of a wider range of customers through an expanded portfolio of product offerings.

We have begun work -- we have begun the work of the integration. While we are still early in this process, we are very impressed with the IPC management team and the organization's focus on sales growth, product quality and operational excellence. IPC achieved organic sales growth of 8% in the 2017 second quarter versus the prior year quarter. This marks the 12th consecutive quarter of year-over-year organic sales growth.

Tennant and IPC are highly complementary and attractively differentiated in terms of our geographies, products and go-to-market approach. Geographically, 80% of IPC sales are in Europe, which significantly expands our market presence in EMEA, and allows us to take advantage of scale benefits in this important region. In terms of go-to-market approach, IPC predominantly sells through distributors. Tennant primarily has a direct sales model. This combination of channels and compatible product categories gives us more opportunities for cross selling.

In terms of products, IPC offers a strong mid-tier value proposition. And like Tennant, their brands are known for quality and performance. Together with Tennant's premium brand, we address a larger portion of the overall market. We have significant synergy opportunities with this new combination, and our forecast in this area remains unchanged. We have identified roughly $10 million in run rate synergies across our cost of sales and selling and administrative expenses to be achieved by 2019 in the categories of sourcing, improved sales and service capabilities and operating scale benefits.

We expect to incur $10 million of costs that will be necessary to achieve these synergies, including approximately $6 million in capital expenditures for information technologies and facilities and approximately $4 million in redundancy costs. There are also potential tax synergies to be realized through tax planning and entity reorganization initiatives.

Our acquisition of IPC Group is off to a promising start, and we anticipate that it will be accretive to Tennant's 2018 full year earnings per share.

Turning to our restructuring initiatives. As you know, during the 2017 first quarter, we undertook a significant global organizational restructuring to support our key strategic growth initiatives, reduce costs and accelerate Tennant's ability to reach our 12% operating profit margin goal. The result was an approximate 3% net reduction of Tennant's global workforce. The savings from the restructuring are predominantly personnel costs, and are estimated to be $7 million in 2017 and a total of $10 million in 2018. We remain confident in these estimates and combined, we expect these actions to further enhance Tennant's revenue and earnings performance.

However, these restructuring initiatives have led to some field service productivity challenges that continued in the 2017 second quarter. In addition, we had a near-term unfavorable impact in our production operations from investments and manufacturing automation initiatives. These challenges, along with raw material cost inflation, negatively impacted the gross margin of Tennant, excluding IPC.

These factors are controllable, and we are committed to improving margins, although these issues may not be fully resolved until early 2018.

The global macroeconomic environment still merits caution, but we are optimistic about our sales momentum as we head into the second half of 2017. However, it will be difficult to improve the field service and manufacturing challenges fast enough to offset the unfavorable variances we had in the first half of 2017. Therefore, as detailed in today's earnings release, we are reaffirming our 2017 full year sales guidance range, but prudently, lowering our 2017 full year earnings guidance range to reflect these headwinds.

Turning now to our new products. Our focus on new product innovation is central to Tennant's growth ambitions. We have a goal of launching 32 new product and product variants in 2017, excluding IPC, and we are on pace to achieve this. Thus far in 2017, our vitality index, which is the percentage of equipment sales coming from products released in last 3 years stands at 45%. This far surpasses our target of 30% and reflects our customers enthusiasm for our innovation.

Our customers want technology that drives productivity and lowers costs, such as improved maintenance and fleet management functionalities. This wide array of customer demands and performance characteristics is at the center of our R&D efforts. For example, we recently launched the enhanced IRIS web-based fleet management system, which allows users to remotely monitor and manage their machines with full visibility of the user's fleet through broad reporting and monitoring capabilities.

Among our major products that launched in the 2017 second quarter were the following: the V3e compact dry canister vacuum. This product is designed for carpeted and hard floor services and provides a three-stage HEPA filtration system and low 68 decibel sound level and features that increase operator productivity.

We also introduced the i-mop. Tennant is the North American distribution for the i-mop as part of a joint venture. It's a highly versatile walk-behind scrubber that combines the cleaning performance of an auto-scrubber with the agility of a flat mop. We are in the early stages with the i-mop, but we are very encouraged by the favorable customer response and are confident that the product will play an important role in helping Tennant open-up new market segments, such as quick serve restaurants.

Going forward, we intend to share information with you about IPC's new product development activities and product launches. We are also exploring new growth avenues that go beyond improving cleaning performance. Our advanced product development efforts include technologies such as autonomous guided scrubbers, water recycling and battery technologies.

As we stated last quarter, satisfying our customers' demand for better ways to engage with Tennant digitally is another core strategy and target of investment. We achieved an important milestone on this front during June, with the launch of our new digital platform and e-Commerce capability for Tennant. Not only will this capability allow customers to tap into better product information and improve their decision-making, but it gives them the option to buy parts and consumables online. This is a good example of how we intend to expand our sales channels and efficiently drive significant additional revenue streams.

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strategic direction and focus on accelerating revenue growth and improving profitability. Notably, our acquisition of IPC Group will put us over our $1 billion sales target on an annualized basis. Additionally, our combined acquisition and restructuring actions will move us closer to our 12% operating profit margin goal.

As we look to the second half of 2017, the global macroeconomic environment still demands caution for industrial companies, but we have made a tremendous amount of strategic progress thus far. We are taking the necessary steps to improve our gross margin and translate our restructuring initiatives into improved operating leverage. Today, we are better positioned geographically and from a product portfolio standpoint. This is creating sales momentum as we head into the second half of 2017. We remain bullish on Tennant's future.

Now, I'll ask Tom to take you through Tennant second quarter financial results. Tom?

Thanks, Chris. In my comments, references to earnings per share are on a fully diluted basis, except for the 2017's second quarter and the first half of 2017, which were calculated with the basic weighted average shares outstanding due to the -- as reported net loss. Note that our financial results for the 2017 second quarter included the financial performance of IPC Group, which was acquired at the beginning of April 2017.

For the second quarter ended June 30, 2017, Tennant's reported net sales of $270.8 million, increased 24.9% compared to sales of $216.8 million in the 2016 second quarter. Excluding an unfavorable foreign currency exchange impact of about 1% and the impact of August 2016 Florock acquisition and the April, 2017 IPC acquisition that increased net sales by 28.2%, organic sales decreased approximately 2.3%.

The second quarter 2017 net loss was $2.6 million, or a loss of $0.15 per share. Tennant reported adjusted net earnings of $10.6 million or $0.60 per share. As adjusted results in the 2017 second quarter excluded 4 special items total the charge of $17.3 million pretax or a loss of $0.75 per share. The special items were $4.7 million pretax or $0.27 per share for acquisition costs related to the IPC acquisition. $6.2 million pretax or $0.22 per share for IPC acquisition-related financing costs. $6.2 million pretax or $0.25 per share for the IPC acquisition-related inventory step-up flow through and $0.2 million pretax or $0.01 per share related to a pension plan settlement charge.

In the year-ago quarter, Tennant reported net earnings of $15.3 million or $0.85 per share.

Turning now to a more detailed review of the 2017 second quarter. Our sales are categorized into 3 geographic regions: which are the Americas, which encompasses all North America and Latin America; EMEA, which covers Europe, the Middle East and Africa; and lastly, Asia-Pacific, which includes China and other Asian markets, Japan and Australia.

In the Americas, 2017 second quarter sales increased 3.2%, but declined 2.8% organically, excluding the 6% impact of the Florock and IPC acquisitions. The foreign currency exchange impact was essentially flat versus the prior year. Sales in the Americas reflected the challenging year-over-year comparison due to the record level of sales in the 2016 second quarter.

In the 2017 second quarter, organic sales declined, however, demand for new products, particularly the M17 sweeper-scrubber effectively impacted sales. Organic sales growth in Latin America also declined in the 2017 second quarter, however, we continue to have strong sales growth in Mexico. In September of 2016, we acquired our long-time distributor in Mexico where the incremental revenue impact is not material. This is an important emerging market for us, and we remain confident about its long-term growth prospects.

In EMEA, sales in 2017 second quarter increased 124.9% but decrease approximately 4.8% organically, excluding an unfavorable foreign currency impact of about 3.5% and the impact of the IPC acquisition of 133.2%.

Solid sales performance in the Central Eastern Europe, Middle East and Africa markets through our master distributor for that area was more than offset by declines in the other countries. EMEA had a difficult year-over-year comparison due to lapping organic sales of 8.3% in the prior year quarter. Remember also that EMEA's organic sales in the 2017 first quarter increased approximately 14.3%, excluding an unfavorable foreign currency impact of about 5.5% and the impact of the Green Machines divestiture of 0.5%.

In the Asia-Pacific region, sales increased 30.7% and increased 3.1% organically, excluding an unfavorable foreign currency impact of about 2% and the impact of the IPC acquisition of 29.6%. Robust sales growth in China and Southeast Asia were partially offset by sales declines in Australia and Japan.

Tennant's gross margin in the 2017 second quarter was 38.6%, and the as adjusted gross margin, excluding the $6.2 million IPC acquisition-related inventory step-up flow through was 40.9% compared to 43.9% in the prior year quarter. The as adjusted 300 basis point decrease, primarily reflects the continued field service productivity challenges related to the organizational changes from the restructuring, the near-term unfavorable impact from investments in manufacturing and automation initiatives and raw material cost inflation.

As Chris mentioned, these factors are controllable, and we are committed to improving our gross margins. We expect the slow recovery throughout the back half of 2017, but we will likely be below our target gross margin range of 42% to 43% for the balance of the year, which is why we lowered our 2017 full year gross margin guidance to the range of 41% to 42%. We anticipate getting back to our target gross margin range for 2018.

Research and development expense in the 2017 second quarter totaled $7.9 million or 2.9% of sales versus $8.4 million or 3.9% of sales in the prior year quarter. We continue to invest in developing a robust pipeline of innovative new products and technologies that Chris noted.

Selling and administrative expenses in the 2017 second quarter was $87.5 million or 32.3% of sales, and as adjusted was $82.6 million or 30.5% of sales. S&A in the second quarter of 2016 was $64.3 million or 29.6% of sales. The 2017 second quarter S&A expense as adjusted was 90 basis points higher compared to the prior year quarter, however, on a dollar basis, spending for Tennant, excluding IPC only increased 1%. We continue to balance disciplined spending control with investments in key growth initiatives.

Our 2017 second quarter operating profit was $9.2 million or 3.4% of sales and the operating profit as adjusted to exclude the IPC acquisition-related inventory step-up flow through and cost of goods sold and the one-time acquisition costs and pension plan settlement charge in S&A expense was an operating profit at $20.2 million or 7.5% of sales.

Operating profit in the prior-year quarter was $22.6 million or 10.4% of sales. As we mentioned last quarter, we are now providing an EBITDA calculation on our non-GAAP financial tables. Our 2017 second quarter adjusted EBITDA was $29.8 million or 11% of sales. Adjusted EBITDA on the prior-year quarter was $27.4 million or 12.6% of sales. For the 2017 first half adjusted EBITDA was $42.8 million or 9.3% of sales, adjusted EBITDA for the prior year first half was $38.5 million or 9.7% of sales.

We do not typically discuss other expense net, however, in the 2017 second quarter, we did have a $6.1 million in interest expense and $0.1 million in net foreign currency transaction losses for one-time financing costs related to the IPC acquisition. This reflects the write-off of debt issuance costs related to the $300 million Term Loan A under our senior secured credit facilities, which was pay off in full, primarily for net proceeds from $300 million senior notes.

We remain committed to our goal of 12% or higher operating profit margin by successfully executing our strategic priorities and assuming the global economy improves. In order to achieve this target, we need to drive organic revenue growth in the mid- to high-single digits, hold the fixed costs essentially flat in our manufacturing areas as volume rises, strive for 0 net inflation at the gross profit line and standardize and simplify processes globally to continue to improve the scalability of our business model, while minimizing any increases on our operating expense.

We continue to successfully execute our tax strategies. Tennant's overall effective tax rate for the 2016 full year was 29.9%. The overall effective tax rate for the 2017 first half was 28.7%, excluding the special items. The base tax rate for 2017 first half was 33.6%, which excludes the special items and the routine discrete tax items.

Turning now to the balance sheet, which now includes the IPC acquisition. Net receivables at the end of the 2017 second quarter was $199.9 million versus $154.6 million a year earlier. Quarterly average accounts receivable days outstanding for Tennant, including IPC were 63 days in the second quarter compared to 60 days in the prior year quarter. Inventories at the end of the 2017 second quarter were $141.6 million versus $82.5 million a year earlier.

Quarterly average FIFO days inventory on hand, including IPC were 98 days for the 2017 second quarter compared to 86 days in the year-ago quarter. Capital expenditures totaled $9.2 million in the 2017 first half, that is $5.6 million lower than $14.8 million in the prior year first half, and reflects our continued planned investments in information technology, our projects tooling related new product development and manufacturing equipment.

Tennant's cash from operations totaled a negative $2.5 million in the 2017 first half compared to a positive $12.4 million in the prior year first half. Cash and cash equivalents totaled $53.3 million at the end of the 2017 second quarter versus $27.9 million at the end of the prior year quarter. Total debt was $411 million, up from $21.2 million at the end of the prior year quarter, chiefly due to incurring long-term debt related to our fall 2016 acquisitions and the IPC acquisition that occurred in April 2017. Our debt-to-capital ratio is 59.1% at the end of second quarter compared to 7.5% a year ago.

Regarding other aspects of our capital structure. Tennant increased the quarterly dividend to $0.21 per share effective December 2016. We paid cash dividends of $14.3 million in the 2016 full year and $7.5 million in the 2017 first half. Reflecting our commitment to shareholder return, we're proud to say that Tennant has increased the annual cash dividend payout for 45 consecutive years.

Regarding our recent financing activities on April 5, 2017, we filed an 8-K for a new $600 million senior secured credit facility with JPMorgan. On April 7, 2017, we announced the offering of $300 million of senior unsecured notes due 2025. The senior notes offering was priced at 5.65% and the closing occurred on April 18.

At the end of the 2017 second quarter, we had $411 million of debt, which was comprised of $300 million of senior unsecured notes, $98 million outstanding of $100 million term loan, $20 million outstanding under the revolving credit facility and an offsetting $7 million of debt issuance cost yet to be amortized.

The overall weighted average cost of debt net of a related cross-currency swap instrument is approximately 4.2%.

Moving to our outlook for the full year 2017. As Chris stated, the global macroeconomic environment still merits caution, but we are optimistic about our sales momentum as we head into the second half of 2017, however, it will be difficult to improve the field service and manufacturing challenges fast enough to offset the unfavorable variances we had in the first half of 2017. Therefore, we are reaffirming our full-year sales guidance range and lowering our full-year earnings guidance.

We continue to estimate 2017 full year net sales in the range of $960 million to $990 million, up 18.7% to 22.4%, or up approximately 1% to 3% organically, assuming an unfavorable foreign currency exchange impact on sales of approximately 1%, an additional 0.8% inorganic growth in the August, 2016 Florock acquisition and inorganic growth from the April, 2017 IPC acquisition in the range of 18.6% to 20.4%.

We now expect 2017 full-year reported earnings in the range of $0.85 to $1.05 per share, which includes the first quarter restructuring charge, one-time acquisition and financing costs relating to the IPC Group acquisition, the impact on earnings from the preliminary estimate of IPC's acquisition-related inventory step-up flow through, a pension plan settlement charge and the interest expense from the IPC acquisition-related financing.

Previously, we expected 2017 full year reported earnings in the range of $1.05 to $1.25 per share. We now expect 2017 full year adjusted earnings in the range of $2.20 to $2.40 per share. Previously, we expected 2017 full year adjusted earnings in the range of $2.40 to $2.60 per share.

The 2017 full-year adjusted earnings exclude the following nonrecurring costs totaling $31.4 million pretax or $1.36 per share: $8 million restructuring charge are recorded in the first quarter in S&A expense; $7.6 million IPC acquisition cost; $2.9 million recorded in the 2017 first quarter and $4.7 million recorded in the 2017 second quarter in S&A expense; $7.4 million IPC related financing cost, $1.2 million recorded in the 2017 first quarter and $6.2 million recorded in the 2017 second quarter in other expense net.

$8.2 million IPC acquisition inventory step-up; $6.2 million recorded in the 2017 second quarter in cost of sales; $0.2 million pension settlement charge recorded in 2017 second quarter in S&A expense.

Foreign currency exchange in 2017 is estimated to negatively impact operating profit by approximately $2.5 million or a negative impact of approximately $0.10 per share. On a as adjusted and constant-currency basis, assuming no change in foreign currency exchange rates from the prior year, 2017 full earnings are now estimated to be in the range of $2.30 to $2.50 per share.

Previously, we expected 2017 full year earnings on an as adjusted and constant-currency basis in the range of $2.50 to $2.70 per share. The revised 2017 full-year earnings guidance still anticipates an as adjusted 2017 dilution from the IPC acquisition of $0.10 per share. For the 2016 full year earnings per share totaled $2.59 on net sales of $808.6 million.

Our 2017 annual financial outlook includes the following additional assumptions: continued stable economy in North America, modest improvement in Europe and a challenging business environment in APAC; gross margin performance in the range of 41% to 42%; R&D expense in the range of 3% to 4% of sales; capital expenditures in the range of $25 million to $30 million and an effective tax rate of approximately 29%. Note that this is 1% higher than our previous estimate of 28% due primarily to unfavorable tax law changes in Italy that occurred after the IPC acquisition. Our objective is to continue to build our business for sustained success both through organic sales growth and through acquisitions.

Now, we'd like to open up the call for questions.

(Operator Instructions) Our first question comes from the line of Joe Maxa with Dougherty & Company.

I wanted to ask to dig in a little bit more to the field service and manufacturing inefficiencies. Just kind of last of the -- rest of this year and start to improve, I suppose, as you're progresses into Q1. Want to get that little ease, maybe, little more color on what you're seeing there? And what you needed to do to improve it?

Well, this is Chris, and I'll start with the service productivity issue. The thing is that -- one of the things that we've realized is that the market place is changing, and our customer base is more segmented than it was between industrial and commercial equipment and the offerings that are required to satisfy our customers. So we -- we've come at our service from an industrial perspective. Historically, we have increasingly been working on establishing a commercial service offering. But really it's only in the last year that we've really taken that on seriously. As part of the restructuring, it was to differentiate the 2 offerings. We need different skill sets for industrial and for commercial. The second thing we did was that our customer expectations are increasing. And so we evaluated the skill set needed at the ground level. Our field service technicians, we have a long tenured service organization, and we needed to upgrade that.

So we took care of some of that in the restructuring. We've also upped the anti in terms of what we're requiring from them. We put GPS in their trucks, so we're now tracking them, the reporting requirements on a daily basis have become more onerous, I think, from that perspective. And so as we were trying to fill our open trucks from the restructuring, we were finding that some of the long-tenured service techs found the new way of doing business was not something they wanted to take part in. And so we struggled because the attrition that we hadn't anticipated was offsetting the filling of the service trucks. The other thing we did is that we needed to actually completely reorganize our field service organization from the frontline supervisor ranks all the way up to regional ranks to take care of the way we're going to operate in the future. All of that happened in the second quarter. And as I said, we had unexpected challenges, especially with the attrition. So we didn't make progress on filling the trucks as quickly as we had anticipated. The good news now is that the supervisor management organization is fully in place, the attrition is pretty much done with, and we are making progress in filling the open trucks. And we expect to make progress in terms of both sales -- service sales and service efficiency going forward. The thing is, we don't know exactly how long it's going to take.

And so we've been prudent in saying that it could take through the end of this year and into early next year. And then on the manufacturing automation, I mean, the good news with all these initiatives, Joe, is that they're all performance-enhancing initiatives. You can argue that maybe we took on a little bit too much at the same time with the acquisition of IPC, with the automation initiatives, the restructuring and the service organization, and I think we've learned from that, but they're all performance-enhancing initiatives. And all the automation front in our factories, we've said to you often that we struggle to find qualified labor in key parts of our factories. So automating functions like welding in our plants. So one of the issues we had is we put in 2 state-of-the-art robotic welding machines that went up and running at 100% are going to be fantastic. But we had some startup issues with those. So it influenced our ability to push through the parts from fabrication to the assembly lines, and therefore, left us with part shortages.

The other thing we've done is, we've realized that we need to automate our material flow and factor -- and warehouse processes. So we put in an automated warehouse management system and had some hiccups with that nearly going which both caused some additional costs in the second quarter. And also in Europe, it prevented us from getting some volume out the door. The good news with volume is that, that will show up in the third quarter. On that front, we think the worst is also behind us. Things have stabilized, and we're going to see improvement. We just don't know how quickly we can get after it, which is why we're hopefully being conservative.

Understand, that really small amount of additional color about 60%-or-so of the unfavorable versus prior year was the servicing efficiency related. The next component that mattered the most was the inefficiencies in the factory and the least relevant was inflation. While we're still concerned about inflation, because it is -- there is some risk involved. Relative to prior year was the difference, where last year we saw basically flat inflation and reasonable pricing. This year, we had more pricing, and we think we are adequately pricing to cover it. But we're still going to be monitoring that closely the balance of the year.

That's all very helpful. Just one follow-up on the filling the trucks. Are you finding qualified people for that role as your service technicians?

Yes. That doesn't seem to be the issue right now. We are filling the trucks. The issue is more of the attrition of existing service techs that offset the filling of the trucks. That's ended, and so we are now filling the trucks and we're doing it on the schedule that we've anticipated.

So you've talked -- you given some color on your thoughts of getting to the 12% operating margin. I'm just wondering, along those lines, what's really going to take to get there? I mean, you got have some, obviously, stronger growth and things are highlighted, but do have a sense on the timing of this is going to take 3 to 5 years from now? Or what's your best kind of guess as you take a look at...

I'm not ready to give you an exact timing, Joe, but if we get extended out in any kind of 3- to 5-year time frame, particularly if you get out to 4 or 5 years, you're going to be pretty disappointed in our performance. I think it's quite relevant that we really do believe we're in the front-end of beginning to return to growth, and growth is super important to us. The IPC acquisition as we are seeing the performance is we're really confident in the ability to grow, maybe even in the excess of the acquisition plan. And then we're going to drive the synergies that we're going after, and we also -- we are on track with our restructuring actions even though we went too fast and it caused some problems, we will save the money that we targeted of $10 million next year. So we think all of those things combined, we made all the necessary investments, the leverage other than the investments we have to make an IPC. So we think -- we can see it out there, but it's going to take some time, and we hope that in the not-too-distant future, we can give you guys some more definitive here on when we really think when we get there.

Yes. And we also, Joe, we also said that we needed to get SG&A expenses down to 28%, 29% of sales -- about 28% of sales. Let's say, that's where we want to end up. Now we've been really disciplined on our spending. And so a little bit of growth, we anticipate getting there. We also said that it required us to have gross margins between 42% and 43%. Unfortunately, our guidance this year dropped to 41%, 42%, but we are absolutely positively committed to getting back to the 42% to 43% in 2018, which is a key component of getting to the 12%.

Right. Right, that's great. Actually just one more quickly on the sales synergies with the acquisition. Do you have any initial progress to report on any type of sales you've seen between the 2 companies? Or what maybe are your initial steps?

No. Remember, it's still early days, right. We just finished the 100-day integration planning, and we are now starting to execute against some of the low hanging fruit that both IPC and Tennant decided were priorities. But what we can tell you is that there is a lot of clamoring from both sides, IPC and Tennant, where they see opportunities to enhance our presence with customers by coming in and cross-selling the full line. So there's a list of those opportunities, and some of them are pretty significant. They're happening both in Europe and increasingly a little bit in North America as well. So, so far we are very optimistic that the assumptions that we've built around cross-selling is there, and there could be some upside too as we move forward.

Your next question comes from the line of Bhupender Bohra with Jefferies

Chris, a question on the service technicians side here. I think here, in your prepared remarks, I think, you mentioned about, historically your service technicians have been aligned more so on the industrial side of the business. And last year, you took a step-up to build on the commercial side of the business. Can you explain where you are? Was that like in a way. were you too quick or too fast to build on the commercial side? That's what it led to this issue in the quarter? If you can just give us some color from an industrial point of view?

I don't think that the commercial service offering that we're building was the primary driver, but I think it creates complexity, right. All of a sudden, we've had a pretty monolithic way of going to market that's based on the industrial model, and now we've had to segment between 2 different models. And the commercial service offering, which addresses the needs of BSEs and retailers are very different from warehouses and manufacturing facilities. They need much quicker service. They have more outlets. We saw that -- it also the cost of our offering was too high, and so that we needed to bring that down. Commercial equipment is mostly battery-operated and therefore, easier to fix. A lot of times you have a service technician that has a territory and basically, kind of just goes up and down the streets and visits the customers to make the fixes. But it's a completely different model. So I think complexity was added but we've been doing this very thoughtfully. So yes, I think with the restructuring, there was some -- there was a little bit of a hiccup there. But really, it's more that we looked at the requirements on our field, on our service organization, we needed to upgrade it. We did it through the restructuring, and then we upgraded also the requirements of them operating on a day-to-day basis. So I think the thing that we did not anticipate was the attrition that we would have from our existing service organization that didn't allow us to make progress on filling the trucks as quickly as we had anticipated. And then the second issue is, is that when you bring all these new people in and more people than we anticipated because of the attrition, it takes time to bring them up to speed to get them up to the productivity levels that we required to operate the way we want to. Now as I said, all of these things are within our control and fixable. The worst is over, and we're starting to make progress here in the third quarter.

We really believe in the strategies we are executing. If we could do it again, we'd go slower.

Yes. That's...

Okay. Got it. Despite all of these things which happened in the quarter, I think if you look at the revenue guidance that you kind of reaffirmed with a 1% to 3%. It seems like if you think about it like these should have actually disturbed your sales channel, but it seems like you're comfortable like building this sales force here or technician services and still keeping a sales for the second half intact.

A couple of things are driving that, Bhupender. I mean, one is, we think we did manage to not disrupt customer-facing things that we do. We did not ship some stuff that we intended, but we think we still satisfy -- we will satisfy customer needs. The other thing that's different than we saw in after a good Q1 is we didn't like the order patterns we were seeing in April. We commented on that on our last conference call. And unfortunately, we didn't make up a hole that we started to create in April given expectations. We've -- the beginning of this quarter is far different. I mean, our order patterns are stronger, they're more consistent. We ended the quarter with a reasonable amount of open orders. And importantly, our pipeline is stronger. So we have lots of reasons to have more confidence. We still think we're being prudent, but we feel much better about the revenue side of things. And very importantly, we don't believe we disrupted customers. We did a lot of disrupting to ourselves but we think we managed to keep customers as happy as we could.

Okay. And lastly on the raw material side, I think, Tom, you mentioned that was the least one of the things, which matter in the quarter. But how about the raw material? And you have talked about this year is going to be from pricing perspective was slightly better year. I don't know, if you still have the same thinking?

Yes. We're -- we've achieved pricing to the first half of year about 1%, maybe, even a little bit better than that. But -- and we're seeing an inflation that might accelerate. So -- but we really do think that for the full year, as we look at the balance between the 2 of them, that we will be okay. But given the inflation and where we're watching it closely things like steel, resin, lead, are all areas where we got to pay particular attention, and that could cause us to be a bit more aggressive as we enter next year for pricing point of view, but we think we've been okay. But it was tougher relative to the comparable last year. Last year, very little inflation we did price.

Okay. If I can one more here. If you look at the operating margin like 300 bps down year-over-year, if you -- what's the biggest bucket here? Like the service technician issue is -- I mean, you mentioned that was like 80% of the whole thing...

Service inefficiency is about 60% of the differential. You got to remember that some of that difference, Bhupender, is related to as we -- our previous targeted gross margins was 43% or 44%. With the acquisition, we adjusted that to 42% to 43%. So we wouldn't have anticipated, we repeat precisely the same gross margins as the prior year. We knew we would be down relative to the consolidation of IPC. But we certainly -- we would never have anticipated it to be 300 basis points down relative to that. Maybe as much as 200, but certainly, not any more than that. But 60% of that is really driven by the service inefficiencies and the balance was the other 2 areas, operating inefficiencies and inflation differential.

Your next question comes from the line of Chris Moore with CJS Securities.

Maybe, we could just stay with the sales momentum a little bit coming into Q3. So it sounds like your order patterns coming into Q3, were positive. Historically, it seems like the last 6 weeks of Q3 are kind of what's key, and I'm trying to understand kind of how the 2 match up? Is that back half of Q3 still kind of the critical point? Or you see some orders slowed early this quarter? Or how do you...

it's supercritical. I mean, we make or break -- I mean, honestly, we make or break rest of the year with starting and in the middle of the August through the end of the year. I mean, particularly, September all way to December it matters more. But it's absolutely reassuring to see our order pattern be up versus prior year and have a pipeline that's more robust than we've seen. So it's really a combination of both of those. And we're paying attention to economical data. I mean, who knows what's really going to happen, but it does broadly speaking feel a little better, but we certainly are smart enough to know.

And what we know is that we -- we have a pretty strong strategic account organization, especially, in Europe and in North America. And we lap some really big strategic account deals last year. Last year, we didn't have many or really any in the second quarter. We do have a big strategic account deals in the pipeline and in the back half, which also bolsters our confidence in ability to drive sales.

Got you. Thank you. IPC organic growth was quite strong. It's just -- it's the mid-tier pricing that you're focused on that, that's the difference in terms of the organic growth or lack of a Tennant versus what you seen at IPC? And does that carry forward you think?

We're not really -- we're not certainly not ready to say that. We think there is a time, and a place for both of the brands and both of kind of customers we're going after. We would just say -- and also we're certainly not going to commit that IPC is only 8% organically...

No. No. It's just on a relative basis.

Sure. We are not ready. We still believe the Tennant brand has its place, and we still believe the Tennant brand can grow organically. And I would remind you that we -- 15%, 14% organic growth with the Tennant brand in Q1, and we will see it for the full year. So we think that both the brands have a place in the market and both can grow organically solidly. And the combination of both together does satisfy a much broader set of customer needs.

And you got to remember that IPC, it's only in last 2 or may be 2.5 years that they started to improve their performance. They were coming up pretty low base. And so they -- they've had 12 straight quarters of organic -- of sales growth, but it's really those 12 quarters maybe a few quarters before that, that are important to their recovery. And one of the reasons we were so interested in buying them because we thought that momentum is sustainable.

We certainly don't want to diminish their importance. We're more excited than we ever been after a quarter like that we had obviously.

(Operator Instructions) Your next question comes from the line of Marco Rodriguez with Stonegate Capital.

I was wondering if you can talk a little bit here about the second half of the year, and just the service productivity issues you had? And then also the automation of -- on the welding side? Are you expecting some dramatic uptake such that the gross margins are dramatically higher in the second half of the year? Or is it going to be kind of like a stair step as we go through the year -- rest of the year?

What I would say is, we would expect to see improvement in Q3 and further improvement in Q4. But we really honestly, we just absolutely cannot count on the fact we're going to be all the way or back where we'd expect to be till we enter Q1 next year. But it's in our control. What we're feeling was a very disappointing quarter, but we are making real progress and we're moving in the right direction, but we want to be prudent in our expectation. So we don't anticipate a stair-step improvement. We think it will be consistent throughout the back 6 months.

Got you. And maybe if you can talk a little bit about the -- you mentioned to your prior question that the differences between the servicing on the industrial side versus the commercial side, and how that caused some potential issue or some issues there for you guys. Was there a particular individual who was in charge of both? And maybe had more of a strength on the industrial side versus the commercial side? And has that been changed? Or any additional color there as to why those kind of impacted you so negatively?

No. I mean no, it has nothing to do with an individual running one piece of the business versus the other. You understand, we have been servicing the commercial side of our business for a long time. But if you look at -- we capture a very high percentage of machines with Tennant service contracts on the industrial side. We were very, very underrepresented on the commercial side. So we realized we need to do something else. We started out with and some pilot markets to prove out the business model that we were contemplating. And so those pilots were really successful, and we realized we were on to something. We were able to deliver a higher level of service and generate better profitability from them. And so what you saw is, this is a fairly new effort and new business model from us -- for us. And so we went from the pilot stage to then rolling this increasingly out on a national basis in North America. Right at the same time that we -- we're upgrading the skill set of our service tech organization, at the same time, we are putting GPS on everybody's trucks and upgrading reporting requirements from them. There was a lot of stuff. And as Tom said before, in retrospect, we probably took on too much, we should have done it in a more measured fashion. We may not have ended up in the situation that we did. I do say, still think that we would've had attrition in the service organization because of the new standards of performance that we were holding them to. So under any circumstances, that probably would have happened. But some of the other issues we could have minimized if we had taken them on in a more measured pace. But the good news is we are in a really good position. We're going to drive a significant incremental commercial equipment service business and do it profitably. We also on the industrial side are better positioned to satisfy customers’ needs there, drive sales and margin as well. So as I said, all of these initiatives were performance enhancing and should pay significant dividends when fully up and running. So we're really bullish on what we've done in the service organization it's just going to take a little longer to get back to the level of excellence that we anticipated.

Got you. And if I heard you correctly, just wanted to confirm something, again, on the servicing and inefficiency that you guys saw in the quarter. I know you guys called that out last quarter as well. But it sounded like this quarter, what caught you guys by a surprise just the attrition levels from, I guess, trying to meet these new standards. One, did I hear that and understand that correctly? And then #2, it sounds like from your prepared remarks and answers to questions that you sound pretty confident that, that is behind you and we shouldn't see those type of issues going forward, is that correct?

Yes and yes. And it's the only other factor that we didn't quite anticipate was because we had higher attrition that we had to hire more new people. And therefore, we had a productivity challenge, right. As we ramp these people up to the levels that we expect them to operate at, and this takes take up to 6 months. So our assumption was we have a smaller pool of new people that we have to train and get up to speed. We actually had a much larger pool because of the attrition. So that was the other factor playing into the performance in the second quarter.

Got you. Last quick question here just on SG&A and R&D. The numbers came in a bit different than what we had modeled SG&A a fair amount higher and R&D a little bit lower. And I think, I'm noticing here that the R&D guidance has also kind of changed a bit. Were there -- was there like a shift in expense allocations between R&D to SG&A? Or is this a new spend level for R&D? Any sort of color there?

Yes. The biggest difference is the consolidation in IPC. Their spending is lower than 2% of revenue, where ours has been closer to 4%. And so that drove some of the difference. Which is really the reason we changed the range from 3% to 4% recognizing that we will be somewhere between 3% and 4%. We certainly won't be at the 4% range. It would be far more likely for it to be in the middle of that range. And then the other differential is just timing related. I mean, we --- you'll see our R&D spending and as you go forward, is likely to be higher as a percent of revenue in the other quarter. So was a bit lower than the normal even after adjusting for IPC.

And SG&A?

Yes. And the SG&A piece is -- really, if you look at it -- I mean, we still won't like where it's at in total, but we did a nice job of controlling. We did have a few -- a couple of one-time things and they're related to medical expenses and et cetera. But we -- the way we will manage our S&A spending the balance of the year is we'd like to see at least some level of improvement relative to S&A as a percent of revenue. So we will manage S&A to be at or lower than where we were in Q2. But hopefully, we can begin to increase some leverage relative to where we've been.

Since there are no further questions at this time, I would like to turn the call over to management for closing remarks.

Thanks, Dan. Before we leave you today, I want to provide some additional context that is helpful to understanding the challenges and opportunities before us. Our strategies to reengineer Tennant Company began well before our acquisition of IPC. Many of the headwinds that we faced, whether it is field service efficiency related to our restructuring or the challenges involved in automating our production facilities are stemming from initiatives to design to enhance the value of the legacy Tennant business. These unfavorable near-term impacts are controllable and correctable, and we will do just that so we can reap the full benefits of these strategies. On top of this, we adding IPC, which comes to us with a proven track record of revenue growth and its own strong commitment to efficiency and returns. Combined with our collective leadership in new product innovation, we have ample reason to be optimistic about our future. We look forward to further updating you on our strategic progress, and our 2017 third quarter results in early November. Thank you.

Mr. Thomas, we have a question joined in queue. It comes from the line Bhupender Bohra with Jefferies.

Just a question, I don't know, if you have time here year. On the end markets here, Tom, if you can give us the cadence of the orders growth in the quarter? You said like April was pretty bad. When we go into like how did the quarter end actually in terms of orders growth and...

The only real color I can provide there was about the order patterns relative to the prior year did get better by the end of the quarter. But we certainly -- we were not forecasting and certainly didn't believe when we gave guidance for the balance of the year in April that we would not have an inorganic quarter. We believed and our internal forecast was more organic growth in the quarter, although, it wasn't as strong as we would have anticipated at the balance of the year. So it -- and we didn't see the improvement relative to the slow start, but it did get better as we went out through the year. And that does help our confidence level and what we're seeing now as where we stand as of today in early August.

Okay. And from end-market perspective, anything which you thought turned kind of stronger, I think, weaker...

No real change in, but I would say, end-market demand. I mean -- and I wouldn't -- I don't -- I haven't seen anything get dramatically stronger, dramatically weaker. We really think that we don't have any end-market issues that are -- that we can't manage our way through. But to be honest, I mean, we're still not even close to be satisfied with 3% organic growth we happen to get to high-end of our guidance. We want to get back to 5% or better, and we believe our business will go back there. But we're not thrilled what kind of growth we're seeing, but we do see improvement and that's encouraging.

And we have no further questions in the queue at this time. I'll turn it back over to management.

Since I read the closing remarks already, I'll just thank you all once again for your time today and your questions. And we wish you well. Thank you.

Thank you to everyone for attending today. This will conclude today's conference call, and you may now disconnect.