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Good day, ladies and gentlemen, and welcome to the Second Quarter 2018 Generac Holdings, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this call is being recorded.
I would now like to introduce your host for today's conference, York Ragen, Chief Financial Officer. Please go ahead.
Good morning and welcome to our second quarter 2018 earnings call. I'd like to thank everyone for joining us this morning. With me today is Aaron Jagdfeld, our President and Chief Executive Officer. We will begin our call today by commenting on forward-looking statements.
Certain statements made during this presentation, as well as other information provided from time-to-time by Generac or its employees, may contain forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in these forward-looking statements. Please see our earnings release or SEC filings for a list of words or expressions that identify such statements and the associated risk factors.
In addition, we'll make reference to certain non-GAAP measures during today's call. Additional information regarding these measures, including reconciliation to comparable U.S. GAAP measures, is available in our earnings release and SEC filings.
I will now turn the call over to Aaron.
Thanks, York. Good morning, everyone, and thank you for joining us today. Overall, our results this quarter were the best second quarter numbers that Generac has experienced, with robust year-over-year organic sales growth leading to strong improvements in margins as we leveraged our operating costs and demonstrated the earnings power of the company. Specifically, overall net sales increased 25.3% compared to the prior year, with core sales growth of approximately 23%, when excluding the favorable impact from acquisitions and foreign currency. This sales growth drove an overall 190 basis point improvement in gross profit margin and a 300 basis point improvement in adjusted EBITDA margins.
Demand for residential home standby and portable generators was strong again this quarter, given the afterglow from power outages in previous quarters. In-home consultations and end user activations remain elevated as we head into the second half of the year with continued momentum. Shipments of domestic commercial and industrial, or C&I products, also experienced significant growth during the quarter, driven mainly by the ongoing replacement cycle for mobile products, as well as solid growth in orders and shipments for stationary products. Sales within our International segment continue to grow as well, as global demand for our backup power generation equipment remains strong, helping to drive double-digit EBITDA margins in the segment.
Our second quarter results highlight the benefit from the increased awareness of the home standby product category, primarily from the afterglow demand generated by the active 2017 hurricane season and the storms in the Northeastern U.S. in the first quarter. As a result, shipments of home standby generators in the quarter increased significantly again compared to the prior year.
The recent higher outage environment has allowed us to make further progress with optimizing our targeted marketing and PowerPlay in-home selling solution to generate more sales leads and improve close rates.
In-home consultations, or IHCs, also increased significantly during the quarter, a good leading indicator of future home standby demand. And end user activations remain very strong, with activity in the Southeast and Northeast regions growing dramatically compared to prior year levels. In addition, we continue to expand and develop our distribution, ending the quarter with approximately 5,900 residential dealers who sell, install, and service our products.
Toward the end of the quarter, we also began to ship the latest version of our flagship home standby product line, which includes WiFi connectability as a standard feature. The ability for these products to be remotely monitored will allow homeowners to gain further peace of mind that their generator stands ready to protect their home and their family.
Additionally, our dealers will now have access to important information about their generator fleet to improve their efficiency and effectiveness regarding service intervals and critical repairs, including the ability to view activity logs and error messages, and perform selective maintenance functions remotely. The new WiFi-enabled generators are also capable of receiving important firmware updates automatically, such as product improvements as well as new features for our customers that may be developed in the future.
The launch of WiFi-connected products marks an important milestone for the home standby generator category, which we believe will only further improve our customers' experience and dealer engagement, and also provides us with a tremendous amount of knowledge about the use of these products, while creating additional revenue streams and future opportunities to further monetize a home standby generator.
Shipments of portable generators also grew substantially compared to the prior year, and were higher than expected due to retail channel replenishment resulting from the elevated outage environment experienced in recent quarters.
Additionally, we are launching a number of new portable generators in the second half of the year, including a new inverter product offering, a new PRO generator line, and a series of products that include our new CO-SENSE technology, that shuts down a portable generator automatically and alerts the user when high levels of carbon monoxide are detected. This innovative new safety feature is the result of years of research and development around improving the safe operation of these products, and has been very well received by our retail channel partners and end users.
The combination of these new product launches, coupled with our team's execution during last year's active hurricane season, allowed us to win additional retail shelf space for our portable generators for the coming season, which should benefit the second half of the year.
Demand for domestic mobile products, primarily serving the rental markets, also remained strong during the quarter, adding to the recovery that began early last year. Similar to the last several quarters, the majority of the improvement came from our national account customer base as they continue to refresh their fleets. Additionally during the quarter, we saw increased demand for our oil and gas-related mobile equipment, as higher energy prices are helping to improve fleet utilization rates for the specialty equipment rental companies that serve this market. We remain optimistic about the further growth for mobile products, with the ongoing fleet refresh cycle, rebounding oil and gas markets, and impacts from recent tax reform all underpinning higher future demand for the product category.
Shipments of stationary C&I products in North America during the quarter were up substantially compared to the prior year, as we began to see the positive effects of higher baseline outage activity impacting demand. In particular, interest in backup generators for the telecom market improved, as certain national account customers allocated capital to new projects focused on protecting the uptime of their wireless networks.
In addition, we are seeing positive trends with our industrial distributors, as improvements in quotation and order rates are beginning to translate into higher shipments. In particular, interest in our natural gas products continues to grow, as we have recently introduced a number of higher output models, thereby further extending the use of natural gas generators in larger projects.
Also during the quarter, activity associated with the state of Florida's legislation requiring that nursing homes and assisted living facilities have sufficient backup power began to have an impact across our distribution channels. In addition to engaging directly with several national account customers on a number of projects, we are also working with our distributors, dealers and wholesale channel partners on several opportunities with other long-term care providers in the state.
Although we are optimistic about the potential for incremental business in the coming quarters as a result of the new regulations, it is also clear that the resulting demand will likely roll over into 2019, due to the lengthy permitting process and challenging labor environment, which are both contributing to extend the typical project cycle associated with these types of products. In addition to a strong domestic market, our International segment continued to add to its recent track record, with sales growth of approximately 27% and margin expansion of 350 basis points as compared to the prior year second quarter.
Importantly, the International segment has also expanded margins on a year-over-year basis in each of the past three quarters, due to a number of factors, most notably from synergy execution, improved sales mix, and leverage of fixed manufacturing and operating expenses on the higher sales volumes.
We believe these favorable trends and financial performance will continue throughout 2018 as we work to gain market share in the regions around the world that we serve, and as we further focus on optimizing the margin profile of these businesses. More specifically, we continue to build on the strength of our International business, by further expanding our presence in the important Latin American markets, as we closed on the acquisition of Selmec late in the second quarter.
Headquartered in Mexico City and with a history spanning more than 75 years, Selmec is a leading designer and manufacturer of diesel and gaseous fueled industrial generators, ranging from 10-kilowatts to 2.75 megawatts. With particular experience in telecom, data centers, and other mission critical applications, Selmec is an excellent complementary fit with our current footprint in Latin America and should allow us to dynamically scale and leverage our existing operations and distribution in this region to offer the Latin American market a broader portfolio of products and solutions.
With approximately one-quarter of our business now being transacted outside the U.S. and Canada, we believe Generac is quickly developing into a global power equipment leader with one of the broadest product lines and distribution networks in the industry.
I now want to turn the call over to York to provide further details on our second quarter results. York?
Thanks, Aaron. Before discussing second quarter results in more detail, recall that effective January 1, 2018, Generac adopted the new GAAP revenue recognition accounting standard. For comparability purposes, the full retrospective method was elected under the standard, which requires application to all periods presented. Although the adoption of this standard did not have a material impact on our financial statements, the prior year 2017 figures that we are discussing this morning have been adjusted accordingly.
Now, looking at our second quarter results in more detail, net sales for the quarter increased 25.3% to $494.9 million, as compared to $394.9 million in the second quarter of 2017, including $4 million of contribution from the June 1, 2018 Selmec acquisition. Core sales growth, which excludes the favorable impact of both acquisitions and foreign currency, was approximately 23% over the prior year. Looking at consolidated net sales by product class, residential product sales during the second quarter increased 24.1% to $246.4 million, as compared to $198.5 million in the prior year quarter.
As Aaron mentioned, the current year quarter experienced strong growth in shipments of both home standby and portable generators, as end market demand for these products continued to be robust, given the afterglow from last year's hurricane season, together with higher baseline outages.
Our intense focus and operating model has allowed us to successfully execute on this recent outage-driven demand. In addition, we continue to accelerate baseline demand on an everyday basis through our initiatives to drive awareness, availability, affordability and connectivity for automatic home standby generators.
Looking at our commercial and industrial products, net sales for the second quarter of 2018 increased 26.9%, to $215.6 million, as compared to $169.9 million in the prior quarter, with core sales growth being approximately 21%. This core growth was broad-based globally, as C&I shipments accelerated during the current year quarter. Domestically, we experienced strong growth from our industrial distributors, as both quoting and ordering rates improved. In addition, the telecom market began to recover and health care opportunities related to new regulations in Florida materialized during the quarter. The replacement cycle for our mobile C&I products remains strong, with our national rental account customers continuing to invest in their fleets.
Internationally, our Latin American shipments grew organically at a solid pace, while we also closed on the Selmec acquisition on June 1 of this quarter. Our Pramac business also experienced very strong growth, driven by large product volume, market growth in Mainland Europe and the continued expansion of our business in the Asia Pacific region. Net sales for the other products category, primarily comprised of service parts, increased 24.2% to $32.9 million, as compared to $26.5 million in the second quarter of 2017. This strong growth was largely due to increased demand for replacement parts resulting from the elevated power outage activity experienced during recent quarters, as well as the growing install base of our products on a global basis.
Gross profit margin expanded 190 basis points to 35.6%, compared to 33.7% in the prior year second quarter. The expansion in margins was driven by improved leverage of fixed manufacturing costs on the significant increase in sales, a more favorable pricing environment, and focused cost reduction initiatives to lower product costs and improve margins. These improvements were partially offset by a slightly unfavorable sales mix and general inflationary pressures from higher commodities, currencies, wages and logistics costs.
Operating expenses increased $9.7 million, or 11.9%, as compared to the prior year. As a percentage of net sales, operating expenses, excluding intangible amortization, declined 150 basis points versus the prior year, primarily due to improved operating leverage on the higher organic sales volumes. The increase in operating expense dollars over the prior year was driven by: higher variable expenses on the higher sales volumes; an increase in employee costs, including additional incentive compensation; and increased international operating expenses due to the stronger euro. These increases were partially offset by lower promotional costs benefiting from improved end market demand and lower intangible amortization expense.
Adjusted EBITDA attributable to the company, as defined in our earnings release, was $99.6 million in the second quarter of 2018, as compared to $68.3 million in the same period last year. Adjusted EBITDA margin, before deducting for noncontrolling interests, was 20.7% in the quarter, as compared to 17.7% in the prior year. This 300 basis point increase compared to the prior year was largely due to the previously mentioned price cost dynamics that improved gross profit margins and the favorable operating leverage on the strong organic increase in sales.
I will now briefly discuss financial results for our two reporting segments. Domestic segment sales increased 24.8% to $381 million, as compared to $305.4 million in the prior year quarter. As I previously discussed, this impressive organic growth was broad-based, driven by strong shipments of home standby generators, portables, C&I mobile products, C&I stationary generators, and service parts. Adjusted EBITDA for the segment was $90.6 million, or 23.8% of net sales, as compared to $63.7 million in the prior year, or 20.9% of net sales.
International segment sales increased 27.3% to $113.9 million, as compared to $89.5 million in the prior year quarter, including $4 million of contribution from the Selmec acquisition. Core sales growth was approximately 16% for the segment, primarily due to robust shipments of C&I products across our Pramac, Ottomotores and Motortech subsidiaries. As we continue to grow the International segment, adjusted EBITDA, before deducting for noncontrolling interests, improved to (15:26) $11.6 million, or 10.2% of net sales, as compared to $6 million4 or 6.7% of net sales, in the prior year.
Now, switching back to our financial performance for the second quarter of 2018 on a consolidated basis, GAAP net income for the company in the quarter was $53.3 million, as compared to $25.3 million for the second quarter of 2017. The increase in operating earnings previously discussed, together with the lower GAAP tax rate, contributed to this increase in GAAP net income. GAAP income taxes during the second quarter of 2018 were $18.4 million, or an effective tax rate of 25.3%, as compared to $13.9 million, or 35.4% for the prior year. The large decline in GAAP tax rate is primarily due the enactment of the tax reform act, which became effective in December of 2017. Diluted net income per share for the company on a GAAP basis was $0.82 in the second quarter of 2018 compared to $0.41 in the prior year. The specific calculations of these earnings per share amounts are included in the reconciliation schedules of our earnings release.
Note that current quarter earnings per share were impacted by a $2.3 million adjustment to increase the value of the redeemable noncontrolling interest for the Pramac acquisition, resulting in a $0.04 reduction in GAAP earnings per share. Under U.S. GAAP accounting rules, any adjustments to this redemption value are recorded directly to retained earnings, however, the redemption value adjustments are required to be reflected in the earnings per share calculation.
Adjusted net income for the company, as defined in our earnings release, was $68.9 million in the current year quarter versus $42.7 million in the prior year. The significant sales growth and improved operating earnings just discussed were the primary drivers of this increase.
With regards to cash income taxes, the second quarter of 2018 includes the impact of a cash income tax expense of $11.1 million, as compared to 5.6 million in the prior year quarter. The current year cash taxes now reflect an anticipated cash income tax rate of approximately 14% to 15% for the full year 2018, while the prior year second quarter was based on a cash tax rate of 14% for the full year 2017. The current year cash tax rate benefits from the tax reform act, however, this is fully offset by a higher level of pre-tax earnings, anticipated for the full year 2018, as every incremental dollar of profit over and beyond our tax shield is taxed at the GAAP income tax rate of approximately 26% for 2018.
As a reminder, our favorable tax shield of approximately $30 million through our annual intangible amortization deduction on our tax return, results in our cash income tax rate being notably lower than our GAAP income tax rate. Adjusted diluted net income per share for the company, as reconciled in our earnings release, was $1.11 per share for the current year quarter compared to $0.68 in the prior year.
Cash flow from operations was $50.7 million, as compared to $59.5 million in the prior year second quarter. And free cash flow was $45.9 million, as compared to $53.7 million in the same quarter last year. This year-over-year decline in cash flow reflected incremental working capital investment related to our strong organic sales growth and the replenishment of inventory levels in anticipation of the summer storm season. On a last 12 months basis, free cash flow was $251 million.
As of June 30, 2018, we had a total of $933 million of outstanding debt and $112 million of consolidated cash and cash equivalents on hand, resulting in consolidated net debt of $821 million. Our net debt leverage ratio at the end of the second quarter was 2.2 times on an as-reported basis, declining from the 3.5 times at the same time last year. Additionally, at the end of the quarter, there was approximately $192 million available on our ABL revolving credit facility. Given the recent amendments of our term loan and revolving ABL credit facilities, both our term loan and ABL now mature in the year 2023.
With that, I'd now like to turn the call back over to Aaron to provide comments on our improved outlook for 2018.
Thanks, York. As our end markets continue to improve more than originally expected, and given the June 1 closing of the Selmec acquisition, we are raising our guidance for revenue growth for full year 2018. We now expect net sales to improve between 13% to 14% over the prior year, which is an increase from the 6% to 8% growth previously forecast.
Recall that the second half of 2017 included elevated portable generator shipments from the active hurricane season. And with no major power outages assumed in our current guidance, we estimate there is an approximately 4% growth headwind related to this strong prior year comparison. Importantly, core sales growth is now expected to be approximately 10%, which is an increase from the previous guidance of 5% to 6%. This change is primarily due to improving end market conditions for both domestic residential and C&I products, as order rates remain strong heading into the second half of the year. In fact, we now expect second half home standby generator shipments to increase year-over-year, as many of the initiatives we have worked on over the last several years are helping to extend the afterglow period and contribute to the new and higher baseline of demand for these products that is developing.
Our top-line guidance assumes no major power outage events in 2018 and also assumes a baseline power outage severity level for the remainder of the year similar to that of the longer-term average. Should the baseline power outage environment be higher or if there's major outage activity in the second half of the year, it is likely we could exceed these expectations. For historical perspective, an average major power outage event could result in $50 million or more of additional sales, depending on a number of variables.
Adjusted EBITDA margins for the full year 2018, before adjusting for noncontrolling interests, are now expected to be approximately 20%, which is an increase from the 19% to 19.5% previously expected. The improvement in margins is a result of increased operating leverage on the higher core sales growth, as well as a favorable sales mix.
We continue to very closely monitor the status of the recently announced importation tariffs and are estimating the impact on our business of the various proposals. Given the likely timing around their implementation and considering our pricing lags from supply chain and our inventory turns, we would expect these tariffs, if they are enacted, to be largely a 2019 consideration. In order to mitigate the anticipated future impact, we are currently evaluating pricing strategies, as well as supply chain, engineering, and operational changes in response to these tariffs. Overall, we are confident that we can fully offset these additional costs through these mitigation activities, as well as other potential cost reduction initiatives.
For full year 2018, operating and free cash flow generation is expected to remain strong and follow historical seasonality, benefiting from the solid conversion of adjusted net income to free cash flow, which is still forecasted to be over 90% for the year. In addition, we are providing an update on certain other guidance details to help model the company's earnings per share and cash flows for the full year. Interest expense is now expected to be approximately $42 million, as a result of the lower LIBOR margin spreads from the term loan and ABL refinancing transactions that closed during the second quarter.
Additionally, as a result of the expected improved earnings outlook, cash taxes are now anticipated to be approximately $39 million to $40 million, which translates into a full year 2018 cash income tax rate of between 14% to 15%. GAAP and tangible amortization expense for the year is now expected to be approximately $22 million, given the additional amortization from the Selmec acquisition. And, as a result of our higher net sales outlook, capital expenditures are now forecasted to be approximately 2% of net sales for the full year.
In closing today, we are very pleased with our results for the first half of the year, which we believe demonstrates the tremendous earnings power of the company. I'm incredibly proud of our team's ability to execute, as demand for our products has accelerated and continues to be very strong. With the momentum we are seeing across the entire business, I'm optimistic about our performance for the remainder of 2018 and beyond as we establish a new and higher baseline of demand and we further execute on our Powering Ahead strategy.
This concludes our prepared remarks. And at this time, we'd like to open up the call for questions. Operator?
Thank you. Our first question comes from Christopher Glynn with Oppenheimer. Your line is now open.
Hey, thanks. Good morning., and pretty impressive quarter.
Morning, Chris.
I had a question about the adjusted EBITDA margin and the strong incrementals at International. Do you kind of view the 10% and runway from there as kind of sustainable, at this point?
Yeah, I mean, I think on the International side, we're very proud of the 10%. We've been talking about growing the International margins as we execute on the synergies and drive the top-line growth. And so, International had a great quarter. And you can really see the leverage of that fixed operating cost layer that they have to support that global business come through with the 10%. Expect to see continued year-over-year growth, expect to see continued strong EBITDA margins, depending on how that comes through from quarter-to-quarter, but for the full second half, we expect those strong margins to continue.
Yeah, and, Chris, this is Aaron. I think it's important to note that it really does fit our thesis all along here with International. We see tremendous opportunity for Generac's products, which have generally historically only been available here in the U.S. and Canada. By putting those products into the distribution that we've acquired internationally, we see – and have said this many times, we see a lot of upside potential. That's gas products. It's residential, standby products, as well as all the wonderful synergies that we think have been available to us around sourcing and operations. And we think we're executing on that. And that really is underpinning, I think, that growth in margins that you're seeing, that expansion of margins, along with, as York pointed out, the top-side growth is also giving us good leverage on that kind of larger fixed operating cost of an international business.
How would you quantify or qualify the pull of the legacy Generac products for gas and resi standby?
It's early. I mean, the world market has traditionally been a diesel market. And so, getting those types of products in the hands of distributors and our distribution and channel partners and getting them to understand the differences, and, frankly, obviously, the benefits of gas that we experience here in the U.S. I mean, the U.S. market is pretty well developed that way. And the growth rates for gas in the U.S. market over the last 20 years, have been about double that of the traditional diesel market. We think that that same type of growth rate'll play out globally, but it's going to take time. We've always said it's a long-term story, and we're in this for the long term. But we had to have the distribution and we had to have the local footprints, really, to enable that.
And so, we're in the very early innings of enablement there, and what we've been working on, really, to this point, is squeezing out all the synergies around the existing product lines that these subsidiaries have. And I think we've been reasonably successful in that regard. And then, I have think having them be part of a larger organization and focused kind of on a global execution has helped them to grow their top lines as well, which again is helping leverage the operating cost structure.
While creating a market on the nat gas side.
Right.
Okay, and then, lastly, just wondering if the levels of business you're seeing with the rental companies and their fleet refresh cycle, if there's any sense that that activity is kind of pulling forward and front-loading a little bit?
Everything we see there when we talk to our customers – and we are a supplier to all of the major national account customers, as well as all of our smaller independent channel partners, is that the market, the end market, is strong. So their utilization rates are up, which is helping prop up rental rates, which obviously gives them a lot of confidence in continuing to invest in their fleets.
And I would say that I think in a typical refresh cycle, maybe we'd be later innings, but I think in this particular refresh cycle, the uniqueness of that almost two-year period of deferral of CapEx spending by many of these customers has created a situation where the refresh cycle just has to go longer.
So I think for us, we see it as being very solidly kind of middle innings. And then, we've got, obviously, on the backside of that, the opportunity with oil and gas. And as higher energy prices continue to be supportive of those activities, in particular, we're seeing marked interest from the specialty rental companies that serve those markets. And that's been a welcome addition to the recovery there.
Thank you.
Thanks, Chris.
Thank you. Our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Your line is now open.
Hey, good morning, guys.
Morning, Jeff.
Just a couple questions on the residential business, one, just kind of how would you characterize channel inventories for portables heading into the selling (29:58) season? It seems like those have been kind of struggling to catch up and low. And just maybe how would you characterize those?
And then second, we picked up in the channel that you brought your 10-year warranty back. And I'm just wondering, one, what feedback are you getting? And two, just a little surprised, given how strong the underlying demand is that you'd need the higher rebate offer. Thanks.
Thanks, Jeff. So on the channel inventories discussion, I think you hit it squarely on the head. We've said we've struggled to catch up all year, and with portable generators in particular, that's been the case. It's been a very strong year for portable gens, especially coming off of the nor'easters late in Q1, which really we were still struggling at that point to replenish off of last fall's active hurricane season. So the channel inventories for portable generators still, in our view, are below where they need to be.
Now, we're catching up. We expect that the third quarter, and our guidance reflects this, that the channel inventories will return to a more appropriate level for a season. So you'll see some more of that channel refill in Q3. And I also mentioned we've got some unique things going on as well in the second half around new product rollouts and some additional shelf space wins, some placement that we got that we need to put stock in for. So we're going to continue to have, I think, a pretty decent year around port gens, and our guidance reflects that.
On home standby, those channel inventories, it's interesting. They're lower in kind of aggregate. And in terms of the number of days of inventory, they're quite a bit lower and, in particular, when you look at certain regions. We mentioned significant strength in activations and interest in the product in the Southeast and the Northeast regions. Those regions are particularly low in inventory. So, we are working hard with our partners to get product in those markets. And I think that even in the other regions, I would say, that they're maybe adequate going into season, but I wouldn't say that they're, by any means, over-filled.
On your second part of your question on the promotion, the 10-year warranty promotion, that we've running or that (32:21) we're currently running, that's a national promo. We plan our promo schedule far in advance, but that's a national promo. And while there are certain regions that are very strong, as we just talked about, that, being on a national basis, continuing to raise awareness for the category, is a really important element of growing the home standby baseline level of demand that we've talked about.
And so, we feel that the 10-year extended warranty promo is a very cost effective way to continue to do that. And I think that that's something that our channel partners, in particular, it helps them get excited about the category. It helps them maybe tip potential future owners of the product category who might be on the fence. It helps them tip them over into the buying category. So we think it's an important thing to continue to promote. We have to be smart, obviously. And as we've mentioned in some of our other remarks, we've been able to improve our pricing power this year on the back of a stronger market, but you still need to promote the category. And, in particular, a category like this, where perpetration rates are low, we've got to get that baseline demand to continue to grow in the absence of events. And so we think that promoting is still an important part of that.
Okay, great. And then, as you kind of look at the tariff pressures, any way to kind of quantify what the impact would be on 2019, from the stuff you buy that might be on the list?
Yeah, it's like a moving target. I mean, I woke up this morning and, all of a sudden, the $200 billion list is being contemplated going from 10% to 25%. So I hesitate to give a number. I think the important element of this is that the impact, we believe there's enough mitigation strategies around combinations of pricing, resourcing, substitution of materials, potential operational changes and things of that nature, that we're going to fully offset this. And, obviously, it's an exercise that all companies that have any kind of importation have to go through, but it is what it is. We have to go through it and we have to figure out how to offset it. And we're working very hard.
We're pushing our team very hard to do that. And that's obviously at the same time here, we're faced with rising demand across all of our end markets, so we're also working with supply chain to make sure we can satisfy that additional demand. So there's a lot of things going on, a lot of moving pieces, but I just hesitate to throw a number out. And I know others have, but I don't know the timing of when they're going to go in, and I don't even know what the number's going to be anymore, because it keeps changing.
So until things get settled on that front, I think when we get better views on what the actual numbers are, we'll share that when we feel confident we think we know it. But I think important thing is whatever it is, we're going to fully offset it.
Okay, that's fair. Thanks, Aaron.
Thanks.
Thanks, Jeff.
Thank you. Our next question comes from the line of Charley Brady with SunTrust. Your line is now open.
Hey, thanks. Good morning, guys.
Hey, Charley.
Hey, Aaron, the commentary around the fact you're getting pricing and just you commented a moment ago about offsetting, mitigating the tariffs, but it sounds like you're being pretty successful at putting through price. I'm just wondering maybe a little more granularity on that. Is that across the board? Are you seeing it stronger or maybe more importantly perhaps, are there areas where you're struggling a little bit more to get price? I would have thought maybe you would have had a little bit more of a headwind on that, but sounds like it's not the case.
No, I think what we're seeing here in the second quarter and actually even the first quarter, that the environment, we do have pricing power given the increased demands for our products, but we had laid this out. We saw our views on commodities and so you look at the residential side of the business, the C&I side of the business, and we rolled out our price increases in the beginning of the year. We also, as we rolled out our new flagship residential home standby product with WiFi connectivity, we also factored pricing into that product launch here in the second quarter. And then, you couple that with the incremental pricing power that we get, and the less discounting that we're doing, all of that equates to better price cost dynamics for the first half of the year and we feel confident that that can continue.
And I mean, obviously, Charley, there are some areas where pricing can be harder to get, like we've got national account customers that you've got some, I won't call it contractual, but obviously, there are fees that were pinned around pricing, whether it be national rental accounts or whether it be some of our telecom customers. And so we have to work a little bit harder on those types of product lines to get cost out, as opposed to putting price in.
But for the most part, most of our channel partners, they're either experiencing it themselves in terms of the inflationary pressures around everything from commodities to wages, to all the other inputs. But, as York said, I think one of the successful strategies that we've employed historically here is with new product launches. Innovation, I think the vitality of our new products is an incredibly important part of how we continue to give our customers additional value, but also in the same manner, we're able to get some pricing out of that. So I think that's been an historical hallmark of our company. And we're not going to slow down on that because we think it's an important part of the value of Generac.
Yeah, thanks, got it. And just on the commentary of outage activity being above average right now, can you give any sense as to, I guess, in the first half, how much above that long-term average is it and defined by how you folks track it, and kind of where you see the second half going on that? I mean, I know it's hard to predict. I'm just trying to get a sense of when things were going tough and we were well below average, it was obviously a focal point. Now we're above average. I'm just trying to gauge how much above that average we're at right now.
Yeah, fair comment. So, in Q1, I think we commented, especially with those nor'easters that hit in the month of March, Q1 came in above that long-term average. Q2, actually, was more in line with the long-term average. And so, therefore, for the first half collectively, it would be deemed above. Again, this is our outage severity metric that we've created. So it's our statistic that we track. But when you track it back to 2010, first half has been above that average, long-term average.
Thanks. And, Aaron, I just wonder, on a bigger picture, longer-term basis on home standby, the install base continues to grow. At some point, these reach end of useful life, and you start entering more of a replacement cycle for that install base. Any sense as to kind of where we are in that and does it help you any with the underlying growth right now or is still just too early in the install base of those cutting over still too small? (39:38-39:44)
Yeah, Charley, we've often said the useful life of the products are between 15 and 20 years, if they're well maintained. And they're like a furnace or other connected home appliance or system. The category is about 20 years old now. We're coming up on what would be, roughly, the 20-year anniversary of really kind of launching it more mainstream. And we're starting to see, very small numbers, but we are seeing replacement numbers. We do track it. And every quarter that we go out and we track it, it ticks up a little bit.
And at some point, it'll be something maybe more meaningful, but today, it's still very early. I do think that per my comments before, as we continue to innovate, the WiFi connectability feature that we added. We've heard from some certain customers, that they really desire that feature. And if they have an older product, even if it's not at end of life, they may be considering an upgrade because that's an important feature for them. And some of the older products just don't have that capability, not at least cost-effectively.
So I think that things like that, as we innovate around the category, introduce new features like WiFi connectability, that also should maybe speed up some of that replacement cycle that I think that is out there in the future for us.
Thanks.
Yes.
Thanks, Charley.
Thank you. Our next question comes from the line of Brian Drab with William Blair. Your line is now open.
Hey, good morning, guys.
Morning, Brian.
And, obviously, great work managing through this step-up in demand. First question, just on the Florida and Puerto Rico impact from last year, and I'm just thinking about how you talk about impact from major events and trying to gauge, now that you're looking back on the demand, the incremental demand, that you saw from these events, how big has it been? I'm trying to gauge it relative to that $50 million that you talk about for a major event.
Well, it's hard to correlate exactly a sale in 2018 back to an event in 2017, but...
You could take Florida as an example. And, Brian, I think it's really hard. We've tried to do this internally, because obviously we want to be able to more accurately project the impact of different events. But the attribution analysis, if I can use the terminology, of trying to attribute a sale back to a particular single event is really difficult, right?
So take Florida. We had Matthew come through and kind of skirt the coast the year before. So maybe some people lost power for a brief period of time, but that second event, which may have been Irene or some of the other storms that came through, was that the tipping point for somebody? I don't know. Do you attribute that back to a storm in 2017 or do you attribute it back to something before that?
Same thing is true in Puerto Rico. Puerto Rico had some power quality issues well before the hurricane activity last year. They had a bankrupt utility company serving the island, and so a lot of power quality issues that have plagued the island. And so was the active hurricane season with just the massive tragedy there of having power be out for so long, is that the attribution or is it all the other things added up? So I think it's really, really hard for us to say with any degree of certainty.
So we really don't do that because we can look at what activations do year-over-year and we can see regionally that the Southeast is up very nicely over last year. We can see the Northeast is up as well. We know that those increases are due to an acceleration of penetration in those markets because of the specific major events or specific events that have occurred, but it's really hard to kind of attribute that at any local level.
Yeah, and I think to clarify, like when we say in our prepared comments, we say an "average" event could impact our sales positively by $50 million, that is meant for that year. So for that year, it could impact the forecast for that year's guidance by $50 million for an average event. What you do have, though, is that you have infinitely higher sales of home standby, because you have a new and higher baseline that's established in the following years.
Just to compare, so Irma, there was roughly 7 million to 8 million people without power for a week, call it, down in Florida and Georgia. So that was probably an above average major event. I think we even called out in our prepared comments, that if we don't get a major event this year, that we would have a 4% headwind in growth, strictly just from portable sales that we sold in the second half of 2017. So that's roughly $60 million to $70 million right there. So just in portables alone in 2017, was $65 million. And then you get the home standby on top of that and you get the new and higher baseline.
So again, it's a tough question to answer, Brian, but hopefully, we're giving you some color there.
Yeah, no, that's all helpful in thinking about it. And I guess following on to that question, if you look at the second half of the year, you made the comment that you – I believe that you said you expect home standby sales in the second half of 2018 to be up year-over-year. Can you make a broader comment on the residential segment for the second half year-over-year? Can you grow for the whole segment?
Well, you've got the portable headwind, which is going to be, in the absence of another event, I think we're really pleased with, obviously, the strength that portables have displayed so far this year. And as our prepared remarks around home standby, as you noted, we said it was going to actually be up in the back half of the year, which was not the original guide. I mean, there's still a fair amount of port gens that we have to comp against in --
Yeah, and having said that, I mean, our new products that we're launching...
Definitely help.
The shelf space that we won is helping to offset some of that.
To neutralize that, yeah, for sure.
But resi's going to be good for the second half.
Yeah, a lot better than we thought.
Yeah.
Okay, great. And then I don't know if you guys can make any comment, if there's any update on what you're seeing in the regulatory environment or any changes potentially coming for assisted living facilities more broadly outside of Florida. Is there any momentum in that area?
There's a couple of states that are reviewing it, Brian, and I think on the back of what Florida did. We still believe that there's probably an opportunity at a national level to improve the regulations. The HVAC loads, the air conditioning and heating loads, really are the issue that are central to the changes Florida made by adding a livable temperature range around their regulations. And so by doing that, in effect, they've made the HVAC loads deemed critical in that regulation.
And so we have seen a couple of other states, Oklahoma has a proposal out there. There's a couple others where there's some talk, but beyond that, we think maybe others are probably going to wait for the next national code cycle, which is a three-year cycle. So it'd be coming up in the next couple of years. And I think it's something that all states should consider, and certainly at a national level should be considered, given the risks associated with not having temperature control available when power is out.
Got it. Okay. Thank you very much.
Thanks, Brian.
Thanks, Brian.
Thank you. Our next question comes from the line of Ross Gilardi of Bank of America. Your line is now open.
Hey, good morning, guys.
Hey, Ross.
Hey, your full-year guidance implies, I think, like $380 million in EBITDA, and you just did $170 million or so in the first half, and you did $100 million or so in Q2. So I mean, you're basically just a little over $100 million a quarter for the next two quarters, and I just went back and looked. I mean, other than, what was it, 2013 or 2014, I mean, your EBITDA goes up every single year in Q2 to Q3. I mean, Q2 is not typically a seasonal high point. I mean, I get the whole portable issue, but it just doesn't seem like, given the strength of the environment right now, I mean, you guys aren't baking in any second half improvement from where you are in Q2. So could you talk to that a little bit?
Yeah, I mean, it's a fair comment, Ross, because we looked at it as well. So second quarter, we had a very strong second quarter, and a lot of demand, and we're executing on that demand. So Q2, from a normal seasonality perspective, Q2 was just higher than it normally is. Again, you'd expect that after a major event in the previous year. And so we expect that strength to continue into the second half. But you're right. It's going to be, because of such a strong second quarter, our guidance anticipates that the second half quarterly run rate would be more level-loaded off that second quarter run rate.
We don't have a major event in the second half that we're assuming. We also are just assuming just normalized long-term average baseline outages. So I think we say that there's always could be some upside there. But basically, the assumption is that the strength from Q2 will carry into the third and fourth quarter. But could we get some extra weather that we could exceed that? Yes. Extra, more outage environment, yes, we could exceed that.
Even if you don't get extra weather, I mean, isn't this just a natural progression? Like I said, I mean, I think 2015, in the middle of an industrial recession, your EBITDA went up pretty substantially from Q2 to Q3. I don't remember exactly what was going on that year, if there was an outage or not. But it would seem like you don't even necessarily need a major power outage for the third quarter to be higher. It just seems like that's what it usually does.
Yeah, again, on the back of a major event, second quarter is always very strong. You'd have to look back to, what, 2013. You'd have to look back and --
Yeah, usually you don't have that same ramp that you have.
Yeah.
That you're referring to some of those other periods, Ross. But it's just a little bit different pacing this year as a result of that. And I think we're reflecting that in our guidance.
Can you talk about the telecom improvement? I mean, I think that's a pretty consolidated customer base, and I think you're talking about a handful of customers. Is it really just one customer that's been out of the market for a long time that's driving that improvement? And remind us or give us some sense as to how far below prior peak that business is now? And what portion of C&I, just very, very roughly, does it account for?
Yeah, Ross, we don't comment specifically on our individual customers' plans, but there are a number of customers. I would say you're right. The market, there's a fair amount of consolidation, but there are still a number of major players there. And I would say some of those major players have been advancing the hardening of their networks, as we refer to it, relative to protecting them from outages. And it's an investment cycle. It does cycle. We've seen it as high – as we said before, it was a meaningful part of our C&I business back in the 2013 and 2014 time period. And it has done that before, even prior to us being a public company.
We have been serving this market for nearly 30 years now. So we see cycles. And it feels to us like we're in the early stages of another investment cycle here. Some of that is being spurred by 5G investment. Some of it is simply the need to continue to protect these networks. As more and more critical communications go across wireless networks, making sure those networks are backed up and making sure they're protected is beyond just the simple annoyance of not being able to make a phone call.
I mean, there's a lot of critical data and voice that's going across these networks and I think the network operators themselves would tell you that aside from that, it's the lost revenue opportunity of being down with an outage. Outages are a fact of life. I was amazed. I was watching a baseball game the other night and there was a half hour power outage at Dodger Stadium. And just clear blue sky and power goes out. And these things happen. They take down the networks, the telecom networks, around them the same way they do the lights in a stadium. So, that provides for a very serious problem, obviously, for first responders and other people who really depend on those networks for just the critical nature of them.
What are your electrical contractor customers asking you to do in terms of product development? I mean, you guys have got this like massive market share of home standby generators. And you've been adding new features for years to make the product more value added and so forth, but there's got to be a lot of other things that you can sell through that channel. I mean, your acquisition strategy has been mostly focused on diversifying C&I, and it's paying off nicely, at least it looks like. But is there an opportunity for you guys to make acquisitions in residential and ancillary products where you can leverage that very unique distribution channel you have with all these small contractors?
Yeah, it's a great question and one that we've debated internally here. I think, obviously, one of the strengths of our residential business is that network. And we've invested heavily in that network, in terms of training them on the home standby category, how to sell it, how to install it, how to service it, how to monetize it in preventative maintenance contracts and things down the line. And we've talked a lot about are there other product categories that we could put into that channel that could become an acquisition target.
And frankly, what we struggled with in that kind of thought process is diluting their focus on the opportunity that is residential standby. It's such a small penetration rate today, and there's so much opportunity we believe to continue to grow that. It's almost like we don't want to introduce something that could dilute their focus. A lot of our dealers, a lot of our contractors are small, one and two-man teams. And so their bandwidth, their capacity to add other things is somewhat limited, actually. I mean, right now, in particular, they're very busy with new housing construction being on the rebound. There's a lot of remodeling going on. There's no shortage of potential projects for them to work on. And, in fact, it's the inverse. There's actually a labor shortage. There's less people going into the contractor trades today. So I think we're being very sensitive and very careful about not diluting their focus by introducing a number of other products.
Now, if we came across something that had margin profiles similar to where we're at today with home standby and something that we felt just was a can't miss kind of thing, obviously, we'd look at it, but nothing to this point has crossed our radar that would shake us from the path that we're on there.
Got it. Okay. Thanks very much, guys.
You bet, Ross.
Thanks, Ross.
Thank you. We have no further questions at this time. I would now like to turn the call back over to Aaron Jagdfeld for closing remarks.
We want to thank everyone for joining us this morning. We look forward to reporting our third quarter 2018 earnings results, which we anticipate will be sometime in early November. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone, have a great day.