Generac Holdings Inc. (NYSE:GNRC) Q4 2022 Earnings Call Transcript

Generac Holdings Inc. (NYSE:GNRC) Q4 2022 Earnings Call Transcript February 15, 2023

Operator: Good day, and thank you for standing by. And welcome to the Fourth Quarter Full Year 2022 Generac Holdings Inc. Earnings Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session . Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Mr. Mike Harris, Senior VP, Corporate Development and Investor Relations. Please go ahead.

Mike Harris: Good morning. And welcome to our Fourth Quarter and Full Year 2022 earnings call. I’d like to thank everyone for joining us this morning. With me today is Aaron Jagdfeld, President and Chief Executive Officer; and York Ragen, Chief Financial 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 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 will make reference to certain non-GAAP measures during today’s call. Additional information regarding these measures, including reconciliation to comparable US GAAP measures is available in our earnings release and SEC filings. I will now turn the call over to Aaron.

Aaron Jagdfeld: Thanks, Mike. Good morning, everyone, and thank you for joining us today. Our fourth quarter results reflect continued strong momentum in our Commercial and Industrial product categories during the quarter, but softer residential product sales, resulted in consolidated net sales at the low end of our previous guidance range. Specifically, higher home standby field inventory levels continue to impact orders and shipments in the fourth quarter and clean energy product shipments were lower as we work to further improve the reliability of these products and expand our distribution capabilities. Year-over-year, overall net sales decreased 2% to $1.05 billion and core sales declined 7% during the quarter. Residential product sales decreased 19% from the prior year due to the previously mentioned home standby and clean energy products headwinds.

C&I product sales increased 27% on a year-over-year basis with robust core sales growth across all channels domestically and all regions internationally. Adjusted EBITDA margins declined during the quarter as the unfavorable effect of sales mix, reduced operating leverage and the increase in recurring operating expenses from recent acquisitions were partially offset by favorable price cost dynamics. For the full year 2022, Generac achieved another year of record top line growth with total net sales increasing 22% over 2021, which marked our third consecutive year of double digit growth. While residential product shipments faced headwinds in the second half of 2022, the category still experienced strong year-over-year growth of approximately 19%.

Additionally, sales of our C&I products have never been stronger, as global shipments grew 26% over the prior year, resulting in $1.26 billion in annual sales. We exited 2022 with record backlog for these products, setting our expectations for another strong year in 2023. In addition to record net sales, our international segment achieved all time highs and adjusted EBITDA and adjusted EBITDA margins for the year as we continue to benefit from increasing global demand for backup power and mobile products. Also, our strong liquidity position allowed us to opportunistically repurchase more than 2.7 million shares during the year. Before discussing fourth quarter results in more detail, I want to provide an update on the progress we made over the course of the year to advance our evolution into an energy technology solutions company and discuss the continued development of the powerful mega trends that are driving our business.

Despite the softer second half of 2022 for our residential products, we continue to make important progress in building out our portfolio of energy technology related solutions during the year. Importantly, we began assembling a significantly deeper and more experienced leadership team focused on improving and advancing our clean energy product and distribution capabilities, while further integrating the multiple energy technology investments we’ve made in recent years. We also continue to develop and invest in numerous new technologies and capabilities, including taking a minority equity interest, investment in WATT fuel cell, acquiring Blue Pillar and launching our single pane of glass initiative. Blue Pillar’s capabilities provide us with the foundation for connecting our growing portfolio of C&I focused energy technology solutions, while our single pane of glass initiative is focused on developing the end user interface or central hub of our smart home energy ecosystem and heavily leverages ecobee’s platform development expertise.

We also brought multiple new solutions to market during the year as we began shipping our second generation load control device called PWRmanager, launched a line of portable battery solutions called Portable Power Stations and announced new EV charging solutions for utilities and EV owners. Our grid services team also announced several additional project wins during 2022 and had a strong year across several key operating metrics. Additionally, the mega trends that drive the long term growth trajectory of our business became even more evident in 2022. Extreme weather and multiple high profile outage events further highlighted the poor reliability of the US power grid, while war and geopolitical instability in Europe forced consumers and businesses to evaluate the importance of energy security.

The home is a sanctuary and aging in place trends that are helping drive demand for residential backup power solutions remain very compelling. A structural shift in consumer preferences and work habits in the US in recent years has further increased sensitivity to power outages with the percentage of individuals working from home tripling and home health referral volumes doubling since 2019. As the effects of climate change become increasingly evident, the policy backdrop for our energy technology solutions has never been more favorable. Most notably with the passage of the Inflation Reduction Act in 2022, providing additional conviction for us to maintain a long term focus with our investments in energy technology. Additionally, increased federal infrastructure spending and the ongoing upgrade of global telecom networks help support our future growth expectations for our C&I products as well.

The massive changes taking place with our nation’s power grid are yet another mega trend that continues to strengthen as growing demand for electricity is met with less reliable supply. According to the North American Electric Reliability Corporation, or NERC, approximately 25% of Americans are at high risk of resource adequacy shortfalls during normal seasonal peak conditions in the 2023 to 2027 period due to the growing supply demand imbalances across our power grid. With the electrification of everything trends accelerating and the growing penetration of EVs, coupled with an increasingly higher mix of supply from intermittent renewable power generation sources, we believe this megatrend will drive a significant focus on the need for power resiliency for years to come.

NERC’s high risk categorization comes before considering the notable increase in severe and volatile weather we’ve witnessed in recent years, which we believe only further magnifies the need for reliable decentralized energy technology solutions. Now discussing our fourth quarter results in more detail. Residential product sales declined at a double digit rate as compared to the prior year, primarily driven by lower home standby shipments in the quarter resulting from higher field inventory levels. However, end market conditions continued to be strong during the quarter. Baseline power outage activity in the US was above the long term average with winter storm Elliot and other larger localized outages providing yet another reminder of the fragility of our electrical infrastructure.

The extreme temperatures over the holiday season created a surge in demand for power for residential heating and coincided with supply disruptions as the nation’s largest grid operator saw nearly a quarter of its power plants fall offline, resulting in rolling blackouts. This event took place in an especially inconvenient and sensitive time for many households, further supporting the continued increase in consumer awareness of the growing need for backup power solutions. Home consultations or sales leads in the quarter remain strong, matching the record high for our fourth quarter period in the prior year. Additionally, home consultations for full year 2022 were more than 3 times 2019 levels. This strength has continued early in 2023 with home consultations growing again on a year-over-year basis and reaching record levels for the month of January following the holiday season outage activity.

We remain focused on expanding our distribution network as we experienced sequential growth in our residential dealer base and ended the quarter with more than 8,700 dealer partners, a net increase of approximately 200 dealers from the third quarter. Activations, which are a proxy for installations, grew at a robust rate in the fourth quarter compared to the prior year, and also grew sequentially as a result of increased install bandwidth. In addition to this encouraging growth in activations and dealer count, we also experienced sequential improvement in close rates and dealer project lead times. Although, these two metrics are not yet back to normalize levels. The number of home standby generators and field inventory declined sequentially during the fourth quarter, and are down more than 20% from r peak levels, benefiting from reduced production rates and record activation levels in the quarter.

Days of field inventory, which considers recent trends and activation rates, also declined sequentially during the fourth quarter. However, relative to historic seasonal patterns, days of field inventory are still well above normalized levels as of the end of 2022. We expect that field inventory levels will remain elevated through the first half of 2023, which will continue to weigh on orders and shipments of home standby generators during the first and second quarters. Improving the installation bandwidth for home standby generators is a key initiative for the company in 2023. We are focused on adding more dealers, providing support for dealer recruiting, training to improve installation efficiency and developing additional technical innovations to make it easier for contractors to install our products.

Recent dealer count growth has been very encouraging as we added over 500 dealers in the second half of 2022. We also rolled out our dealer talent network to help channel partners recruit qualified labor and are actively engaging with trade groups, such as the independent electrical contractors to further drive awareness for the home standby generator category among contractors. Initiatives to help dealers to streamline the installation process are also progressing well, including the launch of a universal permitting package that allows dealers to pull the necessary project documentation for their specific location. In addition, we have further expanded our field training efforts and the sharing of installation best practices for dealers and non-dealer contractors.

The combination of these actions is expected to result in meaningful improvement in activation rates as the year progresses. Consistent with the comments provided in our third quarter earnings call in early November, we expect home standby sales to decline for the full year 2023 due to significant weakness in first half shipments, resulting from elevated levels of field inventory with the first quarter expected to mark the trough for shipments during the current channel destocking process. We continue to anticipate more normalized fuel inventory levels in the second half of the year based on our current view of home consultations, activations and our production rates, along with the assumption of power outage activity inline with the long term baseline average.

As we ramp home standby shipments sequentially into the second half of the year, we expect home standby sales to return to solid year-over-year growth in the third and fourth quarters, even when assuming no major outage events. Favorable end market demand metrics, significant growth in our dealer counts, low nationwide penetration in the mid single digits and strengthening mega trends reinforce our confidence in the long term growth trajectory for the home standby category and also support our near term expectations for a return to growth once the home standby market reaches more normalized field inventory levels. I’d now like to provide some commentary on our residential energy technology products and solutions, as sales were inline with the low end of our prior expectations during the fourth quarter, with continued softness in residential energy storage shipments offset by strong top line performances from ecobee and Generac Grid Services.

Shipments of our PWRcell energy storage systems were again negatively impacted by the loss of a large customer that ceased operations in the third quarter and the overhang of the SnapRS quality related concerns. We are committed to supporting the dealers that are participating in our SnapRS warranty coverage upgrade program as well as ensuring that end customer systems are performing as intended. Channel partner response to these efforts has been favorable thus far, and we are working to build a larger and stronger network of installers and distributors, which remains a top priority for the company in 2023 as we position our residential clean energy product offering for long term success. We are investing heavily on further improving the quality and reliability of our clean energy products and view the residential storage market as a key strategic opportunity for Generac.

Additionally, we are making good progress towards our next generation energy storage system and we will begin alpha testing of these products in the second quarter of this year with an anticipated launch to the market in 2024. I’d now like to provide a quick update on ecobee, which forms the core of our connected devices strategy within our residential energy ecosystem. ecobee sales continued to grow at a strong rate in the fourth quarter, despite aggressive promotional activity from competitors, which underscores the strong competitive positioning of ecobee’s feature-rich solutions. In addition to their core smart thermostat product continuing to gain traction in the professional contractor channel, a number of larger utilities have been seeking out grid service partnerships with ecobee, further validating our differentiated offering.

We also recently announced the integration of home standby monitoring capabilities into the ecobee platform, which allows homeowners to monitor their home standby generator and propane tank fuel levels and receive alerts directly on the ecobee platform. This marks an important first step forward in our single pane of glass initiative in developing the central user interface for our suite of residential products that will heavily leverage the ecobee platform and the development team. I also want to provide some commentary on our grid services team and their efforts as they closed out a strong year in 2022 with continued growth across key performance metrics, including connected megawatts, assets under management, number of customers and gigawatt hours of capacity delivered.

The growing grid services sales pipeline is being driven by both new and existing customers as well as a wide range of connectability hardware, including the Blue Pillar acquisition, which will now provide our C&I products with connectivity capabilities to allow previously stranded C&I assets to be made available to grid services programs. In addition, grid services programs can also provide incremental economic support to the residential solar plus storage market as higher financing costs impact traditional consumer loan driven demand. Not only can these programs improve the economics for homeowners that own storage systems but we’re also seeing increased opportunities to deploy grid services programs, utilizing utility and third party own systems.

We believe our unique portfolio of hardware and software solutions remains a key competitive advantage within the grid services space. The long term market opportunities for residential energy storage, power conversion, energy monitoring and management services and grid services remains highly attractive and core to our strategic vision, and we will continue to target these markets and adjacent opportunities. To that end, we recently announced the launch of our new EV charger, which marks Generac’s initial offering into this large and rapidly growing market. This product will be available later in 2023 through Generac’s omnichannel distribution network, including our residential dealer network, leading home improvement in hardware retailers and electrical wholesalers.

We’re excited to incorporate this product into our smart home energy ecosystem while continuing to pursue future EV charging innovations and capabilities. EV charging will become an increasingly important part of the energy ecosystem of the home. And as a leader in residential power, this product is a natural extension of Generac’s portfolio of energy technology solutions. Given these significant market opportunities, we continue to invest heavily in the people and processes involved in the development of these products and solutions. And this remains a key strategic area of focus for the company. We are encouraged by the progress of our new residential energy technology leadership team in integrating and improving the solutions we have acquired and developed in recent years.

The investment level necessary to build a home energy technology foundation for growth will contribute to higher operating expenses as a percentage of sales for the company in 2023. But we anticipate strong returns on these investments well into the future as we position Generac as a leader in the deployment and integration of hardware and software solutions for home energy ecosystems. As a result of these initiatives and investments, we expect the combination of residential energy technology products and services to deliver gross sales between $300 million and $350 million for the full year 2023. We anticipate that these results will sequentially improve throughout the year, driven by strong growth from ecobee and grid services, alongside our expectations for continued improvement from our clean energy product and distribution efforts in the coming quarters.

Switching gears, now I want to provide some commentary on a part of the business that has continued to outperform our expectations, as our C&I products experienced and outstanding quarter globally as sales grew by 27% as compared to the prior year, benefiting from very strong demand and higher production levels resulting from capacity expansion initiatives. Growth in shipments for domestic C&I products in the fourth quarter was highlighted by strength across all channels, including national rental equipment, telecom, industrial distributors and other strategic customers. We experienced continued strength in demand during the quarter as the backlog for our C&I products grew again sequentially, and ended the year at record levels, giving us excellent visibility into continued growth for the category in 2023.

Shipments of C&I stationary generators through our North American distributor channel grew significantly again in the fourth quarter, and order trends indicate growth will continue in 2023 as backlog in the channel also increased again on a sequential basis. Quoting activity and closed rates remain elevated compared to the prior year levels, highlighting our sustained market share gains as well as the durability of overall demand trends for these products. Shipments to national telecom customers also increased at a robust rate during the fourth quarter as compared to the strong prior comparison, as several of our larger national customers continue to deploy generators to harden their existing sites and build out their fifth generation of 5G networks.

Investment in telecom infrastructure remains one of the key megatrends that we expect to drive growth for our C&I products in the coming years, as global tower and network hub counts further expand and the increasingly critical nature of wireless communications requires backup power for resiliency. As the leading provider of backup power to the North American telecom market, we expect to benefit from this secular trend. We also experienced another quarter of tremendous growth with our international and independent rental equipment customers as they refresh and expand their fleets. We believe the demand environment for mobile products will remain robust in the quarters ahead, as evidenced by ordered growth outpacing shipment growth in the quarter and the megatrend around the critical need for infrastructure improvements continues to play out.

Additionally, we’re helping these customers advance their sustainability goals with solid demand for our newly introduced mobile energy storage systems, and as we delivered the first containerized hydrogen fuel cell unit to a national rental customer through our recently announced distribution agreement with EODev. Strong customer interest for natural gas generators used in applications beyond traditional emergency standby projects also continued in the quarter as shipments of these products grew at an exceptional rate. Order rates also remain strong with our quarter end backlog for these products up substantially both year-over-year and sequentially. We believe we are in the very early innings of growth for this exciting new market opportunity as grid stability concerns and volatile energy markets are expected to further drive demand for these innovative solutions.

Internationally robust momentum continued as shipments increased 22% year-over-year during the fourth quarter with 28% core total sales growth when excluding the unfavorable impact of foreign currency. Core total sales growth was driven by strength across all regions, most notably in Europe and Latin America with intersegment sales again growing substantially in the quarter as our Generac Mexico facility continued to ramp production of telecom products for the North American market. International segment EBITDA margins also increased during the quarter, primarily due to improved operating leverage on the higher sales volumes. The European region has seen remarkably strong demand, most notably for C&I products and portable generators due to a heightened focus on energy independence and security.

Power security concerns amid the war in Ukraine have remained and we are providing backup generators to the region through our European sales branches. Although geopolitical and macroeconomic conditions in the region remain volatile, driving less certain long term demand trends, end market awareness of the need for resiliency is undoubtedly increased across the continent. The subsequent effect of the war on Europe’s energy complex has highlighted the need for reliable on site power resources for homes and businesses around the globe. We also recently announced the acquisition of REFU Storage Systems, a German developer and supplier of battery storage hardware products, advanced software and platform services for the commercial and industrial market.

This acquisition represents our initial entrance into the large and rapidly growing C&I stationary energy storage market for behind the meter applications, which we view as a natural extension of our long history in the C&I backup power generation market. Given the continued momentum in the international segment, along with strong demand fundamentals and existing backlog across domestic C&I channels, we expect net sales growth for our global C&I products to be in the mid to high single digit range for 2023. In closing, this morning, we’re encouraged by the initial progress and our action plans to address the near term challenges that have impacted our results over the past two quarters. We believe we have a line of sight to normalization of home standby field inventories as we rightsize our production and continue to expand our installation bandwidth.

We have significantly strengthened our residential energy technology leadership team over the last six months and they are driving an increased focus on quality and innovation, while we further build out our product and distribution capabilities in this strategically important part of our business. Global interest in our C&I products and services has never been stronger, and is well positioned to continue growing in 2023. We remain confident in the long term strategic growth themes within our business, including the still significant penetration opportunity for home standby generators and the rapidly developing market for energy storage. The previously discussed megatrends that support these growth themes have never been more evident. Our refined focus on execution through our portfolio of backup power and energy technology solutions has uniquely positioned us to create value in the transition to the next generation grid.

I’m extremely confident in our team’s ability to continue developing innovative products and services as we execute on our mission to lead the evolution to more resilient, efficient and sustainable energy solutions. I’ll now turn the call over to York to provide further details on the fourth quarter as well as full year 2022 results and our outlook for 2023. York?

York Ragen: Thanks, Aaron. Looking at fourth quarter 2022 results in more detail. Net sales decreased 2% to $1.05 billion during the fourth quarter of 2022 as compared to $1.07 billion in the prior year fourth quarter. The combination of contributions from acquisitions and the unfavorable impact from foreign currency had an approximate 5% favorable impact on revenue growth during the quarter. Net sales for the full year 2022 increased 22% to approximately $4.56 billion, an all-time record for the company. Briefly looking at consolidated net sales for the fourth quarter by product class. Residential product sales declined 19% to $575 million as compared to $706 million in the prior year. A partial quarter of contribution from the ecobee acquisition and the slight unfavorable impact of foreign currency contributed approximately 4% of revenue growth for the quarter on a net basis.

Lower shipments of home standby generators and weakness in PWRcell energy storage systems drove the decline in residential product core sales growth. Commercial and industrial product sales for the fourth quarter of 2022 increased 27% to $361 million as compared to $284 million in the prior year quarter. Contributions from the Electronic Environments and Blue Pillar acquisitions were fully offset by the unfavorable impact of foreign currency during the quarter. The very strong core sales growth was broad based across all regions internationally and all channels domestically, with particular strength in national rental equipment, telecom, industrial distributors and other direct customers for beyond standby applications. Net sales for other products and services increased 46% to $113 million as compared to $77 million in the fourth quarter of 2021.

Contributions from the Electronic Environments and ecobee acquisitions contributed approximately 34% of this growth, given their additional service capabilities. Core sales growth for the category was 13% due to strong growth in our services offerings in certain parts of our business, both domestically and internationally, along with continued growth in aftermarket service parts and extended warranty revenue recognition. Gross profit margin was 32.7% compared to 34% in the prior year fourth quarter as unfavorable sales mix had a meaningful negative impact during the quarter. This was partially offset by the realization of previously implemented pricing actions. Operating expenses increased $49 million or 26% as compared to the fourth quarter of 2021.

This increase was primarily driven by higher recurring operating expenses from recent acquisitions and unfavorable adjustment for acquisition contingent consideration, certain legal and regulatory reserves, higher intangible amortization expense and increased employee and marketing costs. These increases were partially offset by lower acquisition related transaction costs in the current year quarter. Adjusted EBITDA before deducting for noncontrolling interest, as defined in our earnings release, was $174 million or 16.6% of net sales in the fourth quarter as compared to $220 million or 20.7% of net sales in the prior year. For the full year 2022, adjusted EBITDA before deducting for noncontrolling interest was $825 million or an 18.1% margin as compared to $861 million or 23.1% margin in the prior year.

I will now briefly discuss financial results for our two reporting segments. Domestic segment total sales, including intersegment sales, decreased 3% to $881 million in the quarter as compared to $909 million in the prior year, with the impact of acquisitions contributing approximately 7% revenue growth for the quarter. Adjusted EBITDA for the segment was $144 million, representing a 16.4% margin as compared to $197 million in the prior year or 21.6% of total sales. The lower domestic EBITDA margin in the quarter was primarily due to unfavorable sales mix, partially offset by the realization of previously implemented pricing actions. In addition, the impact of acquisitions and continued energy technology operating expense investments for future growth negatively affected margins during the quarter.

For the full year 2022, Domestic segment total sales increased 23% over the prior year to $3.93 billion. Adjusted EBITDA margins for the segment were 18.2% compared to 24.8% in the prior year full year. International segment total sales, including intersegment sales, increased 22% to $219 million in the quarter as compared to $180 million in the prior year quarter. Core sales, which excludes the impact of acquisitions and currency, increased approximately 28% compared to the prior year. Adjusted EBITDA for the segment before deducting for noncontrolling interest was $29.5 million or 13.5% of net sales as compared to $23.7 million or 13.1% of net sales in the prior year. This margin performance was driven primarily by improved operating leverage on the higher volumes.

For the full year 2022, International segment total sales increased 32% over the prior year to $791 million. Adjusted EBITDA margins for the segment before deducting for noncontrolling interests were 13.8% of total sales during 2022, a significant 280 basis point increase compared to the 11% margin in the prior year. Now switching back to our financial performance for the fourth quarter of ’22 on a consolidated basis. As disclosed in our earnings release, GAAP net income for the company in the quarter was $71 million as compared to $143 million in the fourth quarter of 2021. The current year net income includes pretax charges totaling approximately $21 million related to an unfavorable adjustment for acquisition contingent consideration and certain legal and regulatory reserves.

In addition, interest expense increased approximately $10 million compared to the prior year due to higher borrowings and higher interest rates. GAAP income taxes during the current year fourth quarter were $13.6 million or an effective tax rate of 15.5% as compared to $20.6 million or an effective tax rate of 12.4% for the prior year. The increase in effective tax rate was due to certain favorable discrete items that were reflected in the prior year, which did not repeat in the current year quarter. Diluted net income per share for the company on a GAAP basis was $0.83 in the fourth quarter of 2022 compared to $2.04 in the prior year. Adjusted net income for the company, as defined in our earnings release, was $113 million in the current year quarter or $1.78 per share.

This compares to adjusted net income of $160 million in the prior year or $2.51 per share. Cash flow from operations was $101 million as compared to $62 million in the prior year fourth quarter and free cash flow, as defined in our earnings release, was $80 million as compared to $42 million in the same quarter last year. The improvement in free cash flow was primarily due to lower working capital investment in the current year quarter as we reduced our material receipts and production rates for home standby generators. This was partially offset by lower operating earnings. As of December 31, 2022, we had approximately $1.29 billion of liquidity, comprised of approximately $133 million of cash on hand and $1.16 billion of availability on our revolving credit facility.

Also, total debt outstanding at the end of the quarter was $1.43 billion, resulting in a gross debt leverage ratio at the end of the fourth quarter of 1.8 times on an as-reported basis. Additionally, during the fourth quarter, we repurchased 2.2 million shares of our common stock for $222 million or an average price of approximately $102 per share. There is approximately $278 million remaining on our current share repurchase authorization as of the end of 2022. With that, I will now provide further comments on our new outlook for 2023. As disclosed in our press release this morning, we’re initiating 2023 net sales guidance that is consistent with the high level comments provided in our third quarter earnings call on November 2nd. As Aaron previously discussed, shipments of residential products are expected to face significant headwinds in the first half of the year due to elevated field inventory levels for home standby generators and the continued build out of our clean energy product and distribution capabilities.

We expect the residential product category to return to year-over-year sales growth in the second half, resulting in a full year decline in the high teens range compared to prior year. We anticipate continued growth for C&I product sales across several channels domestically and internationally, resulting in expected C&I net sales growth in the mid to high single digit range for the full year with higher growth rates anticipated in the first half of the year. As a result of these factors, we expect overall net sales for the full year to decrease between minus 6% to minus 10% as compared to the prior year, which includes approximately 1% of net favorable impact from acquisitions and foreign currency. Importantly, this guidance assumes a level of power outage activity during the year in line with the longer term baseline average.

As a result and consistent with our historical approach, this outlook does not assume the benefit of a major power outage event during the year, such as a Category 3 or higher landed hurricane or major winter storm. As a result of this top line outlook, we expect sales to be more weighted to the back half of the year for 2023, similar to pre-COVID periods, which did not include substantial residential backlog, with overall net sales in the first half being approximately 44% weighted and sales in the second half being approximately 56% weighted. Specifically, with the return to normal seasonality and the destocking of home standby field inventory, we expect first quarter total sales to decline by approximately minus 25% to minus 26% from the prior year with growth in C&I product sales more than offset by residential product headwinds.

Looking at our gross margin expectations for the full year 2023 compared to 2022, we expect favorable price cost impacts driven by previously implemented pricing actions that have not yet fully annualized, certain cost reduction initiatives and lower input costs to more than offset the negative impact of unfavorable sales mix resulting from lower home standby generator shipments. As a result, we expect gross margins for the full year to increase by approximately 150 basis points as compared to 2022. From a seasonality perspective, we expect first quarter gross margins to be the lowest during the year due primarily to the outsized impact of unfavorable sales mix and lower overhead absorption on the lower home standby volumes. Specifically for the first quarter, we expect gross margins to be approximately 200 basis points below the first quarter of 2022.

Sequential quarterly improvements in gross margins are expected as the year progresses due to improved sales mix from higher shipments of home standby generators, along with lower input costs, improved overhead absorption and realization of cost reduction initiatives as we move throughout the year. And as a result, gross margins are expected to progressively improve with fourth quarter margins to be approximately 500 basis points higher than fourth quarter of 2022. In addition, we continue to focus heavily on supporting innovation, executing on strategic initiatives and driving future revenue growth in new and existing markets. As a result of these continued investments, we expect operating expenses, excluding intangible amortization expense as a percentage of net sales to be nearly 20% for the full year of 2023, with operating leverage improving throughout the year.

As a result of our gross margin and operating expense expectations, adjusted EBITDA margins before deducting for noncontrolling interests are expected to be approximately 17% to 18% for the full year compared to the 18.1% reported for the full year 2022. From a seasonality perspective, we expect adjusted EBITDA margins to improve significantly as we move throughout the year, primarily driven by the sequentially improving gross margins as previously discussed in detail and to a lesser extent, improved leverage of operating expenses on the expected higher sales volumes in the second half of 2023. Specifically regarding the first quarter, adjusted EBITDA margins are expected to be the lowest for the year at approximately 10% and then improve sequentially throughout the year, returning to more normalized levels in the low 20% range in the fourth quarter.

As a result, second half adjusted EBITDA margins are expected to be approximately 800 basis points higher than the first half margins. As is normal practice, we are also providing additional guidance details to assist with modeling adjusted earnings per share and free cash flow for the full year 2023. For 2023, our GAAP effective tax rate is expected to be between 24% to 25% as compared to the 19.6% full year GAAP tax rate for 2022. This increase is driven primarily by expectations for lower share based compensation deductions, increased mix of income in higher tax jurisdictions and higher tax on foreign income in 2023 compared to 2022. Additionally, to arrive at appropriate estimates for adjusted net income and adjusted EPS, the related reconciling item should be forecasted net of tax using this GAAP tax rate as well.

We expect interest expense to be approximately $90 million, assuming no additional term loan principal prepayments during the year and assuming elevated SOFR rates throughout 2023. Our capital expenditures are projected to be approximately 2.5% to 3% of our forecasted net sales for the year in line with historical levels. Depreciation expense is forecast to be approximately $56 million to $58 million in 2023, given our assumed CapEx guidance. GAAP intangible amortization expense in 2023 is expected to be approximately $100 million during the year, and stock compensation expense is expected to be between $40 million to $43 million for the year. Operating and free cash flow generation is expected to follow historical seasonality of being disproportionately weighted towards the second half of the year in 2023.

Specifically related to the first quarter, we expect free cash flow to be negative, assuming a continued use of cash for working capital with a sharp recovery in the second quarter. For the full year, we expect free cash flow conversion to be strong at well over 100% as recent trends of significant working capital builds are reversed. Our full year weighted average diluted share count is expected to decrease to approximately 63 million shares as compared to 64.7 million shares in 2022, which reflects the share repurchases that were completed in 2022. Finally, the 2023 outlook does not reflect potential additional acquisitions or share repurchases that could drive incremental shareholder value. This concludes our prepared remarks. At this time, we’d like to open the call for questions.

See also 12 Most Undervalued Dow Stocks To Buy and 13 Most Undervalued REIT Stocks to Buy.,

Q&A Session

Operator: And our first question comes from Tommy Moll from Stephens.

Tommy Moll: Aaron, I appreciated your comments and insight on the field inventory levels for home standby. I think what I heard you say was in terms of days on hand, it was down sequentially, but well above normal. So my related follow-on question is, is there any way you can frame quantitatively or qualitatively what normal looks like? And to what extent do you need to continue to build out the dealer network in order to achieve that level in the back half of this year?

Aaron Jagdfeld: Obviously, the field inventory destocking process that we’re going through, there’s a lot of metrics there that we have at our fingertips in terms of how much inventory is in the field, you know activation rates. You can look at them as we do on a seasonal basis, The comments, as you indicated, you were spot on, we said that from a days of field inventory standpoint, they improved sequentially from the fourth quarter, but still high. I think if you go back to our comments on the last call in November, we said we were about double. We thought field inventory levels were about double where they needed to be from a normal kind of, quote unquote, normal level. We’re better than that today. So the raw numbers are, we’re about 20% off the peak in terms of just raw units in field inventory, home standby units, which is great.

And as that days of field inventory also coming down sequentially, the combination of those two things, reducing production rates, the activation rate was up nicely in the fourth quarter. So we continue to see installation building out. So all of those metrics are favorable. And point two, the destocking event that’s going on. But as our prepared remarks indicated, still high relative to where they need to be normally. So it’s not quite double. It’s less than that, maybe, I don’t know, 1.6 times, 1.7 times still the level in terms of just the raw numbers as we look at them, but coming down nicely. In terms of the second part of the question, there’s a — it’s kind of a — it’s a multipart — multipronged approach, if you will. The biggest of which, as we’ve indicated and I think you’re latched on to as well, is that we have to increase the raw dealer count.

And so to that end, we added over 500 dealers on a net basis in the second half of the year, which is the strongest second half of a year we’ve ever had in terms of new dealer ads at 8,700, we ended the year actually over 8,700 dealers and progressing very nicely there in terms of broadening our our reach, also focused on training. I think one of the things we mentioned with the pandemic over the last several years, we had very aggressive training — face-to-face training programs. Pre-pandemic, we had to scale those back during the pandemic, we just weren’t able to do that. And we’re back to training now face-to-face with dealers, with contractors, and that is super helpful in terms of the engagement level with those partners. Another area is helping them find labor.

One of the big things that we heard in the second half of last year was the labor constraints that our dealers have and our contractor partners have in being able to expand their installation capacity is just headcount, just people. And so we created something we call the dealer talent network and we’ve rolled that out here early in 2023. And we’re getting good traction there in helping dealers find and hire and onboard the talent they need to increase their installation capacity. So all of those things together — and then longer term, we have some technical solutions we’re working on, obviously, trying to take labor out of the actual installation process is a big part of this as well. So all of those efforts, we think that certainly on the shorter term efforts like adding distribution, training and helping dealers find qualified headcount, we’re making really good progress on those short term initiatives.

And then longer term, on the innovation side, we see and have a number of really good kind of ideas around how we can continue to take labor out of the home standby installation process. So I think we’re making good progress. We see the metrics reflecting that in a lower field inventory level, but we’re still going to see that kind of exist here through the first half. And we own that. We know that’s going to result in pressure on the first half of the year. And because of the margin profile of those products, in particular, as you heard York’s remarks around the outlook, it’s going to be kind of a tale of two halves. Seasonally, top line is going to be relatively similar, 44% being the first half, 56% being the back half. But I think profitability, because of the heavy mix shift, you’re going to see that play out in that 800 basis point move from Q1 to Q4 in EBITDA margins that we’re — in gross margin, that we’re anticipating over the course of the year.

But great question and obviously a central focus, not only for us but others as well.

Operator: And our next question comes from Michael Halloran from Baird.

Michael Halloran: So just a follow up on that, Aaron. Maybe you can just talk about what your assumptions are for the underlying demand dynamics as you work through the back half of the year? In other words, it sounds like you think that the current strength that you’re seeing in home consultations and some of those megatrends you mentioned. It sounds like you think that carries through the year into the back half of the year. Just some thoughts on what’s underpinning that back half strength from an underlying demand perspective, kind of ignoring that inventory normalization side that you’ve talked about?

Aaron Jagdfeld: Mike, I think there’s — optically, I think when you look at first half, second half, right, like I think it looks like, wow, that’s a really big hill to climb. Again, seasonally, interestingly enough, you get kind of normal seasonality, you go back to 2019 levels, and actually pre-2019, just looking back, we’re really not that far off of how the top line would pace seasonally. But we’ve got this, what I’ll call, kind of artificially low. We’re referring to it as an air pocket with home standby because of the destocking event. But to answer your question, what gives us confidence that the year will play out, at least the underpinned — what’s underpinning the demand metrics that we’re seeing and how we’re building out our view on the full year.

So there’s a couple of things. One is you look at the fourth quarter IHC levels. That was a record fourth quarter for us, it matched the fourth quarter of the prior year. So that was a record. And so they’re both records in terms of IHC flow. So we’re seeing really strong sales lead volume. And that has continued here in 2023, as we said, January was an all-time record for us for January. Best January we’ve ever had with IHCs. So we’re really encouraged by the continued focus by homeowners. Look, I think that what is — maybe there’s a lot of noise in the story right now with the destocking and everything else that some of the clean energy challenges that we’ve had, we’re talking about. But what’s not — which shouldn’t be lost on people is the fact that power outages are happening and people are concerned about resiliency.

Grid operators are very concerned about their ability to supply power on a normal basis, like forget weather for a second. But just with kind of the way that the grid is changing, as we electrify everything on the demand side and on the source side, on the power generation side, the addition of all these renewable sources, these mandates to increase renewable sources, and those are intermittent sources, that’s driving supply and demand challenges for grid operators and utilities like they’ve never seen before. And so their ability to solve for those challenges is a huge focal point. And you can just see what’s happening, right? I mean, look at the holiday outages that we saw in the Carolinas and in areas along the East Coast, where there were rolling blackouts because of the demand from electric heating, residential heating and the cold weather taking power plants and supply offline.

So — and Austin, we had the ice storm here recently as well, another 400,000 homes that were without power there. So power outages and the concern on power outage is front and center for homeowners. So we’re seeing that come through in our sales lead volume. We’re also seeing, as part of our metrics here and what we’re — the assumptions that we’re making to answer your question, we’re assuming a higher close rate. Why are we assuming that because we’re seeing that. And we’re coming off of kind of the lows. We’re about 20% higher on close rates today than we were a year ago, which is really encouraging. Now they’re not back to pre-pandemic levels yet, but they’re improving, that’s the opportunity. So we see improving close rates. We see higher sales lead volume.

We’ve got the distribution adds. This is another really important part of the story. I mean we added 500 new dealers on a net basis in the second half of the year. This is how — we’ve always talked about this business kind of being a step function grower and we have these periods of elevated growth and then things kind of level off and you kind of come down off the peaks, and you level off into what we refer to and have referred to historically as a new and higher baseline level of demand. And that’s really what we’re targeting in the second half of the year is that normalization, if you will, of that baseline demand, right, the presentation of that and then the field inventories, that destocking process being completed here by the first half of the year.

So you put all that together and package it up and then obviously you surround all that with continued strength in our C&I business, which has been great. We probably don’t talk enough about that, but a fantastic property that we’ve built over the last 15 years here that’s been a great way to help us diversify this business and has given us exposure to some awesome megatrends around telecom and some of the infrastructure rebuild type of efforts that are going on, not only domestically here but globally. So we put all of that together and that’s what really gives us confidence in kind of this first half, second half story.