U.S. Markets closed

Edited Transcript of GNRC earnings conference call or presentation 31-Oct-19 1:00pm GMT

Q3 2019 Generac Holdings Inc Earnings Call

WAUKESHA Nov 5, 2019 (Thomson StreetEvents) -- Edited Transcript of Generac Holdings Inc earnings conference call or presentation Thursday, October 31, 2019 at 1:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Aaron P. Jagdfeld

Generac Holdings Inc. - President, CEO & Executive Chairman

* York A. Ragen

Generac Holdings Inc. - CFO & CAO

================================================================================

Conference Call Participants

================================================================================

* Chip Moore

Canaccord Genuity Corp., Research Division - Senior Associate

* Christopher D. Glynn

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

* Jeffrey David Hammond

KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst

* Jerry David Revich

Goldman Sachs Group Inc., Research Division - VP

* Joseph Aiken

William Blair & Company L.L.C., Research Division - Associate

* Philip Shen

Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst

* Ross Paul Gilardi

BofA Merrill Lynch, Research Division - Director

* Thomas Lloyd Hayes

Northcoast Research Partners, LLC - MD & Senior Research Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Ladies and gentlemen thank you for standing by, and welcome to the Third Quarter 2019 Generac Holdings Inc. Earnings Call. (Operator Instructions)

I would now like to hand the call over to Mr. York Ragen, Chief Financial Officer. Sir, the floor is yours.

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [2]

--------------------------------------------------------------------------------

Good morning, and welcome to our third quarter 2019 earnings call. I would like to thank everyone for joining us this morning. With me today is Aaron Jagdfeld, President and Chief Executive Officer.

We'll 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 and involve risks and uncertainties that could cause actual results to differ materially from those in these forward-looking statements. Please see our earnings release or 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 back over to Aaron.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [3]

--------------------------------------------------------------------------------

Thanks, York. Good morning, everyone, thank you for joining us today. Our third quarter results represent a continuation of the strong start we experienced this year in the first half and are the best quarterly numbers, we've ever had as a company.

Strong domestic sales growth of 9.2% was driven by our residential and industrial stationary power generation markets again during the quarter, with overall net sales increasing approximately 7% compared to the prior year. EBITDA margins remain strong at 21% as we have been largely successful mitigating the impact of regulatory tariffs.

Increases in power outage activity over the last several years together with the threat of potential outages in California drove continued penetration gains in home standby generators during the quarter.

Shipments of stationary C&I products were also significantly higher year-over-year as demand for natural gas generators and telecom-related backup power more than offset softer shipments of mobile products as a number of larger rental customers continue to defer certain fleet purchases.

Once again, demand for home standby generators remained very strong during the quarter. Activations and in-home consultations were again robust with proposal close rates, which have been trending higher for the last several years, at all-time highs as we continue to refine our sales and marketing processes.

Additionally, we added approximately 200 new dealers during the quarter as we stayed intensely focused on developing this important channel to increase the sales, installation and service bandwidth needed to further expand penetration rates for the category.

Over the last 2 decades, we've invested heavily to create the home standby generator market as our efforts to develop distribution, create targeted marketing and deploy in-home selling processes have dramatically increased the overall awareness and growth of the category.

We estimate the market today is more than $1 billion annually. And with penetration rates of single-family unattached homes in the U.S. only at 4.5%, there remains plenty of room for this market to grow. Recall that every 1% of penetration represents $2 billion of additional market opportunity at retail prices.

Power outages have steadily increased in frequency and duration over the last 25 years, primarily due to underinvestment in the electrical grid, which has left it more vulnerable to the increasingly unpredictable and more severe weather patterns that are being driven by a changing climate.

In addition to the direct impacts from severe weather that cause power outages, the indirect effects of an increase in the conditions that cause wildfires is creating a much higher level of interest in backup power as utility companies have announced their intention to shut down huge portions of their service areas to prevent their equipment for potentially causing a catastrophic fire.

In California, where presentation rates of home standby generators stand at less than 1%, we have seen a dramatic increase in the number of in-home consultations and other leading indicators that continue to point to the rapid expansion of this market. Over the last 3 weeks, local utilities have triggered numerous shutoffs impacting millions of customers as they seek to mitigate the risk of wildfires. These shutoffs have been multi-day events and are projected to continue in the years ahead as the impact of climate change and the massive underinvestment in Northern California's power grid have combined to create a situation where public safety takes precedence over power quality. As a result, we're working to drive awareness of home standby generators in this part of the country through television and digital advertising to promote the category.

As we've previously noted, we've relatively underdeveloped distribution in this region, which could limit our ability to satisfy the increase in demand in the near term as we work to qualify, train and onboard new channel partners across the State. As is the case with most major power outage events, expanding distribution and working together with local regulators, inspectors and gas utilities to increase their bandwidth and sense of urgency around improving and providing the infrastructure necessary for this product category are critical for future growth.

This is typical of markets that are developing. And to quicken the pace, we have an incredible team of people working in the region to assist the residents of California as they look for solutions to deal with future extended outages. Based on the scale of the power shutoffs experienced to date, we estimate the impact of these events could add more than $50 million of sales in the current year off a relatively small base, which is roughly double our original projection.

As we continue to develop awareness and distribution in the region and if public safety shutoffs remain a concern for Californians, we believe the total market for backup power in the State could potentially be as high as $200 million annually in the years ahead.

Our efforts in this part of the country will also be helpful in developing the market for energy monitoring, management and storage. Recall that earlier this year, we entered this nascent but fast-growing market with our acquisition of Pika Energy and Neurio Technologies. We believe energy landscape will undergo significant changes in the decade ahead as a result of rising utility rates, grid stability issues, environmental concerns and the continuing performance and cost improvements in renewable energy and batteries.

On-site power generation from solar, wind, geothermal and natural gas generators will become more prevalent as will the need to manage, monitor and store this power, potentially developing into a multibillion-dollar market opportunity annually. The combination of Pika's power electronics, battery management software, and proprietary invertor technologies alongside Neurio's hardware and software for energy monitoring and management will allow us to bring an intelligent and efficient energy saving solution to this exciting new market and should solidify Generac's position as a key participant.

Although very different from the extended emergency backup power space we serve today, we believe the energy storage market will develop similarly as the home standby market did over the past 2 decades.

Our efforts to develop omnichannel distribution, targeted consumer-based marketing content and proprietary in-home sales tools have played a critical role in creating the market for home standby generators, and we believe they will be equally important as we work to grow the energy management and energy storage markets. We recently announced the minority investment in Softdesk, a Canadian software company focused on developing sales acceleration tools for the solar industry. The company's flagship product, Solargraf, is an all-in-one software tool used by solar installers for lead management, array design and proposal creation as well as permitting an overall project management. We intend to fully integrate these capabilities with elements of our proprietary PowerPlay sales system to create PowerPlay CE, the industry's first complete solar-plus-storage sales and lead management tool for installers and dealers.

In September, we launched PowerPlay CE as well as our new Generac-branded intelligent storage system called PWRcell at the Solar Power International show in Salt Lake City.

Our entry into this market has been incredibly well received to date and we believe our clean energy efforts could materialize much more quickly than we had originally anticipated. As a result, we are aggressively working to expand our supply chain capacity with the intent to ship well in excess of 100 megawatt hours of storage as early as next year, more than doubling our initial second year projection for this business.

In addition to our efforts to expand the residential side of our business during the quarter, our commercial and industrial generator business also grew again with another strong quarter driven by a number of important secular themes which continue to develop.

Shipments of generators to telecom customers were higher again in the third quarter as wireless carriers further built out and hardened their existing networks as they prepare for the impending deployment of 5G technology. The need for a continuous supply of power to wireless sites will become even more crucial as faster speeds and increased bandwidth will enable a number of impactful mission-critical technologies in the future.

Generac is a key supplier of backup power systems to every single Tier 1 carrier in the U.S. and is also the largest provider of backup power for the telecom market in Latin America.

Combined with our efforts at Pramac in Europe, we believe we can become a leader globally in telecom backup power, similar to the leading position we've built in the Americas, as this key vertical begins another extended investment cycle in the years ahead.

We have also worked hard over the years to promote the benefits of natural gas power generation as an alternative for diesel-powered systems that have traditionally been used in emergency backup applications. Increased regulation around diesel emissions have driven prices higher for diesel generators and when combined with the inherent refueling drawback of these systems and additional environmental concerns, an opportunity has developed for natural gas fuel generators as a cleaner and better alternative. We believe that natural gas has many superior characteristics when used to generate power. With its abundant supply, low price, logistical advantages and environmental benefits, which have driven growth rates for gas generators that are twice that of diesel sets in the emergency backup power market over the last 25 years.

We also see a developing opportunity for natural gas generators to be used in certain grid support applications beyond traditional standby power, such as demand response programs, which are used to help utilities better balance the supply of power with demand. A gas generator used in a limited fashion for emergency backup could be deployed and managed by the end user, the local utility or a third-party aggregator as a decentralized power generation asset. Production of power on site for local consumption or for export to the grid is not a new concept, but the economics of using natural gas in a reciprocating engine-driven genset for this purpose have become more attractive in recent years as utility rates rise and natural gas prices remain low. In response, we're focused on expanding and tailoring our gas generator product offering for these types of projects, and we're adding sales, engineering and project management resources to effectively develop and participate in these new applications globally.

Although, we continue to see solid domestic demand for stationary C&I products, shipments for mobile products were lower again during the third quarter, mainly due to the continuing reduction of capital spending by certain national rental account customers. Partially offsetting the lower shipments to these customers in the quarter were increased equipment purchases from independent and specialty rental businesses. In our view, the longer-term need for increased levels of spending on infrastructure projects in the U.S. is an important theme that remains intact. And we believe this will translate into greater demand for mobile products in the years ahead.

Internationally, our business is roughly flat year-over-year as demand has softened in certain regions as a result of geopolitical risks, trade conflicts and other economic uncertainties. Adjusted EBITDA margins for the international segment were lower year-over-year in the quarter as unfavorable product mix, increased competitive pressures due to a slowing market and higher operating expenses negatively impacted margins for the segment.

Although we are experiencing a challenging environment for our international business, we believe that longer-term, our global presence will be important as interest in home standby and gas use generators for commercial and industrial applications continues to gain traction in many new markets around the world. In addition, we believe our international footprint will provide an important avenue for growth as we enter the clean energy space on a global basis.

Overall, we have a path to improve profitability and we remain committed to our long-term targets of low double-digit EBITDA margins for this segment.

I'd now like to turn the call over to York to provide further details on our third quarter results. York?

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [4]

--------------------------------------------------------------------------------

Thanks, Aaron. Before discussing third quarter results in more detail, recall that effective January 1, 2018, Generac adopted the new GAAP revenue recognition standard. Upon finalizing our accounting under the new standard at the end of 2018, we made certain immaterial prior quarter reclassifications to our 2018 consolidated statements of comprehensive income related to extended warranties. Therefore, the prior period in our earnings release has been updated accordingly. See our press release for more information related to these reclassifications.

Now looking at our third quarter 2019 results in more detail. Net sales for the quarter increased 6.9% to $601.1 million as compared to $562.4 million in the third quarter of 2018. Excluding the $4.8 million of contribution from the Captiva, Neurio and Pika acquisitions and the almost $4 million negative impact from foreign currency, core growth rate during the quarter was approximately -- was still approximately 7%.

Looking at our consolidated net sales by product class. Residential product sales during the third quarter increased 7.4% to $335 million as compared to $311.9 million in the prior year quarter, with core growth being approximately 7% when excluding the M&A contributions from Neurio and Pika and the slightly unfavorable impact from foreign currency.

As Aaron mentioned, home standby generators sales experienced significant year-over-year growth as we continue to drive penetration of the product category. With power outages on the rise and interest in home standby generators at an all-time high, we have ramped up our efforts to increase awareness, distribution and close rates for these products with particular focus in California.

In addition, shipments of portable generators were similar to prior year, aided by the impact of Hurricane Dorian, which made a brief U.S. landfall in early September of this year. Recall that the prior year period included the impact of Hurricane Florence, which also resulted in significant portable generator shipments into the impacted region.

Looking at our commercial industrial products. Net sales for the third quarter of 2019 increased 4.1% to $214.9 million as compared to $206.4 million in the prior year quarter, with core growth being approximately 5%, when excluding the M&A contribution from Captiva and the unfavorable impact from foreign currency.

Domestically, we continue to see strong growth from our telecom customers as they invested in backup power for their cell towers to improve the reliability of their networks. In addition, shipments to our domestic industrial distributors also remain very strong as we continue to drive share gains across our product portfolio. Partially offsetting this growth, shipments of C&I mobile products declined year-over-year as our national rental account customers continue to defer CapEx spending during the current year quarter.

Internationally, our C&I products were approximately flat with prior year on a core basis. We've executed on a number of sales initiatives to drive penetration of our products across the globe. However, these strategic growth initiatives were largely offset by certain geopolitical headwinds resulting in economic softness in various regions around the world during the current year quarter.

Net sales for the other products category, primarily made up of service parts and extended warranty sales, increased 16.1% to $51.2 million as compared to $44.1 million in the third quarter of 2018. A larger installed base of our products and higher levels of extended warranty revenue drove this increase versus prior year.

Gross profit margin was 36.2% compared to 35.6% in the prior year third quarter. We have successfully grown our gross margins as we more than offset higher regulatory tariffs with pricing actions, favorable sales mix and lower realized commodity and currency input costs.

Operating expenses increased $18.1 million or 19.3% as compared to the third quarter of 2018. As a percentage of net sales, operating expenses, excluding intangible amortization, increased approximately 170 basis points versus the prior year as we continue to focus on future growth opportunities for the company. Specifically, we continue to invest in additional employee resources to drive strategic growth around connectivity and lead gas opportunities globally. We're investing in marketing content, campaigns and promotions to drive awareness of the home standby generator product category with an added focus in the California market. Additionally, the incremental operating expenses from the recent acquisitions of Neurio and Pika have given us the R&D capabilities to enter the energy storage and energy management markets in a meaningful way. We believe these investments will be important drivers of future growth.

Adjusted EBITDA, before deducting for noncontrolling interests and as defined in our earnings release was $126 million in the third quarter of 2019 as compared to $124.5 million in the same period last year. The corresponding adjusted EBITDA margin was 21% in the quarter as compared to 22.1% in the prior year. This margin decline was primarily driven by the increased operating expense investment previously discussed. Over the last 12 months, adjusted EBITDA was $451 million.

I will now briefly discuss financial results for our 2 reporting segments.

Domestic segment sales increased 9.2% to $498.2 million as compared to $456.1 million in the prior year quarter, which includes $3.1 million of contribution from recent acquisitions. As previously discussed, this year-over-year increase reflects strong end market conditions for home standby and C&I stationary generators. Portable generator shipments were approximately flat despite a tough prior year comparison. The Domestic segment growth was partially offset by lower shipments of C&I mobile products.

Adjusted EBITDA for the segment during the quarter was $121.2 million or 24.3% of net sales as compared to $117.1 million in the prior year or 25.7% of net sales.

International segment sales decreased 3.1% to $103 million as compared to $106.3 million in the prior year quarter. Core sales were approximately flat versus prior year when you exclude the unfavorable impact of foreign currency and the impact of the Captiva India acquisition. As previously mentioned, market share gains were fully offset by geopolitical headwinds, which caused economic softness in certain regions of the world.

Adjusted EBITDA for the segment during the quarter before deducting for noncontrolling interest was $4.7 million or 4.6% of net sales as compared to $7.4 million or 6.9% of net sales in the prior year. Unfavorable sales mix and incremental operating expense investment contributed to this margin percent decline.

Now switching back to our financial performance for the third quarter of 2019 on a consolidated basis.

GAAP net income attributable to the company in the quarter was $75.6 million as compared to $75.8 million in the third quarter of 2018. The incremental earnings from our top line sales growth was mostly offset by the additional OpEx investment previously discussed.

GAAP income taxes during the current year quarter were $20.1 million for an effective tax rate of 21.1%. This compares to GAAP income taxes in Q3 2018 of $20.1 million for an effective tax rate of 20.8%. The relatively consistent effective tax rate versus prior year reflected the lower federal statutory tax rate related to U.S. tax reform and both years also included certain discrete tax deductions as a result of tax planning to help lower our overall tax obligations.

Diluted net income per share for the company on a GAAP basis was at $1.18 in the third quarter of 2019 compared to $1.11 in the prior year. The specific calculations for these earnings per share amounts are included in the reconciliation schedules of our earnings release. The current year quarter earnings per share calculation of $1.18 includes the impact of $1.5 million adjustment to increase the value of the redeemable noncontrolling interest for the Pramac acquisition, resulting in $0.02 reduction in GAAP earnings per share. The prior year quarter earnings per share calculation of $1.11 includes the similar adjustment of $6.9 million, resulting in $0.11 reduction in GAAP earnings per share.

Adjusted net income for the company, as defined in our earnings release, was $90 million in the current year quarter or $1.43 per share versus $89.1 million in the prior year or $1.43 per share.

With regards to cash income taxes, the third quarter of 2019 includes the impact of a cash income tax expense of $15.1 million as compared to $15.2 million in the prior year quarter. The current year reflects an expected cash income tax rate of 17% for the full year 2019, while the prior year third quarter was based on an expected cash tax rate of 15% for the full year 2018. This increase in cash tax rate is due to a higher level of expected pretax earnings in fiscal 2019 versus fiscal 2018.

Recall that every dollar of pretax earnings over and beyond our $30 million tax shield is now taxed at the expected GAAP tax rate of approximately 25%.

Cash flow from operations was $111.2 million as compared to $59.3 million in the prior year third quarter, and free cash flow, as defined in our earnings release, was $100.8 million as compared to $47 million in the same quarter last year.

As we discussed last quarter, we expected to monetize a significant portion of our primary working capital in the second half of 2019, in line with normal seasonality. To that end, primary working capital was a $28 million higher source of cash flow in the current year third quarter versus prior year. In addition, the prior year included a $9 million pension contribution and $7 million of additional interest as we changed the timing of our term loan interest payments, both of which did not repeat in the current year.

Taking a look at our balance sheet, on January 1, 2019, we adopted the new GAAP lease accounting standard. This new standard requires that we recognize right-of-use assets and lease liabilities related to operating leases on our balance sheet. As a result, we recognized approximately $40 million of additional other assets and other long-term liabilities on our balance sheet in Q1 to adopt the new standard.

As of September 30, 2019, we had a total of $954 million of outstanding debt, net of unamortized original issue discount and deferred financing cost. Our gross debt leverage ratio at the end of the third quarter was 2.1x on an as-reported basis. Additionally, at the end of the third quarter, we had $216 million of cash on hand, and there was approximately $271 million available on our ABL revolving credit facility. Both our term loan and ABL facilities mature in the year 2023.

With that, I'd now like to turn the call back over to Aaron to provide comments on our updated outlook for 2019.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [5]

--------------------------------------------------------------------------------

Thanks, York. As we've discussed end market conditions for our residential products remain strong and better than expected as a result of recently elevated power outage activity. Conversely, our C&I mobile products in the international businesses have softened in recent months, partially offsetting the gains we're seeing with our residential products. However, based on the strength of our residential products, we're raising our guidance for revenue growth for full year 2019, as we now expect overall net sales to improve approximately 8% to 9% versus prior year, which compares to the previous guidance of 6% to 7% growth.

On a core basis, full year 2019 net sales growth is now expected to be approximately 7%, which compares to the previous guidance of 4% to 5%. These growth rates assume normal baseline power outage activity for the remainder of the year. As a result of a more favorable sales mix and improved operating leverage compared to previous guidance, we're also raising our margin expectations for the full year 2019.

Net income margins before deducting for noncontrolling interests are now expected to be approximately 11.5% versus the 11% previous guidance. The corresponding adjusted EBITDA margins are now expected to be approximately 20.5% for the year as compared to the previous guidance of 20%.

Operating and free cash flow generation for the full year 2019 is expected to remain strong with the conversion of adjusted net income to free cash flow anticipated to be approximately 80% as we work to further monetize our working capital in the fourth quarter. The remaining guidance items provided in previous earnings calls are not expected to change.

This concludes our prepared remarks. At this time, we'd like to open up the call for questions. Operator?

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) Our first question comes from the line of Tom Hayes of Northcoast Research.

--------------------------------------------------------------------------------

Thomas Lloyd Hayes, Northcoast Research Partners, LLC - MD & Senior Research Analyst [2]

--------------------------------------------------------------------------------

I was just wondering, as you build out your California network with a growth in activity out there, are you guys currently able to, kind of, keep up with the demand for the in-home consultations and maybe are you kind of facing any backlog in that right now?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [3]

--------------------------------------------------------------------------------

So it's a great question, Tom. Obviously, things are incredibly busy out in California. IHC numbers are kind of off the charts now, off of a fairly small base from last year, but up 500%, 600% over the prior year. So we're seeing -- and that's a tremendous leading indicator for us and we look at that and we look at our close rates and that translates really well to strong demand in the -- over the next several quarters. This is not going to be 1 quarter event, this is going to be a -- we think, a long-tail event similar to other kind of major events that we would see. Generally, you see a tail that is, in some cases, multiyear as opposed to even multi-quarter. So that's kind of how the things are shaping up.

To answer the question though on whether we're able to keep up, the actual answer is, no. We are inundated right now. We're adding distribution. We're actually doing some pretty unique things around sharing those leads with other channel partners outside of our traditional dealer channel, simply because our dealer counts, which are growing in the State, we're now about 300 dealers in the State of California. We started the year at about 100. So we've added a fair number of dealers in California in a very short period of time. But yet, just on boarding those dealers and developing them, it takes time. So we've had to take those leads, and we're doing other things with those leads. So that -- obviously, we don't want people have to wait to talk to somebody about these products. So there is a backlog. In some cases, depending on which region you are in, which zip code actually, it's down to the zip code level that are you in, it could be a backlog of a couple of weeks. We hope it doesn't get longer than that. We know that we need to stay focused on turning around IHCs very quickly and maintaining the quality of those IHCs as well, that's also incredibly important. So that goes hand-in-hand with our success rate in closing those deals. So it's a challenge right now, but it's not unlike what we see in other parts of the U.S. when we get outages, California is particularly -- things are particularly acute because we're relatively underdeveloped there.

--------------------------------------------------------------------------------

Thomas Lloyd Hayes, Northcoast Research Partners, LLC - MD & Senior Research Analyst [4]

--------------------------------------------------------------------------------

I appreciate the color. Maybe if I can just ask one more related to California. I think you called out you expect about $50 million in contribution in this year and maybe growing to almost $200 million in the near future. I was just wondering, is that primarily the residential applications? Because I know if you're looking at the news and everything, you're also seeing that light commercial grocery stores, many marks out, maybe talk about kind of how you are -- are you focusing on that commercial application opportunity as well?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [5]

--------------------------------------------------------------------------------

We are, Tom. The $200 million would be representative of both residential and commercial backup power. It does not include the clean energy opportunities that we've spoken to. So I think that's important is that -- and that will largely be a California story as well. So California as a State for us, in totality in the next few years, we anticipate it's going to be a really important market for us.

But back to your question, the $200 million -- obviously, the penetration rates for backup power are relatively low, both on the residential side and C&I side in the State. But the larger opportunity is still going to be residential for us. We just -- we feel that, that's -- C&I will be very interesting as well. But I think a good chunk of that $200 million, we anticipate, is going to come through the residential channel, which, obviously, from a margin perspective, is going to be mix positive.

On the C&I side, I think, we may actually see next year, this is kind of my premonition based on our experience and seeing this in the past, I think the telecom companies are going to be evaluating their networks in California in a much deeper way. I think they're going to provide a lot of scrutiny on just how much backup power they have. We know that, again, penetration rates even in California for telecom gensets are less than 30%. So that means that 2/3 -- more than 2/3 of all the sites, these wireless sites in California, do not have long-range backup power. And so that's a problem. And if this is going to be the kind of situation in terms of the shut off, it's going to extend years as people have said it will. It's going to be absolutely critical that those wireless networks are backed up. You can imagine just the combination of having the power out and then the threat of these fires to be completely cut off from a communication standpoint is really an untenable position to be in. And so I think the communication companies, the telecommunication companies, are going to focus very heavily on that. And that could -- being the #1 provider to those markets, that could be an upside potential for us next year. We're going to put together our guidance for 2020, and we'll bring that out with more clarity here in the quarter ahead. But my premonition would be that there's some decent potential, at least around that vertical within the State of California.

--------------------------------------------------------------------------------

Operator [6]

--------------------------------------------------------------------------------

Next question comes from the line of Ross Gilardi of Bank of America.

--------------------------------------------------------------------------------

Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [7]

--------------------------------------------------------------------------------

Yes. I just wanted to make sure I understood your guidance because you're sticking with this base case scenario of no material outages, but you've just had 4 fairly material outages in California. So are you -- I don't know if you would characterize them all as major, so are you including the revenue benefit from what's happened in the last 2 weeks in the outlook or no?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [8]

--------------------------------------------------------------------------------

So here's -- I think the way to think about unpacking this, Ross, there's a couple of moving pieces here. One is, on the residential side, portable generators. We had a really solid quarter in Q3. And actually, port gens were flat in Q3, and we thought we were going to have a really tough comp. But with Dorian that kind of skirted up the coast, the Eastern seaboard, we were able to ship a lot of product. That was a -- we had a lot of visibility of that storm coming and everybody thought it was going to -- Florida was going to take a direct hit. So we put a lot of product into the State of Florida and kind of in the Carolinas, that never materialized. So the sell-through was poor. And so what we've got is we've got an inventory -- field inventory kind of situation that has to be worked through. We think that will happen in the fourth quarter, but it's going to probably manifest in lower portable generator shipments in Q4. So kind of, think of Q4 as there was some pull ahead into Q3 on port gens.

Then you've got our industrial businesses and our international businesses. Specifically, in the industrial businesses, the mobile component of that continues to slow down. That's been disappointing for us. It's beyond our expectations, actually, it slowed down. You've heard many of the large national rental accounts come out and say just they're cutting back on CapEx spending. We see it kind of as a momentary pause in their buying cycles, but it's a pause, nonetheless. And it's probably a deeper pause than we had originally projected. So there's that component. And then internationally, we just continue to see things like Brexit, some of the things that are going on in Latin America. I mean you can look at just about every country in Latin America right now and there's some kind of geopolitical issue going on. You've got the trade -- tariff trade war type of stuff also impacting and creating uncertainty around the world. And so our international businesses have been feeling that.

On the flip side of that, you have home standby. And now there is some port gens that will go out to California. But one of the limitations with port gens in California is that they have to be CARB certified. So that puts a bit of a cap on what we can ship into the State. California, historically, hasn't been a big market for backup power. So at the beginning of this year, when we make our portable gen kind of pre-buys for the year and our production forecast, those were lighter for our CARB certified portable gens. So we're actually in communication with CARB and with EPA on whether or not we can get a waiver to supply additional portable generators that are non-CARB certified into California because we've got a lot of those products, and we could help a lot of people in California if we could get a waiver approved, a temporary waiver. We haven't heard back on that yet. We're negotiating that. If that happens, there could be some potential upside to that.

And then on home standby, that, as I said, that's just going to take time to develop. I think we had originally sized the prize in California, it's probably $25 million of upside if shutoffs happen. We're doubling that to $50 million. Most of that's going to happen in the fourth quarter. So I think we've appropriately sized this and we're including it in our guidance. There are some potential upside there and there's some offsetting pieces with international and industrial. I think that's kind of the way to think about the guide.

--------------------------------------------------------------------------------

Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [9]

--------------------------------------------------------------------------------

Okay. So it sounds like the home standby business, since you had 2 scenarios last quarter, it sounds like the home standby business went to the upper end if not above the high end of the previous assumption, but it is offset by the mobile products business, international and the field inventory situation in portable. Is that a fair way to think about it?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [10]

--------------------------------------------------------------------------------

Yes, that's exactly it, Ross.

--------------------------------------------------------------------------------

Ross Paul Gilardi, BofA Merrill Lynch, Research Division - Director [11]

--------------------------------------------------------------------------------

Okay. And then could you comment on your solar storage products coming in double your initial projections. In your 3-year outlook, you had suggested that these products would add 200 basis points annually to growth for the next 3 years. I mean I know that was a little bit back-end loaded. But based on that comment, can we assume that you at least do actually get the 200 basis points next year? Or are you actually saying that you're going to add 400 basis points of growth next year from Pika and Neurio, et cetera?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [12]

--------------------------------------------------------------------------------

No. I think what we're saying is we get to that long-term kind of target quicker, and which means we'll get more of that next year. I don't -- I wouldn't double the 200 to 400. But that 150 to 200 basis point improvement, that could happen quicker. I mean I went to the SPI show in Salt Lake City. And I'll be -- for perfect honesty here on the record, I'm not a fan of trade shows. I just never have been. But this was -- this -- it was an amazing reception to our entry into this market. I think it caught us -- I don't want to say it caught us by surprise, but we were genuinely pleased with the receptivity to our entrance here. And this is not going to be a demand-side problem. That much, I think, we -- most times, when you enter a new market, I think going after demand is always kind of one of your concerns, your chief concerns. My chief concern here is supply chain constraints. It's going to be around battery. It's going to be around power electronic components. It's going to be around our ability to produce. We're going to have to onboard distribution, of course, to do installations. We have a lot of work to do to make this happen. But we're basically taking -- as we think about the acquisition targets, when we put those together, we put a model together for what we thought the acquisitions could do for us in year 1, year 2, year 3 and out, we're basically essentially doubling what we had on the page for year 2. More than doubling, to be honest. I think -- and I -- if we could -- probably, if we could get more capacity, if somehow we can come through on that, maybe there's even further upside. I think we're limiting that because we're just -- the capacity thing is kind of a wildcard here, right? I think we fairly sized it with what our comments represent today, but this is going to be a supply-side constraint, more than it will be a demand-side constraint, at least in the early innings here.

--------------------------------------------------------------------------------

Operator [13]

--------------------------------------------------------------------------------

All right. Next question comes from the line of Jerry Revich of Goldman Sachs.

--------------------------------------------------------------------------------

Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [14]

--------------------------------------------------------------------------------

I'm wondering if you could talk about how your in-home consultations have been tracking outside of California. And it looks like your dealer count grew by 100 outside of California as well in the quarter, if I triangulate the numbers right? Are you seeing that dynamic that you've seen during prior major power outage events where you get a nationwide halo, is that playing out?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [15]

--------------------------------------------------------------------------------

It is to a degree. I mean I would say this, Jerry, whether I say it's a halo because of what's going on in California or I think it's more -- we keep looking at this. This home standby category is -- it's amazing. I have to tell you, the resiliency of this category, the potential upside here in terms of just overall penetration opportunity, IHCs have been very strong this year. They were strong. Obviously, the Dorian situation drove a lot of interest in the category for a period of time. That didn't materialize in terms of outages, but it did materialize for us in terms of home standby interest. It got people thinking about outages again. Certainly, the California outages from a national perspective -- I think California is a little unique when it comes to national coverage. I don't know why that is. I think it just is a little bit like that. What happens in California is a little bit more bubble than it is maybe in other -- than things that happen in other regions. I can't explain that, but it just is. So maybe there's a little bit of tempering of that in terms of a halo effect. But I would say overall, IHCs have been just amazingly strong this year. And the home standby business is just -- it's a great, great business. And there's so much runway left in that, that every time I look at that business, I mean, for us, and I think it's really important to point this out, we're at the point now with that product line in terms of capacity, production, we're looking at alternate sites where we can build that product and building out other supply chains. It's become so big that we need to expand our kind of thinking around how big it can be in totality. I think the home standby generator category is something that is going to become the kind of part of your home's infrastructure like central HVAC has become. I think it's going to -- especially as homes become more connected. One of the things, it's a really interesting observation out in California in particular, is as people buy home standby generators, we're seeing a much higher connectivity rate with our Mobile Link. So this is our monitoring system, our Wi-Fi enabled monitoring system. We're seeing a 4 to 5x number of connectivities in terms of percentage of connected generators over the kind of national average, which tells me just California is always ahead of the curve on kind of IoT and connected homes and things like that. But I think it's just a sign of where things are going to go. And we're just -- we're really bullish on home standby.

--------------------------------------------------------------------------------

Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [16]

--------------------------------------------------------------------------------

And the last time you folks were supply-constrained in home standby, there was a material carryover effect into the seasonally weak first quarter. Is that playing out now? I'm just trying to put that into context with your comments about inventories coming down, that was probably a portables comment, but can you just comment on those 2 items, please?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [17]

--------------------------------------------------------------------------------

Yes, Jerry. So right now, our home standby production levels are relatively high. They can go higher. In fact, we've made some provisions here to take them higher here throughout the fourth quarter. And we're going to keep them higher going into the first quarter. A couple of reasons for that. One, obviously, we're watching very closely how quickly home standby demand can develop. Again, it's -- a home standby generator project is a home improvement project. It just takes time. I can't underestimate under -- kind of put those in words just how long it does take to do a project. It's just -- it's months in the making. You have to -- you start out, you find a dealer. You go through the process of getting a proposal. You have to make arrangements from a project standpoint for other subcontractors of gas and electric. And there's landscaping involved. There's permitting involved. It's a process. And like any home improvement process, it generally always takes longer than you think it should. So that will develop over time. And so one of the unique things about California, and we see this when we get hurricanes down south and things like that is, you can install generators year-round in California. This is something you can't do out in the Northeast or in the Midwest. So typically, we get seasonal slowdowns in Q1 because of the slowdown in installation of home standbys in the Northeast and Midwest. We think because the California is a new element here, installations should remain fairly robust through the first quarter. So that's a cool, new dynamic for us. And I think it should have a positive impact, and we want to maintain really high levels or decent levels of flow in terms of production on home standby because if this does develop more quickly, Q1 could potentially represent a decent quarter because of that install type of capacity that can happen. We're not making a call on that. Now we're not talking about Q1 guidance. But at the same time, those are the realities of things that we've seen in the past and how we think this might develop.

--------------------------------------------------------------------------------

Jerry David Revich, Goldman Sachs Group Inc., Research Division - VP [18]

--------------------------------------------------------------------------------

Okay. And then given those moving pieces, it does sound like you're embedding a significant production cut in C&I in the fourth quarter. Can you just expand on your production outlook by line of business within C&I, please?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [19]

--------------------------------------------------------------------------------

Yes. So I mean -- actually, on the C&I stationary side, what's interesting is, we've been in a deeper backlog there than we normally get into. Our lead times have been extended, demand has been high, particularly around telecom, and in the back half here of the year, what we hit is, we kind of hit a telecom air pocket in terms of installs. You've got some unique things going on out there in the marketplace with a couple of our Tier 1 wireless carriers, both T-Mobile with the Sprint acquisition, and then you've got AT&T doing some things around capital optimization and some things there that have been in the news recently. And that slowed down some of the CapEx spending on networks here in the back half of the year. Again, we think that's kind of a momentary pause. Some of it is T-Mobile just absorbing quite a bit of purchasing earlier in the year. But that -- where we're slowing production, if we're slowing it at all, is in those areas. But frankly, our C&I factories are very busy and will remain so. They were just incredibly busy for the first half of the year. Now they're just going to be somewhat busy in the back half of the year. I would say mobile products is a little bit different, that continues to slow down. And I would say our factories that produce mobile products we're probably going to see those kind of slowdown, especially as we exit the lighting tower season, which is kind of Q3 and into early Q4. We generally see lighting tower business is somewhat seasonal that way. And so as that slows down, we'll probably see our mobile products factories slow a bit.

--------------------------------------------------------------------------------

Operator [20]

--------------------------------------------------------------------------------

Next question comes from the line of Christopher Glynn of Oppenheimer.

--------------------------------------------------------------------------------

Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [21]

--------------------------------------------------------------------------------

I got a couple of questions on the acquisition. So curious on the relative emphasis on the Pika ESS solution versus combined solution with the Neurio home energy management systems. And secondly, the view around the installed cost to the customer and where that is in the process? How that trends to more affordable over time?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [22]

--------------------------------------------------------------------------------

Yes. So just so I'm clear, Chris, your question -- your first part of your question on the combination of Pika and Neurio, you're curious as to how that's going or how it's progressing? Or -- was that your question?

--------------------------------------------------------------------------------

Christopher D. Glynn, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [23]

--------------------------------------------------------------------------------

--

Just where is the first couple of years of runway more pronounced on the combined BEMS, HEMS or more on the BEMS Pika standalone solution?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [24]

--------------------------------------------------------------------------------

Got it. Got it. So that's a good question. And there's some different views even internally here on that. But I'll give you -- since I'm the CEO, I can do this. I'll give you my view. And I think what's going to happen is the combined solution was really well received at SPI. This idea of an intelligent storage solution and really being the first one in the market that's going to have kind of end-to-end energy management, energy monitoring and storage in a single package by a single supplier. This is the other thing. Most of the packages on the market today, if they have any bit of intelligence to them, they're generally cobbled together pieces from other suppliers. We're going to provide the end-to-end solution here at Generac, all the way through. Now it's a combination, admittedly of the Pika technologies and of the Neurio technologies and actually some of the Generac technologies. But it will come together, be supported, and it will come in together under one brand of the Generac brand. That was really well received at the show.

Now I personally think the HEMS only solution, which we're actually going to start shipping in the fourth quarter, our HEMS-only solution bundled with our transfer switches for backup power for home standby. So in the future, starting here in the fourth quarter, roughly December time frame, you can buy a home standby generator that could have a transfer switch option, which includes the Neurio technology, which is pretty cool. Today, you can install it as a separate stand-alone device, but it will be embedded technology. We're actually looking at that as potentially being a standard feature down the line. We have to get the cost structure right to do that. But we really think that, that's a potential differentiator. We've got a lot of differentiation in that product line already. That's why we have 75% market share, but that could be an additional potential differentiator for us going forward. I like the HEMS-only solution, which is what I'm kind of referring to that as, but I do think that there's no denying that the just incredible receptivity we had to the combined intelligence storage solution.

And then on your question about install costs, we're very focused on this. And I think this is an area that where our experience with home standby generator is going to be very helpful. We've known for a long time that affordability is an incredibly important component of adoption rate, the speed of adoption, the penetration rate. And so a massive part of affordability -- of course, when you look at home standby, half of the cost of the home standby is the actual generator itself and the other half is installation. Now it's not quite to that degree with the storage solution, but it is -- installation is still a meaningful component.

What we really liked about the Pika solution, and this is one of the reasons why we chose Pika over others in terms of acquisition, is that they use an approach to installation, which was much more cost-effective than what others were doing. They can do a single installer, a single person can do an install of a Pika solution because the actual battery modules are modular. So there's no single component in the Pika solution that weighs more than 70 pounds. So you can actually effect that installation with a single individual, which dramatically lowers cost. If you look at some of the other solutions in the marketplace, you need 2 or even 3 people to lift these things or special gear to lift these things up and mount them on walls or other areas. So that's a part of the -- that was a part of the draw for us with Pika. But going forward, there are other things that we can do in the interconnections to the home's electrical system that we think we can improve even further the installation costs. It's going to be a major focus area. That's being said, there's obviously a massive focus. There's probably a bigger upside on the cost structure of the product itself, from the batteries, to the inverters, power electronics, all the other components and subcomponentry. We think is -- as we've said before, we have a great road map in front of us, and we're executing against that roadmap and we will, throughout 2020, to take cost out of that solution.

--------------------------------------------------------------------------------

Operator [25]

--------------------------------------------------------------------------------

Next question comes from the line of Joe Aiken of William Blair.

--------------------------------------------------------------------------------

Joseph Aiken, William Blair & Company L.L.C., Research Division - Associate [26]

--------------------------------------------------------------------------------

I'm on for Brian Drab today. I just want to circle back on California for a second. Has your outlook in terms of the longer-term revenue potential there, has that changed at all since the Analyst Day?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [27]

--------------------------------------------------------------------------------

So I would say this, what we laid out at the Analyst Day was home standby only, is what we kind of talked to. We talked to $100 million potential in home standby by, I think we said 2022 if memory serves me correct. I would say that at that point in time, when we put that together, I don't think we saw perhaps the shutoffs being as large in scale or as numerous in frequency as maybe they've turned out to be here.

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [28]

--------------------------------------------------------------------------------

They hadn't started yet.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [29]

--------------------------------------------------------------------------------

They hadn't started yet. So I don't think we had a frame of reference other than what we had. We knew that when there are red flag days, that would be the likely trigger, and we looked at historical red flag days, but we weren't sure that PG&E would do this. And I think also tempering our enthusiasm and maybe even still so, just how long will this go on? I mean the CEO of PG&E came out and said it could be as much as 10 years. A decade of darkness for the people in California. I mean that's -- that really kind of -- after we heard that, we really started to think about this maybe a little bit differently. And I can tell you internally, we have -- we really -- we're burning a lot of calories right now across the business. And it's interesting. It's not just in the residential side of the business, which is what we've been talking about, it's, as we mentioned on this call, the C&I opportunity with telecom. There's a mobile opportunity for mobile generators and lighting towers, right? When the lights go out, it's dark. So there's lighting tower opportunities. There's water pump opportunities. Sometimes utilities fail, water utilities fail when you don't have power. So there's -- our mobile business has some opportunities. We've got our chore business. Oddly enough, our chore business, they manufacture, one of their #1 product lines is brush cutting equipment. There's a lot of brush in California that needs to be cleared to be successful. So we're actually seeing an uptick in brush cutting equipment, in stump grinding equipment, some of the forestry management equipment that we manufacture for that business, which is really interesting. And then you've got the clean energy side of that. And I think that's probably the side. And again, I wish I could tell you we were this smart when we did our acquisitions earlier this year and we kind of looked at the battery -- the storage market and the energy management and monitoring markets to know that this was going to happen. We did not have this on our -- kind of in our math or in our model. So to answer your question directly, yes, I think we have a lot more optimism regarding the importance of California to the business going forward than what we were probably talking about during the Investor Day.

--------------------------------------------------------------------------------

Joseph Aiken, William Blair & Company L.L.C., Research Division - Associate [30]

--------------------------------------------------------------------------------

Okay. That's really helpful color. And then just switching gears a little bit more of a quick modeling question. Are you able to provide any guidance in terms of expectations for gross margin and EBITDA just directionally in 2020 versus 2019?

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [31]

--------------------------------------------------------------------------------

Yes, 2020, we're not giving any 2020 guidance, I guess, if that's your question.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [32]

--------------------------------------------------------------------------------

No, I mean, Joe, we're going to -- so our normal process for that would be, we'll finish up the year here, and we're obviously in the middle of that. We're working on that. We're like any company, we've got an AOP process, and we're kind of grinding through that. And obviously, what's pretty unique in our business, and this is always the case and maybe it begs for a different year-end or a different cycle or something, but we always have in the fall, we have -- this is a seasonal business and you kind of don't know what you're going to get in terms of seasonal demand, right? So it could be hurricane season. If you have a strong hurricane season or if it's an early winter season with nor'easters or in this case, the wildfire season, which has played out for us in terms of the blackout out in California. Those always add a new dimension in terms of trying to calibrate what you think you're going to do next year. And as those seasons develop, we're -- right always in the middle of our AOP, we end up redoing our AOP. I don't know how many times, York? It becomes an incredibly iterative process, which is -- it's just -- it's not very efficient, but it is the nature of the beast. And so we're in the middle of that. We're recalibrating again based on my comments here just a second ago to you regarding how we're thinking about California in particular. But we'll put all that together and then it's something that we'll do in Q1, when we do that call for the Q4 call, we'll give our 2020 guidance there in more detail.

--------------------------------------------------------------------------------

Operator [33]

--------------------------------------------------------------------------------

Next question comes from the line of Jeff Hammond of KeyBanc Capital Markets.

--------------------------------------------------------------------------------

Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [34]

--------------------------------------------------------------------------------

Just on the margins, I mean, the mix was better on home standby than like the lower margin commercial on portables, yet there wasn't a lot of leverage. I just want to understand like investment costs and how that impacted the margins in the quarter? And how to think about that going forward?

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [35]

--------------------------------------------------------------------------------

Yes, I think we are -- I mean if you're talking gross margins, we did see that mix improvement, which drove gross margins higher. I think we were pleased, actually, that we saw that increased gross margins in light of the tariff environment. I know we've done a lot of work with pricing actions and our Profitability Enhancement Programs collectively around the company to mitigate the impact of tariffs. So -- and I think we're able to successfully do that. And then on top of that, we were able to, with the higher mix, drive gross margins higher. I think collectively, the price cost, overhead -- improved overhead absorption is embedded in there.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [36]

--------------------------------------------------------------------------------

He is talking about OpEx though. Leverage -- not having the leverage. I think Jeff is talking about...

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [37]

--------------------------------------------------------------------------------

Yes, we're talking gross margin or OpEx?

--------------------------------------------------------------------------------

Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [38]

--------------------------------------------------------------------------------

No. Op margins. Yes, op margins.

--------------------------------------------------------------------------------

York A. Ragen, Generac Holdings Inc. - CFO & CAO [39]

--------------------------------------------------------------------------------

Operating margins. Yes. So that's the gross margin side. Then, on the OpEx side, you're right. If you just look at our fixed OpEx costs, there was obviously a nice leverage on our fixed operating costs.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [40]

--------------------------------------------------------------------------------

From a variable standpoint, we made some pretty big investments. One, you've got the clean energy OpEx running through there now, right? So those are -- we said there was a startups, right? Those are money-losing businesses, at least initially here. We hope to get to breakeven even quicker based on our optimism for that business going forward. But we made some pretty big investments around clean. We've got some big investments continuing to go on around connectivity. That's a big place that we've made investments.

Lead gas, we -- our lead gas initiatives are -- there's a lot of missionary work that's going into that to build that out. Those are global initiatives, too, because obviously, we've got to do a lot of work there. So we just felt -- we felt that the right thing to do for the long-term for this business is to make those investments. I think the easy thing to do would have been to put that in our pocket and not invest. I'm a big believer in continuing to invest not only in the R&D side of the business, but really in the market growth areas. We're also spending pretty heavily in California. So as you can imagine, to build that market -- we're running infomercials now. We're running a lot of digital advertising out there. We've got a lot of awareness building to do. And so that won't necessarily materialize, maybe as dramatically as the spend would indicate, like, if we spent that kind of money in terms of efficiency of spend in other parts of the country, we probably get a bigger lift. But knowing what we know around just how it's going to take to develop California, that's an investment in the future.

So those things are really why you didn't see leverage on the EBITDA margins the way you might have expected. I think York is exactly right, though, on the gross margin line. We're pretty happy with that. I mean we've been fighting off the tariff stuff all year long. And I think we're pretty happy that we're able to do that. And we've had some pretty good leverage in the factories, just being able to run things as utilization rates as high as they've been. But on the OpEx side, we've been making some pretty big investments for next year. So it's -- part of that whole step function changes the company. We got to go and fill in on the OpEx side that next level of -- to get that next level of growth, we've got to fill in the infrastructure to be able to achieve that.

--------------------------------------------------------------------------------

Jeffrey David Hammond, KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst [41]

--------------------------------------------------------------------------------

Okay, that's helpful. Just if you can -- I know you don't want to give 2020 guidance, but if you can just level set us on how to think about clean energy growth from a baseline level in 2020? Just -- I mean it sounds like you're feeling you got very good reception, but you got supply constraints, just trying to think how to model that.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [42]

--------------------------------------------------------------------------------

Yes. I think the prepared remark was well in excess of 100 megawatt hours of storage that we would deploy next year and that is more than double of what our original kind of plan on a page was for year 2 of these businesses. And so I mean, calibrating around that, I'm going to stop short of probably giving you an exact sales number because there are some moving pieces in that.

And we talked a little bit on this call about the individual HEMS devices. So you've got that. That's not really in the 100 megawatt hours obviously. 100 megawatt hours is really storage. But everything else kind of goes along that. We've got what we refer to as PEB links, which are the modules that go on the rooftop that go hand-in-hand with the solar systems that are components of the overall solar-plus-storage. So there's other components outside of just the storage systems themselves.

But I would say this, Jeff, the overall point is that if you go back to our Investor Day and you kind of look at where we were calibrating kind of out to 2022, there's a really good chance that we're going to get there a lot quicker. That's really the comment today. How far we can go next year? I think again, I'm tempering that by talking about supply chain. There could be some upside in that even further if supply chain can go further. This is not a demand-side problem year 1 or year 2. There's a lot of demand. And California is going to drive the demand even higher. I think that's the piece, maybe that's changed even from the Investor Day, is just the level of interest around storage. What you've got is a situation where you've got a lot of solar rooftops. People who have solar on their homes out in California that thought they were covered in a blackout. And what they're finding out is those systems were structured such, they're engineered such that the power is fed back to the grid. It's a one -- it's basically a one-way trip. So when the grid is down, the system's down. So there is no backup. And so the lights are out. And so what they need to do is they need to add storage to their existing solar systems. Only 2% of the 2 million solar systems that are out there in the U.S. have storage, 98% do not. That's a very ripe market for us to go after in terms of adding storage to an existing solar system. And that's going to be a target market for us as we go forward. And I think out in California, it's going to be a very ripe market as people look to add some resiliency to their existing system. And I think they now have a much greater awareness that those systems have a lot more severe limitations than maybe they were aware of.

--------------------------------------------------------------------------------

Operator [43]

--------------------------------------------------------------------------------

Next question comes from the line of Chip Moore of Canaccord.

--------------------------------------------------------------------------------

Chip Moore, Canaccord Genuity Corp., Research Division - Senior Associate [44]

--------------------------------------------------------------------------------

Wondering if we could go back to the $50 million in California, just given some of the emissions regulations. Can you talk about how much of that is portable versus standby? And then as we look forward, anything to consider on the regulatory side on the automatic standby units?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [45]

--------------------------------------------------------------------------------

Yes. I think from a mix standpoint, the majority is standby because we can't get as many portables into that market. Again, it's really kind of a -- it's a conundrum because we have a lot of portable product because we're planned for season. Dorian did take a fair amount of product, but we still had product left over. We're prepared for the winter season, as you would see normally in the Midwest and the Northeast, but those products are what we refer to in our business as 49-state product. So they're EPA compliant. But the California Air Resources Board has a higher level of standard for tailpipe emissions. And so we have a special [SKU] for California, we call it a CARB SKU . We don't plan year in, year out. California traditionally has not been a huge portable generator market. So when we did our planning cycle this year, we just didn't plan for a lot of CARB units. Now we've tried to add more, but we have long supply chains there. And we're bringing more in towards the end of the year. But we have a lot of product we could put in California today. And we have retailers that are begging for it, but we can't ship it there legally. So we're working with Californian regulators to see if we can get a temporary waiver to help people. I think this is a really critical thing. These are incredibly limited use products over their entire lifetime. So in terms of overall tailpipe emissions, they're never going to approach what you might see in a different kind of engine-powered piece of equipment. So I think probably the regulation shouldn't even deal with these types of products, but they do. That's just the nature of the beast, and we have to comply with all the regulations.

Going forward, if we can -- we're obviously going to take a bigger bet on CARB-related portables going forward. We'll plan differently for next season. And we'll have more of those products. So the mix is probably going to be, I don't want to say it's more evenly balanced, but it's certainly going to have more portable gen mix to it in the years ahead if we have the same situation develop. So I think that today, it's going to be very heavily skewed towards home standby, which is, by the way, very margin positive in terms of just overall mix.

--------------------------------------------------------------------------------

Chip Moore, Canaccord Genuity Corp., Research Division - Senior Associate [46]

--------------------------------------------------------------------------------

Great. That's helpful. And anything to consider on the standby side in terms of CARB-related products?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [47]

--------------------------------------------------------------------------------

All of our home standbys are, what we would refer to as, 50-state compliant products. So it's the same product everywhere in the U.S. So no constraints on home standby at all.

--------------------------------------------------------------------------------

Chip Moore, Canaccord Genuity Corp., Research Division - Senior Associate [48]

--------------------------------------------------------------------------------

Perfect. And then just one more on the clean energy side, looking to potentially double that original plan of 100 megawatts, can you talk about some of the key components? And you mentioned the supply chain constraints, just your confidence that you have with those and any price pressures?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [49]

--------------------------------------------------------------------------------

Yes. So I think my confidence would be sized appropriately for my comments today, that it's double the original plan we had. But if we were to satisfy all the demand that is potential there for next year, it could be higher. And I think we've appropriately sized the constraints and the constraints are everywhere, Chip. I mean they are on batteries. They are on the power electronic components going to the inverters. There's some capacity constraints on even assembling the systems themselves. We're looking at our factories here. Today, we have -- Pika had third-parties doing that. They're not a manufacturer, so they had third-parties doing that. We're going to likely bring -- by the end of next year, we'll be going to bring that in-house to do more of that if we can or at least help maybe as a second source to the existing sources, so that we can increase capacity. But it's basically -- it's a capacity constraint along basically all the components.

And then in terms of cost pressures, we're having some good success early on here, taking costs out of the system. We think we are on our original trajectory. So I won't tell you that, that trajectory has quickened. I wouldn't -- the demand has quickened the trajectory of cost out. So we have -- it's going to happen over the course of next year. So the margins starting out are going to be on the lower side as we had projected and will grow to be kind of -- think of kind of our overall corporate margins by the time we hit the end of next year, that's kind of our target. And so today, they're less than that. And by the end of next year, we hope to be kind of in that, kind of overall corporate margin range.

--------------------------------------------------------------------------------

Operator [50]

--------------------------------------------------------------------------------

Next question comes from the line of Philip Shen of Roth Capital.

--------------------------------------------------------------------------------

Philip Shen, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [51]

--------------------------------------------------------------------------------

You talked a lot about constraints on the supply side, can you address the constraints you may be seeing, if any, on the installation side? And how that might play out? I think labor for solar and storage installations, certainly, solar is quite tight, and in the California. Others in the industry have talked about that. So as you guys are generating these leads through your infomercials, what kind of bottleneck or lag are you seeing potentially with your contractors? And how do you expect to address that over time, if that is a problem?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [52]

--------------------------------------------------------------------------------

Yes, it's a great question, Phil. And it is part of the -- we've been focused on the supply chain side constraints, but there is -- as -- it's the same issue we run into with home standby, frankly. So we're actually -- we're pretty experienced that at how to help onboard installation bandwidth. Because it's a problem we face. Anytime we get a major surge in demand for our home standby products, we have similar constraints.

So the way we deal with that and the way we're dealing with this, in particular, around clean energy. A couple of things, I'll talk, in general, to how we deal with it on home standby and how that applies to clean energy, and then maybe something that's a little more specific to clean energy. So on -- what we would normally do is, we onboard dealers. We have 6 -- almost 6,200, 6,300 dealers nationwide here today. And those are mostly electrical contractors. Now we only have 100. We started the year with 100 in California, we're up to 300. But we're adding dealers very quickly out in California. We spend a ton of time training them on installs and training them on efficiency of install. We're very focused. We want them to take a pit crew mentality on installs because we know that if they can double the number of installs that they can do, that has a material impact on inflation bandwidth without having to add a ton of additional installers.

That being said, installation bandwidth is going to be in short supply for the near-term future. So there will be constraints across the board as we add dealers, but I think the unique thing about Generac and what we bring to this clean energy space is the fact that we can bring these dealers on and they can be representing us across a wide range of categories. And we're very good at engaging with electrical contractors on home standby. We're going to be equally as good as engaging with them on clean energy. So we might have -- today, as an example, we could have a dealer who is very interested in home standby and maybe they're out in California and they joined the team. They become a dealer today. And we tell them about our clean energy product. And they say, yes, that's interesting, but I'm up here in Northern Cal and everybody's really talking home standby. That's what I'm focused on. As that demand relaxes, and it will, over time, the ability for that dealer to shift into a clean energy type of installation bandwidth mode and away from home standby is, I think, real, that will happen. The other thing that's real, and this is maybe unique to the CE business or the clean energy business for us, is that we're going to partner with some of the national solar companies because they do have install crews. Many of them have their own install crews or they use third-parties. So we're in negotiations and discussions with a number of those national companies today, and we believe that very soon, we will be announcing several partnerships there that will, I think, help us get that installation bandwidth to an even higher level. So I think it's going to be a constraint in the short term. But I think longer term, I think we're going to be in a great position to be able to resolve that constraint, and maybe in the best position in the industry to resolve that constraint longer term.

--------------------------------------------------------------------------------

Philip Shen, Roth Capital Partners, LLC, Research Division - MD & Senior Research Analyst [53]

--------------------------------------------------------------------------------

Great, Aaron. That's great color. One quick follow-up. As it relates to -- you were talking about potentially some of your existing contractors switching over to clean energy. The -- in solar, you certainly have to get on a roof to do the install. To what degree do you think your contractor base has that skill set? How realistic is it for them to be comfortable working on a roof and developing that safety and other training programs to actually be able to switch over to be able to do solar and storage? Or do you think those contractors would just focus on the clean energy kind of battery side of the skill set and less on solar?

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [54]

--------------------------------------------------------------------------------

Yes. It's another good question, Phil. And so -- as we've kind of polled our existing distribution, right? So these are, again, the 6,200 electrical contractors. There's a percentage of them that are comfortable with the additional duties that are required to install panels. And some of them do actually today already. Some of them have panel installation businesses and solar components of their business. It is a smaller percentage. I'll admit that. And there are others who have said, hey, with the storage component and the other power electronics components, they're very interested in that because that's obviously, I'll call it, high-spec labor, right, for them. You need an electrician making many of those connections when you talk about connecting the actual inverter, connecting the circuits, connecting -- making all the interconnects to the solar system itself. They may choose to focus on that side and hire out labor or add labor that can take care of some of what needs to happen on the rooftops. There are some guys that are getting creative with that in terms of creating partnerships with roofing companies that they believe that have already some of those skill sets and the safety orientation that's necessary to effect that kind of work up on a rooftop.

I think it's going to develop. And I think you're right that, that could end up manifesting itself to be a new dynamic for our existing distribution that we'll have to help them solve for, and it's something we're learning too. We're going through a lot of learning cycles in this business in a very short period of time. And learning about the requirements of being on the rooftop, how those panels go down, what the safety requirements are, which is absolutely paramount, obviously, for everybody, all of those things are new to us. But we're quick studies. One thing you'll know as you kind of follow us a bit, Phil, and others, we pick things up quickly, we adapt very quickly, we move with agility, we react to things with a sense of urgency here. This will be no different. Where we see opportunity or challenges, we go after it. And as this develops, I expect that we'll see both of those things, challenges and opportunities. And I think we're going to be in a really good position. I know our team's ability to execute. I think one of the hallmarks of this company is execution. And I think one of the things as we've watched the clean energy space develop, one of the challenges that market's had is execution. So I like what we bring to that market in terms of our ability to execute. I'm pretty excited about that. And that's part of what was so well received, I think, with our entry into this market at SPI was, hey, here's an entrant, somebody who's been there done that and has a track record of execution. And it's not to say that we'll probably have our own challenges, but I like our chances when it comes to being able to get things done.

--------------------------------------------------------------------------------

Operator [55]

--------------------------------------------------------------------------------

There are no further questions. I would now like to turn the call back over to Aaron Jagdfeld for closing remarks.

--------------------------------------------------------------------------------

Aaron P. Jagdfeld, Generac Holdings Inc. - President, CEO & Executive Chairman [56]

--------------------------------------------------------------------------------

We want to thank everybody for joining us this Halloween morning. We look forward to discussing our fourth quarter earnings results with you at some point in mid-February of 2020. Thanks again this morning, and goodbye.

--------------------------------------------------------------------------------

Operator [57]

--------------------------------------------------------------------------------

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. Have a great day.