Aaon Inc

NASDAQ:AAON

Earnings Call Transcript 2018-Q2

[Operator]

Good afternoon, ladies and gentlemen. Welcome to the AAON Incorporated Second Quarter Sales and Earnings Call. There will be a question-and-answer period after management's brief presentation. This call will last approximately 45 minutes to an hour.

I would like to turn the meeting over to Mr. Asbjornson. Please go ahead, Mr. Asbjornson.

[Norman Asbjornson, Chairman & CEO]

Good afternoon. Before we get underway I'd like to read the forward looking disclaimer. To the extent any statement presented herein deals with information that is not historical, including the outlook for the remainder of the year, such statement is necessarily forward-looking and made pursuant to the Safe Harbor provisions of the Securities Litigation Reform Act of 1995. As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated. Please see the risk factors contained in our most recent SEC filings, including the Annual Report on Form 10-K and the quarterly report on Form 10-Q.

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

[Scott Asbjornson, VP, Finance & CFO]

Welcome to our conference call. I'd like to begin by discussing the comparative results of the three months ended June 30, 2018 versus June 30, 2017. Net sales were up 8.2% to 109.6 million from 101.3 million. New sales for the quarter are mainly due to the increases in our air handlers and water source heat pump products. Our gross profit decreased 12.9% to 27.6 million from 31.7 million. As a percentage of sales, gross profit was 25.2% in the quarter just ended, compared to 31.3% in 2017. The company is closely monitoring its staffing levels to improve its production efficiency.

Overtime, freight costs have also been increased due to the price of fuel and the shortage of drivers. The company is actively negotiating freight rates to help control these costs. Additionally, as the company’s research and development lab approaches completion, the company is incurring costs getting the lab running. These are no necessarily offset by increases in production.

Selling, general and administrative expenses increased 9.3% to 13.1 million from 12.0 million in 2017. As a percentage of sales SG&A increased to 11.9% of total sales in the quarter just ended from 11.8% in 2017. Income from operations decreased 26.2% to 14.5 million or 13.2% of sales from 19.7 million or 19.4% of sales. Our effective tax rate decreased to 19.8% from 30.2%.

The company’s estimated annual 2018 effective rate excluding discreet events is expected to be approximately 27%. The decrease in our effective rate was due to the tax cuts and jobs act that was enacted on December 22, 2017 lowering the federal corporate tax rate to 21%.

Net income decreased to 11.7 million or 10.7% of sales compared to 13.8 million or 13.6% of sales in 2017. Diluted earnings per share decreased by 15.4% to $0.22 per share from $0.26 per share. Diluted earnings per share were based on 52,718,000 versus 53, 151,000 in the same quarter a year ago.

The results of the six months ended June 30, 2018 versus June 30, 2017. Net sales were up 11.3% to 108.7 million from 187.4 million. New sales for the quarter are mainly due to the increases in our rooftop units and water-source heat pump products.

Our gross profit decreased 24.2% to 43.0 million from 56.7 million. As a percentage of sales, gross profit was 20.6% as compared to 30.2% in 2017. In January 2018, the company paid all employees a one-time bonus of $1,000 per employee as a result of the tax cuts and jobs act, which lowered the federal corporate tax rate from 35% to 21%. This bonus increased cost of sales by 1.9 million excluding taxes and benefits.

Additionally, the company typically has seasonality in its sales and work force, with the fourth quarter and the first quarters being lower in production. The company maintained a higher level of workforce through the end of 2017 and beginning of 2018 in anticipation of our growing business. The company’s water-source heat pump business is still in the early stages of production and is not as yet as profitable as our other products.

Selling, general and administrative expenses increased 3.6% to 23.3 million from 22.5 million in 2017. As a percentage of sales, SG&A decreased to 11.2% of total sales as compared to 12.0% in 2017. The overall decrease as a percentage of sales in SG&A was primarily due to the decrease in advertising expense and profit sharing.

Income from operations decreased 42.3% to 19.7 million or 9.4% of sales, from 34.1 million or 18.2% of sales. Our effective tax rate decreased to 19.5% from 30.0%. The company’s estimated annual 2018 effective tax rate excluding discreet events is expected to be approximately 27%. The decrease in our effective rate was due to the tax cuts and jobs act that was enacted on December 22, 2017 lowering the federal corporate tax rate to 21%.

Net income decreased to 16.0 million or 7.6% of sales compared to 24.0 million or 12.8% of sales in 2017. Diluted earnings per share decreased by 15.0% to $0.30 per share from $0.45 per share. Diluted earnings per share were based on 52,754,000 shares versus 53, 176,000 shares in the same period a year ago.

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

[Rebecca Thompson, Chief Accounting Officer and Treasurer]

Looking at the balance sheet, you’ll see that we had a working capital balance of 83 million versus a 103.7 million at December 31, 2017. Cash and investments totaled 24.3 million at June 30, 2018. The investments have maturities ranging from one month to five months. Our current ratio is approximately 2.2 to 1. Our capital expenditures were 25.9 million; we expect capital expenditures for the year to be approximately 53.2 million.

We purchased substantially all the operations and assets of WattMaster for 6 million. The company had stock repurchases of 12.3 million year-to-date. Shareholders’ equity for diluted share is $4.50 at June 30, 2018 compared to $4.49 at December 31, 2017. We continue to remain debt free.

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

[Gary Fields, President]

Net sales increased 8.2% for the quarter. This was just higher volume that we were able to move through the plan. Water source heat pumps are coming along nicely. This quarter we built fewer units than we did the first quarter due to – in the first quarter the units we built were a simple version of the units and in the second quarter we had turned on some very complex options and so as a first time run-through were some of these more complex units.

We are working on updating the design on several of what we would consider our legacy products for improved efficiencies and operating efficiencies, but also some of these will be improved manufacturing efficiencies. Our markets as a whole remain at about 50-50 between replacement and new construction. However in the second and third quarters, we’ve typically seen that tilt more towards 60-40 for those two quarters and that we have a considerable presence in the [K to F] school market and a lot of that replacement occurs in the second and third quarters.

We’ve seen a substantial growth in a couple of particular models of our equipment and we’re very fortunate that these are more profitable that the once that aren’t growing as quickly. So, I think we’re going to see continued improvement because of an improved mix.

So as I said, a replacement market, new construction on an annual basis is at 50-50. The one thing I would want to point is, for the trailing 10 months that architecture of building index has remained above 50 which is a benchmark for growth. It’s cooled off just a little to 51 and the change this past month as opposed to the month before it was 52 nearly 53. So the bottom line is that that gives us a forecast, what kind of opportunities we’ll see out about nine months to 10 months from that published data.

Things are quite strong right now with orders coming in the door and look to remain promising going forward. So, the individual market themselves have not changed appreciably for us, we all continue to increase our market share in some of these areas. The backlog at June 30 was 156.6 million versus 83.5 million a year ago. I’d like to point out that we had a price increase on June 15, which pulled forward some of that and we expected that it pulled forward maybe up until right about today. However, from June 16 through today, bookings have not been near as soft as I would have originally anticipated with as much pull-forward as we got.

So summarized it another way, orders are coming in and the door is stronger than we anticipated. They’ve more than made up for the first quarter which we were short of forecast. So in the first quarter as a summation of the first quarter I think we were somewhere in the 20% short of forecast on orders coming in the door and at the end of the second quarter we were plus 8% for that whole six month period of time.

So the remainder of the year, we’re looking water-source heat pumps production ramping up, orders are in the door, we’ve got to get them build and turn that in to revenue or sales, but we’ve seen a marked increase in orders coming in the door of the water-source heat pumps.

I know that many of you are interest in the status of the AHRI approval, so give you an update on that as well. AHRI selected seven individual products from our entire portfolio of water-source heat pump offerings in order to test for the certification. Six of those products have been tested and passed. The seventh and final product goes in the laboratory for AHRI for testing and certification on Monday August 6.

If things hold true to form by middle to end of the week next week, we’ll have a pass or fail thumbs up or thumbs down. However since we’ve passed six out of six, I’m quite confident that we’ll pass the seventh one as well. So we’re looking at prospects of having all of the testing completed next week, having all seven of those tests passed and historically it has taken AHRI in the range of two to three more weeks to publish that on their website. So the final transaction is very likely to occur in August.

Our R&D lab, we will not total completion of the very last chamber until early 2019. Schedule currently shows February of 19, however the first segment of the laboratory became available to us to utilize three weeks ago. We began using the acoustic testing chamber. About each month from now through completion, we gain the use of an additional either environment chamber or more acoustic capabilities. So, the lab is coming along well and we’re just now beginning to utilize it. And what we’re right now with it is testing products and developing better acoustical signatures for products.

Our gross profit improved considerably first quarter to second quarter, and at 25.2% I believe it was the number for the gross profit for this quarter. I look for that to stay in that range, but with greater volume. So we’re pushing hard to get more out the door. So if we can keep that gross profit in that range of 25% or maybe a little bit better even, because we should have a little improvement in efficiencies by dilution of some fixed overhead. Those could however be offset by some inefficiencies in our growing lab reports.

We’re in a market of 3% unemployment, we have been able to onboard people, but they are not the same quality as our core force, it’s taking a little longer to get productivity from these people, so that could put just a little pressure on it. And then with this huge backlog we have people are anxious to get their equipment. So we’re also utilizing some overtime to make that happen. And so whatever improvement we get from dilution of overhead could possibly be offset by the inefficiencies in the labor of these factors that I just mentioned to you.

Rebecca already mentioned to you the CapEx was – it was budgeted to be 53.2 million. We spent 25.9 right now. The lab we have 32 million in change budget for the lab and we have expended 27 million of that. The balance is allocated predominantly on contracts that are yet to be completed. So, the lab is going to be on budget, it’s a 32 million in change. So that money will by and large be spent in 2018. Obviously with some of the completion going out in to ’19 there could be a few dollars that go over in to ’19 for that CapEx.

Another CapEx situation that we’ve already taken care of this year was with water-source heat pump manufacturing facility. We’ve build that in three segments, 6A, 6B and 6C. 6A has been fully utilized in excess of 18-20 months now I think it would be, and 6B came to utilization about one month ago, and 6C would be coming to utilization in the next month to six weeks. And so all of the equipment is there and has now been paid for.

We have a few better items on our CapEx, budget this year that some of them will be depending on those manufacturers capability of delivering the equipment. We have some additional Salvagnini machines going in to the Longview facility. There are various things like that that it could be what we spend this year contingent on deliveries. And some of these manufacturers are running a bit behind.

We had talked about possibly a new site to build more air handlers. As I’ve stated in the past, we have a business that runs around $25 million to $28 million currently on air handling units. That total market is over $1 billion. So we’re just barely scratching the surface, we still have aspirations for that, but have slowed the pace down on it just a little bit. The reason being, with this huge backlog, we got to keep our focus on producing that equipment and producing it efficiently. And as I said the orders coming in the door have not fallen off as much as we thought they would after that price increase.

So, all of this being said, it tells me to hit the pause button on the air handling unit, building opportunity for a few months. So we’ll probably resume our thought process on that when we get pass this influx of the huge backlog.

With that I’ll open it up to questions.

[Operator]

[Operator Instructions] And your first question comes from the line of [Joe Mundy].

[Unidentified Analyst]

I wanted to see what your thoughts are in terms of the demand that you’re seeing. I mean the backlog was up tremendously, much higher than – I don’t even remember a quarter in the last nine years where we’ve seen this kind of growth. I know there’s probably some pull forward before the price increase, but even considering that it seems like it’s just very strong. So I’m just wondering what your thoughts are in terms of customers, the end market that you sell to, the economy, and you think this – I know that kind of growth is not going to be sustainable, but if you think at these levels, do you think that’s somewhat sustainable?

[Norman Asbjornson, Chairman & CEO]

Well lets kind of go back to the beginning of the company. When we first started with business plan and a plan for product and we didn’t really have a problem obtaining orders, we had problems producing orders. And that was our lifestyle for about 20 years and then about 10 years ago we started catching up with all of our in-house problems and getting ahead of that a little bit and we starting running in to the necessity to do something more to get orders, and that’s really led to the appointment of Gary Fields who has in my opinion perhaps the most outstanding record in this industry of being able to get orders in the heating and air conditioning field.

So we’ve brought in an extraordinarily strong individual as President, and turned him loose and told him to stay after. We were doing okay and running the business, stay after and straighten out the problems simply needed to get straightened out and getting orders, and you could see the results. He totally overwhelmed us, we didn’t anticipate to being that much, and we thought normally pull forward would go forward somewhere in the 20% to 40% business. We pulled forward a 100% more business. We weren’t expecting that and that put us over there. So now he’s getting a rush, education and the inside part of the business of how to run the business on the inside. He’s showing his metal in the outside world, now he’s got his challenge of sitting and (inaudible).

So my job for the past couple of years and year and a half now has been one of letting him go just as far as I thought was reasonable even when it was a different way than I would have gone, as long as it had reasonable chance with expectation. And I’d have to tell you that, we made a couple of little errors along the way, both of us did that has led us in to having a little less profitability than we had now. But the whole things to correct that are already put in place and now we got to dig ourselves out of this backlog.

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

[Gary Fields, President]

Well as Norman said, when I came here sales were in my dead center in my wheelhouse. I had accomplished a decent amount over my 32 year carrier. So I wasn’t terribly challenged on how to get started with that. So over a year ago I started digging in to the operation side of the business, restructured some folks in our engineering function that supported production, started seeing some merit to what we were doing there. Then as we’ve talked about many times, we’ve had some rather senior people for the manufacturing processes retired. So a lot of it has been coaching along some younger people and reassuring them of how things were going.

I probably have dug the end of the operations deeper than I ever would have imagined that I would be capable of doing at this point. One of our members of the senior leadership team, I thought he was rather humorous. He told me that the first quarter of 2018 was the best thing that ever happened to me. And I said, oh my gosh! How do you figured out, this was just awful. And he said, well, you’ve been going along peeling the onion layer back, a layer or two at a time and you’re fixing things and all that’s working. He said this, maybe dice up the onion and look at the whole thing at once.

So as we’ve talked about before in last quarters’ call there were really about five significant contributors to that poor performance financially in the first quarter. And so we dice that onion, we did look at all of that and as you can see we corrected a good bit of it. Now there’s still some more to go, but I feel very confident that we’re going to be able to achieve the same level of performance and bottom line financials as we have the topline.

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

[Unidentified Analyst]

So I wanted to ask to follow-up on that. How challenging do you foresee getting this kind of volume out of the door as efficient as possibly? You’ve already mentioned that you anticipate some productivity issues, whether it’s having to pay some overtime or what not. But could you just go in to maybe sort of some detail on how you’re thinking about the challenges related?

[Gary Fields, President]

Yes. July over June on a daily basis shipping out the door we’ve made significant stride in getting that equipment out the door. I don’t have July figures yet to know how efficiently we did that. I looked a few minutes ago at our population on the floor, and our plant floor population in that 30 day period a time went up in single digit percentage. But our manufacturing output in dollars one month over the other went up double digit percentage. So at least based on number of people, I don’t think we did a terrible job in July, I think we did a decent job.

Now the real challenge is getting enough people in here to get this backlog build in a timely manner so that we don’t harm ourselves long term. If you’re sitting there meeting your unit and I’m not able to give it to you, you’re not going to be real friendly when you come starting to buy another one. So I think our biggest challenge right now is getting it out the door and our second biggest challenge is getting it out there efficiently.

At this time, my view point is that for the dilution that we get in a fixed overhead because of the higher volume that there will be some pressure on those games from the inefficiency. I don’t think that they’ll overcome. I don’t think the inefficiencies will overwhelm the gain. In my opinion at this point it could just be flushed or we could go forward a little. But if we were to able maintain the same gross margin percentage and at a higher dollar volume then we’re going to get more dollars to the bottom, more earnings per share.

[Unidentified Analyst]

And then I wanted to ask regarding the material headwinds, [pricing] on the material side of things have continued to increase through the first quarter and then through the second quarter. So while the November price increase probably offset a little bit maybe by the time of early second quarter, I would think that sort of a little bit of an offset started to turn negative again as we approached the end of the second quarter and probably in the beginning of most of the third quarter.

So my question is I understand by fourth quarter or first quarter of next year that your June increase will start to push things in the opposite direction, but will we see any sort of negative headwind in the third quarter compared to the second quarter. Will it get worse in the third quarter before it starts turning better in the fourth quarter?

[Gary Fields, President]

It’s not anticipated to get worse in the third quarter for two significant reasons. If you look at our inventory levels you’ll see that they are a little bit elevated. So when some of these pricing pressures were appearing we bought forward on some materials. Now we’ve talked about our steel before that we buy our steel in so many pounds for so long and I haven’t analyzed how many pounds it takes to build this backlog through the third quarter. But somewhere towards the end of the third quarter, we run out the steel and we’ll call it the ultra-price and we’ll start on steel on the new price. But it will be towards the end of the third quarter, before that possibly happens.

The components that we purchase, we’ve had people in here talking about price increases. One of our significant compressor suppliers was in here talking about price increases. He was here last week, but he was talking about not making those price increases go in to effect until about September. So if he does not then we’ll be really close to get equipment on the floor with that June price increase, right about the same time we get increased prices from that particular supplier.

Our motor suppliers, I don’t have the exact date on that, but they are talking about price increases as well. So I guess Joe, where I’m at on this is, if there was any pressure - additional pressure in the third quarter on prices, I think it would be not a lot.

[Unidentified Analyst]

Okay, and in last conference call I believe it was sort of a wait and see and see how sort of material pricing trends over the next month or two in May and June and what not until deciding and figure out if you need to know their price increases. So what are you – is there any other plans of increasing of your own pricing and can you update us on sort of how the industry has been trending in price relative to how you have been dealing with price?

[Gary Fields, President]

So our June 15 price increase was 5% across the board. One of our most significant competitors Diakin had 4% to 6% price increase. Other’s I don’t know the exact numbers from others, but the bottom line is, we’ve seen no real push-back from the market on the 5% price increase we’ve put in June 15. And our sales channel partners have been dealing with that because I give them a sort of three months lead on that, so it was about mid-March when I announced that 5%. So they started putting that in to their bid documents, maybe late March, first of April.

And there’s been essentially no pushback from that whatsoever. Fact is some of them have said, hey, we are anticipating that you’re going to have more price increases because of everything we hear in the market. So we will be gathering data this week and next week from our major suppliers and we’ll be evaluating our gross margin reports here our actual cost reports to see because we have third quarter everything that we built was at the November price increase, the 3%.

So we now have a complete quarter with no mixed pricing strategy. So we’ll look at that and see where we’re at. We’ll look at the price increased information that we’ve gotten from major vendors. The other good thing is, and Norman kind of advised me on this, on steel for instance that the tariff was announced back earlier in the year and it was to be 25% on steel and 10% on aluminum. Well almost immediately within days we have steel and aluminum suppliers in here talking about new pricing and they were in the range of 56% elevated, not 25 and 10.

And Norman says, one of the thing we have on that steel bought forward will weather this storm. There’s always a surge on this kind of news and announcement. You see you just sit here and watch with me and that will retreat before we have to go in to the market to buy.

Well we were paying on, we’ll call it an aggregate price for steel because different gauge is different coatings are slightly different, but on an aggregate basis we were paying around $0.48 prior to the announcement and they were coming in here and again that same aggregate thought process they were asking $0.70.

I talked to our supply chain manager in our Longview operation on Tuesday his week and he said that he was getting prices now that were in the high $0.50 range, $0.56, $0.58. So they’ve definitely retreated a lot. The price that he was talking about was about 20% to 22% increase more in line with what the announced tariff was. I didn’t get enough data on aluminum but presumably it would have retreated in the same manner.

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

[Unidentified Analyst]

Last question from me real quick, just on terms of water source heat pump. In the queue it looks like it shows you guys did about a 1,000 units there. You did about 1600 units in the first quarter. Just wondering if you could us on that why we saw sort of a pause or a pullback in volumes in the second quarter with the optimism. With the certification hopefully coming later this month, sort of what your thinking is in terms of volume and demand with that.

[Gary Fields, President]

So the reason that we built a 1,000 versus 1600 is relatively easy to define. The 1600 were rather simple units with few to no options on them and they were smaller sized units. The 1000 that we built in this quarter were some of the very most complex units that we ever anticipate building with, just a whole myriad of options of them. They were higher priced units as well due to that.

So the scenario was your first time to build through some of these complex units, you are developing fixtures for building them and it’s the first time that the work force has built those option, so there is no efficiency. We were obviously running at about half the number of units per day as we did in the first quarter, but it was very definable as to why that was occurring. Now once you’ve built a few those units in those complex strategies then the next time you build them you’ll build it much more efficiently because you have fixtures that have all been worked out, you have people knowledge base already maturing somewhat on that.

In fact they are most complex units we have doubled the production rate per day on that very much complex unit in the last month. So there was just a lot of thing to work out as we expanded the product offering. And the reason these auctions occurred in the second quarter was, we had them not available for them to purchase that one ton. Then we turned on the availability and the market demand was there. We got order for them at the door, they work their through the backlog and it just so happens that we built the majority of those in the second quarter.

Going forward the backlog right now is quite elevated on water-sourced heat pumps. Just an hour or two ago we had our production control vice president in here and we were talking about all the strategies to get the production rate up on those water-sourced heat valves so that we meet lead times. So there are two different things that are occurring there. We had built this manufacturing process line in three phases. We call it line 6 and it was A, B, and C. 6A has been an operation for 20 to 24 months. 6B only came on a month ago and 6C is come on in a few weeks.

While 6B is to build the very most complex u it’s we build and larger sizes. So that satisfied one particular testament that we have that has this need and demand for this extremely complex unit. So we got 6B going a month ago. 6C like I said when it comes on board which will start utilizing at the end of this month, but we’ll have bugs to work out. So we’ll probably about half of this quarter have nice utilization of 6C. So we have the orders in the door that we can build and now we have facilities coming alive to where we can build them at a faster pace.

So my anticipation for third quarter number of units is going to be very much elevated over second quarter. I don’t yet know exactly what that number is going to be. And getting people on those lines and getting them trained is also the other opportunity for us.

[Operator]

[Operator Instructions] and your next question comes from the line of Zane Karimi.

[Zane Karimi, D.A. Davidson]

Good afternoon, Zane on for Brent Thielman today. First question comes back to the backlog, is there any significant orders in backlog that would turn to revenue beyond the usual period. You tend to recognize sales in backlog like beyond the three months?

[Gary Fields, President]

Yes, our lead time on the majority of the backlog is around 12 to 14 weeks right now. There is a segment of the backlog probably 10% to 15% of that backlog that’s as much as 26 weeks. So the 156 million in a normal scenario we would build that entire backlog in the following quarter. This time it’s going to spill over beyond that one quarter. Is that answered the way you were looking for?

[Zane Karimi, D.A. Davidson]

Yes. Thank you very much for that clarity. And it also seems your SG&A is running than anticipated particularly with one (inaudible). Should we be considering this $3.2 million expense going forward and is this related to some pipeline to last year?

[Gary Fields, President]

I’ll let Scott address to you the warranty because that’s the accrual that you’re looking at. So I’ll let Scott talk to you about that real quick.

[Scott Asbjornson, VP, Finance & CFO]

Yes, we did see an increase in the warranty expense. What’s going on at the moment is, we’ve got a calculation that looks historically at the expenses we’ve incurred and then tries to project how much we anticipate needing, and that is incorporating some of the elevated the claims that we paid out last year, because there is a lag time in those claims becoming a factor in the calculation. But it’s beginning to appear at this time along with the increase in overall sales volume driving it up. And then on the offset side is, we’ve got our actual expenditures which for the three months went from 2.3 million to 2.5 million so those also increased somewhat, due in part to some lingering paint charges that we have been dialing with from our paint problems in terms of the new personnel moving in to our paint department and implementing the procedures of painting our equipment.

[Gary Fields, President]

I’m going to add a little clarification to that. The vast majority of the issue with paint occurred early to mid-year last year, and we discovered it and 98% rectified the problem, and I’ll give clarity on the 98% rather than a 100. So we rectified the problem by and large, but some of these units that had paint issues and this was paint bubbling up and peeling off, we didn’t have the ability because of weather and timing and so forth to get those resolved in 2017. So they were still being resolved this year, even though they were discovered last year as far as what was happening.

So we began accrue for them, we got a consolidated list together right at the end of first quarter and we accrued for those as well, and because of payments. And I’ll define the 98%, the vast majority of this occurred in late second quarter early third quarter last year as far as the failure and then the implementation resolution was in the third quarter. However, we had a stray unit here and there pop up with a paint problem as late as January of this year, and we’ve not had any since January. That was the latest one to pop up so we’re probably 100% captured on that now.

What we discovered was that the environmental conditions that we painted in January in our paint booth, we got out of the environmental envelop slightly that was allowable and we have gauges, meters and things that you look at to see if you are in that envelop. When we discovered this we added alarm packages that are strobe lights that essentially when it gets out of the environmental envelop that it’s supposed to be in, it gives a very visual warning as to stop the painting process and figure out why the environmental envelope’s been breached.

So I think we got a 100% cure now, but as it turns out, we were only about 98% prior to finding this out in January.

[Zane Karimi, D.A. Davidson]

Thank you for that. And then one final question, although you already mentioned some inefficiencies with the (inaudible) labor in your gross profit margin, do you think there is a trough in the gross margin and should we see continued improvement quarter-over-quarter through year-end?

[Gary Fields, President]

Well I expect third quarter as I’ve said earlier. From a gross profit percentage my expectation is that it could very well be the same percentage as second quarter, as we head out higher production rates, sales going out the door then that will dilute the fixed overhead and then that very well could be offset by the inefficiency of either uses of overtime or some newer workers that have not yet got much experience. So from a percentage standpoint, I’m thinking that we would be doing well to uphold the margin at the 25 and change that we are now, but have a higher revenue range so that we generate more dollars to the bottom line.

[Operator]

And your next question comes from the line of John [Brax].

[Unidentified Analyst]

A couple of questions, when you look at the backlog number, how much of the backlog is represented by the water-sourced heat pump, how significant a piece of business is that?

[Gary Fields, President]

I didn’t carve that out by itself, has anybody else in the room got that.

[Norman Asbjornson, Chairman & CEO]

It’s not going to be the real version John, it’s probably going to be down 1% to 2%.

[Unidentified Analyst]

Not significant, that’s fine. And then secondly, when you look at some of the – well when I was down there last year at this time, you were working mostly on the standard water-source heat pump line. Is that line now operating sort of at capacity, at maximum efficiency or are there still bugs being worked out in the 6A line. I think you talked of Gary.

[Gary Fields, President]

The bugs have by and large been worked out. Where we are at right now is, we are not fully staffed at every station because – again we are having a lot of pressure on the legacy products to get them produced. So when we do add people, we’re adding on other parts in the plant. So we remain at this point relatively constant that the number of people working on that function.

We are beginning to increase that a bit right now, but up until now we’ve not done that. And the other thing is, as we were only running 40 hours a week on that manufacturing system and of course everything in the plant runs a 168 hours a week. So we do have the opportunity to run it more hours. So the facility itself is not tapped out, it’s a matter getting more people and getting them qualified to build product on that line.

[Unidentified Analyst]

When the production or productivity issues in the legacy plant, legacy product lines, is the real emphasis going to be placed on returning profitability to that piece of - that part of the business rather than so much of the water-source sea pump because obviously the legacy business takes the biggest portions of the builds. And I guess from my perspective how much below the optimal level or you’ve been operating that around gross margin at 31% for a long time and how much pressure is there on the legacy business, how would decline are you seeing in the margin in that piece of the business? And how quickly can you get that back up to a level where you once were?

[Gary Fields, President]

Well those were all gross margins where we once were, let’s say in the 2013 to 2016 timeframe was assisted by the fact that we had gotten some priced increases. We had gotten some price increases that we were able to hold in that period of time, but actually had some decline in materials prices, that did help. And then the other thing was that the topline wasn’t growing at the same rate as it is now, so you were able to add people more methodically and then factor and that you had a guide that had been here in those years for 35 years, VP of manufacturing and director of manufacturing or manager manufacturing had been 14, 15 years position in those years. So you had a very veteran leadership group along with some very stable situation that those margin percentages of that 13 to 16 timeframe were extraordinary. My expectation is that that would be, I won’t say impossible to revive, but it’s really going to be difficult to think in those terms.

Now what we are and we’ve stated this for quite a while now. Our goal is to give more dollars to the bottom line and that’s still remains our goal, and I believe that that’s very achievable. So that being the case in order to get the dollars to the bottom line, if I’ve got limited work force, I am highly motivated to in towards my most efficient dollar producing lines. You feed the golden goose, the one that’s laying the regular eggs you kind of let it scratch around free range.

So we have definitely biased our labor force towards a more profitable lines so that we can get more dollars to the bottom line. The line that had the most pressure on our first quarter financials, we have left the lean time go out to as much as 26 weeks on that product. I refuse to build it faster than that or give any substantial effort until I can improve the profit margin on it. And we’re working on improving the profit margin on it, but we’re probably, I’ll bet we’re three quarters away, two to three quarters away from being able to get it because right now that particular manufacturing line we call line 5 is booked all the way to the end of 2018 at the November price. June price, I won’t build the first unit on that line until January 1 of 2018 as its currently scheduled. Whereas all the other manufacturing lines in the plant somewhere between mid-September and the first of October I’d start building them on the new June press..

So obviously I’m motivated to buy us my work force towards those lines that not only have the ability to get me quicker to the 5%, but they are more profitable anyhow. John let me back up and give you an update. Scott gave me the backlog on the water-source heat pumps.

[Scott Asbjornson, VP, Finance & CFO]

Net of 1%. Yes, it was about 1.3 million at the end of June.

[Unidentified Analyst]

Okay, so nothing.

[Scott Asbjornson, VP, Finance & CFO]

About 1% of the total price.

[Norman Asbjornson, Chairman & CEO]

John about 1% to 2%.

[Unidentified Analyst]

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

[Gary Fields, President]

I know for certain we have not and this is what’s been really. I was sleeping well for a few nights when these thing blew up on this backlog. And then I began to sleep better because our regional sales managers are diverse bunch that worked for some of the competitors still maintain a lot of contact with their former employers, some of which are considerable competitors to us. We found out that they are all in the same boat we are via lead times. Or the vast majority of them.

So what we have done is we’ve done a very good job in my opinion of messaging to our people what the lead times are. So it’s allowed them to plan better. A lot of times these people get lax (inaudible) about getting orders in here. If they think you’re 10 weeks delivery and they don’ need it for 20 weeks then they wake 10 weeks to order it, even though they had all full ability to get it in to earlier.

I mean I’ve lived that life I know for sure it happens that way. So when you gave them a lean timesheet, you say hi, this is the 16 weeks. So I get off my [dough] and get that order in, and then the other thing is with everybody having further questions about price increases. July 6 is when a good many of these tariffs actually went in to affect. And at that point in time people started feeling it real. And there’s things that a lot of folks didn’t anticipate. You know there hardly was a tariff on steel, there hardly was a tariff on aluminum.

While (inaudible) one of our major compressor manufacturers is Emerson, they manufactured the vast majority of the compressors we buy here in the United States that be in Ohio or in Lebanon, Missouri. So I’m thinking well there is no tariff on those. They have parts that’s been manufactured in China, parts like a crank shaft for instance, and then had a Teflon seal and they (inaudible). Those parts made the Tera list. I think so all of this is beginning to become real. So a lot of people out there right now are saying, there are things costing more now. So while we are in this environment, right now people are not giving us a lot of pushback on pricing. So I don’t know that I ever finished answering the question earlier about future price increases, maybe I did, okay, I did not. Scott says I did not.

We will be analyzing thoroughly all of the factors regarding our anticipated cost no a go forward basis, and we will be crafting a notice of another price increase probably in the next 30 days. The calculation will be done in the next couple of weeks.

[Norman Asbjornson, Chairman & CEO]

John there’s something that – and this is true for the whole society. Generally speaking most people do a very methodical method of increasing prices, analyzing steps and going forward. We have a President who made his life doing it the opposite way, creating chaos and he just learned how to manage chaos. That’s not the way that most people manage, and you can see reading the paper, listening television or whatever all the people who are just in a state of wondering what’s going to happen next because its knocked away most people work. But he does work that way.

The net result is he’s going to let you think that it’s going way up, and it doesn’t always go way up. So then you say what do I count on and it’s hard for a lot of us to adjust our thinking. I think we understand it pretty well because in the world we live in and where we negotiate for every order and everything that is kind of the way life works in the construction industry.

There’s a lot of give and take and go forward and go backwards. So it starts something with what I’m accustomed to. We’re only accustomed to it on a national basis, but we grow up in the construction industry do live in that environment that plays unintentionally live in all his life and so we’re trying to understand where he’s going, and it’s difficult to project and know where its growing. But in the long term you can pretty well figure out where it’s going.

We got caught a little bit short when it first started happening, but after we adjusted, I think we picked it up and we’re managing it well now.

[Unidentified Analyst]

One final question, in a perfect world Gary or Norm, where would you like to see the backlog at the end of the third quarter or at the end of the fourth quarter? How much would you like it to work down.

[Gary Fields, President]

If I have the backlog at the end of the third quarter in the range of 100 million, I would be real happy with that, and if I had it in the range of 75 million at the end of the fourth quarter I’d be real happy with that.

[Unidentified Analyst]

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

[Gary Fields, President]

Right now I’ve got the vast majority of the plant on 16 weeks, I would like to be back to 10. That’s really where I’d like to be back to. I think the products that I’d like to shorten up even more than that, but that’s the vast majority.

[Operator]

And you do have a follow-up question from the line of [Joe Mundial].

[Unidentified Analyst]

Just two questions, I was just wondering how much of a drag – it sounds like water –source sea pump was a drag in the bottom line for the first half of the year. I was wondering if you could quantify if that’s the case.

[Gary Fields, President]

Joe we haven’t tried to carve out that metric to see, and there’s so many things that are intangible. When you got an engineering department that is spending a considerable amount of its efforts trying to root out bugs and problems in software and manufacturing processes, how do you quantify that because you apply that overhead evenly over the whole thing, but there is concentrating their efforts on that so they are not looking at something else.

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

[Norman Asbjornson, Chairman & CEO]

Joe, one thing that we did differently than we would do sometimes is because this is such an unusual way in which it’s very software dependent that this new process we’re doing we are way out ahead of normal manufacturing methods. We recognize we’re going to have a lot of those kinds of problems, so we did not go out there with a price that was very low to try and get a volume moving and moving fast. We went out with fairly high price. The net result of it is that we didn’t underprice the product to start with like you would if you knew exactly how to put it in to production and we didn’t anticipate any problems.

We thought exactly the opposite, we don’t know everything we know. We know we’re going to have problems. So let’s price it high, don’ pull too much orders in because all we’re going to do is upset customers because we have these probable problems and we are not going to deliver. And the net volume update water source sea pump relative to our total volume was very small. So we even though we didn’t go out there with a cheap price, so we didn’t have our selves underpriced.

We still had the problems and like Gary says, trying to trace down the problems they are what they are and knowing that they are and spending a lot of money running down and saying hey we got problems, that’s kind of a fruitless thing. You better do something that you can actually do something with once you find out you got it. And we knew we were going to have problems, we had problems. We didn’t go running around trying to quantify them because it wasn’t, we ain’t going to put any money on the bottom line. So you know just work a model and go unbothered and they will work themselves up and that’s what we’ve got. And because it was a small part of our overall running, it really didn’t have the big effect on.

[Unidentified Analyst]

Okay, last question that I have is on, with all this demand that you’re going to see or shipments that you’re going to see in the back half of the year I would imagine your working capital is going to be a big source of use of cash. You have a lot of CapEx in the back half of the year. Do you think you’ll have to tap your revolver at least temporarily for a couple of quarters, given all those cash gone out the door?

[Norman Asbjornson, Chairman & CEO]

Well that’s a very good question. We are working very diligently to free up cash where we can. We renegotiated our revolver or our bank agreement to be able to lower the amount of cash we have to keep on hand at the bank to make sure we have additional flexibility. And as we’d said last year we had been prepaying some vendors, or I shouldn’t say prepay, but paying them as quickly as we got the invoice. Well we have been stretching those back out to full terms and if need be we can always extend terms a little bit further with some of our vendors.

So we’re hoping we can avoid having to carry any real balance on the revolver but it’s from day to day. There is a possibility that we could hit it. It’s just going to be a balancing act between now and the end of the year.

[Operator]

And there are no further questions at this time.

[Norman Asbjornson, Chairman & CEO]

Well with no further questions, we’d like to thank you. We used up just a little bit over an hour, pretty much on our estimated time and look forward to talking to you at the end of this quarter. We expect to have a very good remainder of the year, a little troubling because of personnel and the results that we have to get them, we are getting groped with a very low unemployment rate in person, so it’s a trial, and that’s really the big issue that we’ve got is managing our personnel for the balance of the year, and not hurting our customers.

So we believe we know how to do that, but it is going to be challenging. And everything going forward looks very good to us and so we’re very pleased be where we are right now, and want to thank you for being with us and look forward to talking to you at the end of the next quarter.

[Operator]

And this does conclude today’s conference, you may now disconnect.