Tennant Company
Q2 2017 Earnings Call Transcript

Published: 2 Aug 2017

[Operator:]

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

[Tom Paulson:]

Thanks, Dan. Good morning, everyone, and welcome to Tennant Company’s second quarter 2017 earnings conference call. I’m Tom Paulson, Senior Vice President and Chief Financial Officer of Tennant Company. Joining me today are Chris Killingstad, Tennant’s President and CEO; Karen Durant, Vice President and Controller; Jim Stoffel, Vice President of Global Planning and Analysis; and Tom Stueve, Vice President and Treasurer. Today, we will review progress on our core strategies, Tennant’s performance during the 2017 second quarter, and our outlook for the full-year. First, Chris will brief you on our operations and then I will cover the financials. After that, we will open up for questions. We are using slides to accompany this conference call. We hope this makes it easier for you to review our results. A taped replay of this conference call along with these slides will be available on our Investor Relations website at investors.tennantco.com for approximately three months after this call. Now, before we begin, please be advised, our remarks this morning and our answers to questions may contain forward-looking statements regarding the Company’s expectations of future performance. Such statements are subject to risks and uncertainties, and our actual results may differ materially from those contained in the statements. These risks and uncertainties are described in today’s news release and the documents we file with the Securities and Exchange Commission. We encourage you to review those documents, particularly our Safe Harbor statement, for a description of the risks and uncertainties that may affect our results. Additionally, on this conference call, we will discuss non-GAAP measures that include or exclude special or non-recurring items. For each non-GAAP measure, we’ll also provide the most directly comparable GAAP measure. There were special non-GAAP items in the second quarter and first half of 2017. There were no special non-GAAP items in 2016. Our 2017 second quarter earnings release includes a reconciliation of these non-GAAP measures to our GAAP results for 2017 second quarter. Our earnings release was issued this morning via Business Wire and is also posted on our Investor Relations website. At this point, I’ll turn the call over to Chris.

[Chris Killingstad:]

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

[Tom Paulson:]

Thanks, Chris. In my comments today, references to earnings per share are on a fully diluted basis, except for the 2017 second quarter and the first half of 2017, which were calculated with the basic weighted average shares outstanding due to the as reported net loss. Note that our financial results for the 2017 second quarter included the financial performance of IPC Group, which was acquired at the beginning of April 2017. For the second quarter ended June 30, 2017, Tennant’s reported net sales of $270.8 million increased 24.9% compared to sales of $216.8 million in the 2016 second quarter. Excluding an unfavorable foreign currency exchange impact of about 1% and the impact of the August 2016 Florock acquisition and the April 2017 IPC acquisition that increased net sales by 28.2%, organic sales decreased approximately 2.3%. The second quarter 2017 net loss was $2.6 million or a loss of $0.15 per share. Tennant reported adjusted net earnings of $10.6 million or $0.60 per share. As adjusted results in the 2017 second quarter excluded four special items that totaled the charges of $17.3 million pretax or a loss of $0.75 per share. The special items were, $4.7 million pretax or $0.27 per share for acquisition cost related to the IPC acquisition, $6.2 million pretax or $0.22 per share for IPC acquisition-related financing cost, $6.2 million pretax or $0.25 per share for the IPC acquisition-related inventory step-up flow-through, and $0.2 million pretax or $0.01 per share related to a pension plan settlement charge. In the year ago quarter, Tennant reported net earnings of $15.3 million or $0.85 per share. Turning now to a more detailed review of the 2017 second quarter. Our sales are categorized into three geographic regions which are the Americas, which encompasses all of North America and Latin America; EMEA, which covers Europe, the Middle East and Africa; and lastly Asia-Pacific, which includes China and other Asian markets, Japan and Australia. In the Americas, 2017 second quarter sales increased 3.2% but declined 2.8% organically, excluding the 6% impact of the Florock and IPC acquisitions. The foreign currency exchange impact was essentially flat versus the prior year. Sales in the Americas reflected the challenging year-over-year comparison due to the record level of sales in the 2016 second quarter. In the 2017 second quarter, organic sales declined; however, demand for new products, particularly the M17 sweeper-scrubber effectively impacted sales. Organic sales growth in Latin America also declined in the 2017 second quarter. However, we continue to have strong sales growth in Mexico. In September of 2016, we acquired our longtime distributor in Mexico. However, the incremental revenue impact is not material. This is an important emerging market for us and we remain confident about the long-term growth prospects. In EMEA, sales in the 2017 second quarter increased 124.9% but decreased approximately 4.8% organically, excluding an unfavorable foreign currency impact of about 3.5% and the impact of the IPC acquisition of 133.2%. Solid sales performance in the Central Eastern Europe, Middle East and Africa markets through our master distributor for that area, was more than offset by declines in the other countries. EMEA had a difficult year-over-year comparison due to lapping organic sales of 8.3% in the prior year quarter. Remember also that EMEA’s organic sales in the 2017 first quarter increased approximately 14.3%, excluding an unfavorable foreign currency impact of about 5.5% and the impact of the Green Machines divestures of 0.5%. In Asia-Pacific region, sales increased 30.7% and increased 3.1% organically, excluding an unfavorable foreign currency impact of about 2% and the impact of the IPC acquisition of 29.6%. Robust sales growth in China and Southeast Asia were partially offset sales declines in Australia and Japan. Tennant’s gross margin in the 2017 second quarter was 38.6% and the as adjusted gross margin excluding the $6.2 million IPC acquisition related inventory step-up flow-through was 40.9% compared to 43.9% in the prior year quarter. The as adjusted 300 basis-point decrease primarily reflects the continued field service productivity challenges related to the organizational changes from the restructuring and near-term unfavorable impact from investments in manufacturing and automation initiatives and raw material cost inflation. As Chris mentioned, these factors are controllable, and we’re committed to improving our gross margins. We expect a slow recovery throughout the back half of 2017 but we’ll likely be below our target gross margin range of 42% to 43% for the balance of the year, which is why we lowered our 2017 full year gross margin guidance to the range of 41% to 42%. We anticipate getting back to our target gross margin range for 2018. Research and development expense in the 2017 second quarter totaled $7.9 million or 2.9% of sales versus $8.4 million or 3.9% of sales in the prior year quarter. We continue to invest in developing a robust pipeline of innovative new products and technologies, which Chris noted. Selling and administrative expenses in 2017 second quarter was $87.5 million or 32.3% of sales, and as adjusted was $82.6 million or 30.5% of sales. S&A in the second quarter of 2016 was $64.3 million or 29.6% of sales. The 2017 second quarter S&A expense as adjusted was 90 basis points higher compared to the prior year quarter. However, on a dollar basis, spending for Tennant excluding IPC only increased 1%. We continue to balance disciplined spend control with investments in key growth initiatives. Our 2017 second quarter operating profit was $9.2 million or 3.4% of sales, and the operating profit as adjusted to exclude the IPC acquisition related inventory step-up flow-through and cost of goods sold and the one-time acquisition costs and pension plan settlement charge and S&A expense was an operating profit of $20.2 million or 7.5% of sales. Operating profit in the prior quarter was $22.6 million or 10.4% of sales. As we mentioned last quarter, we are now providing an EBITDA calculation on our non-GAAP financial tables. Our 2017’s second quarter adjusted EBITDA was $29.8 million or 11% of sales. Adjusted EBITDA in the prior year quarter was $27.4 million or 12.6% of sales. For the 2017 first half, adjusted EBITDA was $42.8 million or 9.3% of sales; adjusted EBITDA for the prior year first half was $38.5 million or 9.7% of sales. We do not typically discuss other expense net. However, in the 2017 second quarter, we did have a $6.1 million in interest expense and $0.1 million in net foreign currency transaction losses for one-time financing costs related to the IPC acquisition. This reflects the write-off of debt issuance cost related to $300 million term loan A under our senior secured credit facilities, which was paid off in full, primarily the net proceeds from the $300 million senior notes. We remain committed to our goal of 12% or higher operating profit margin by successfully executing our strategic priorities and assuming the global economy improves. In order to achieve this target, we need to drive organic revenue growth in the mid-to-high single digits, hold fixed costs essentially flat in our manufacturing areas as volume rises, strive for zero net inflation at the gross profit line, and standardize and simplify processes globally to continue to improve the scalability of our business model while minimizing any increases in our operating expenses. We continue to successfully execute our tax strategies. Tennant’s overall effective tax rate for the 2016 full year was 29.9%. The overall effective tax rate for the 2017 first half was 28.7%, excluding the special items. The base tax rate for the 2017 first half was 33.6%, which excludes the special items and the routine discrete tax items. Turning now to the balance sheet which now includes the IPC acquisition. Net receivables at the end of the 2017 second quarter was $199.9 million versus $154.6 million a year earlier. Quarterly average accounts receivable days outstanding for Tennant including IPC was 63 days for the second quarter compared to 60 days in the prior year quarter. Inventories at the end of the 2017 second quarter were $141.6 million versus $82.5 million a year earlier. Quarterly average FIFO days inventory on hand including IPC were 98 days for the 2017 second quarter compared to 86 in the year ago quarter. Capital expenditures totaled $9.2 million in the 2017 first half that is $5.6 million lower than $14.8 million in the prior year first half and reflects our continued planned investments in information technology projects, tooling related to new product development and manufacturing equipment. Tennant’s cash from operations totaled a negative $2.5 million in the 2017 first half compared to a positive $12.4 million in the prior year first half. Cash and cash equivalents totaled $53.3 million at the end of the 2017 second quarter, versus $27.9 million at the end of the prior year quarter. Total debt was $411 million, up from $21.2 million at the end of the prior year quarter, chiefly due to incurring long-term debt related to our fall 2016 acquisitions and the IPC acquisition that occurred in April 20170. Our debt to capital ratio was 59.1% at the end of the [2017] second quarter compared to 7.5% a year ago. Regarding other aspects of our capital structure. Tennant increased the quarterly dividend to $0.21 per share, effective December 2016. We paid cash dividends of $14.3 million in the 2016 full year and $7.5 million in the 2017 first half. Reflecting our commitment to shareholder return, we’re proud to say that Tennant has increased the annual cash dividend payout for 45 consecutive years. Regarding our recent financing activities on April 5, 2017, we filed an 8-K for a new $600 million senior secured credit facility with JP Morgan. On April 7, 2017, we announced the offering of $300 million of senior unsecured notes due 2025. The senior notes offering was priced at 5.625% and the closing occurred on April 18th. At the end of the 2017 second quarter, we had $411 million of debt, which was comprised of $300 million of senior unsecured notes, $98 million outstanding of $100 million term loan, $20 million outstanding under the revolving credit facility and an offsetting $7 million of debt issuance cost yet to be amortized. The overall weighted average cost of debt net of related costs currency swap instrument is approximately 4.2%. Moving to our outlook for the full year 2017. As Chris stated, the global macroeconomic environment still merits caution. We’re optimistic about our sales momentum as we head into the second half of 2017. However, it will be difficult to improve the field service and manufacturing challenges fast enough to offset the unfavorable variances we had in the first half of 2017. Therefore, we are reaffirming our full year sales guidance range and lowering our full year earnings guidance. We continue to estimate 2017 full year net sales in the range of $960 million to $990 million, up 18.7% to 22.4% or up approximately 1% to 3% organically, assuming an unfavorable foreign currency exchange impact on sales of approximately 1% and additional 0.8% inorganic growth from the August 2016 Florock acquisition, and inorganic growth from the April 2017 IPC acquisition in the range of 18.6% to 20.4%. We now expect 2017 full year reported earnings in the range of $0.85 to a $1.05 per share, which includes the first quarter restructuring charge, one-time acquisition and financing costs related to IPC Group acquisition, the impact on earnings from the preliminary estimate of IPC’s acquisition-related inventory step-up flow-through, a pension plan settlement charge and the interest expense from the IPC acquisition-related financing. Previously, we expected 2017 full year reported earnings in the range of $1.05 to a $125 per share. We now expect 2017 full year adjusted earnings in the range of $2.20 to $2.40 per share. Previously, we expected 2017 full year adjusted earnings in the range of $2.40 to $2.60 per share. The 2017 full year adjusted earnings excludes the following non-recurring costs totaling $31.4 million pretax or $1.36 per share, $8 million restructuring charge recorded in the first quarter in S&A expense; $7.6 million IPC acquisition cost, $2.9 million recorded in the 2017 first quarter and $4.7 million recorded in the 2017 second quarter in S&A expense; $7.4 million IPC related financing costs, $1.2 million recorded in the 2017 first quarter and $6.2 million recorded in the 2017 second quarter and other expense net; $8.2 million IPC acquisition inventory step-up, $6.2 million recorded in the 2017 second quarter in cost of sales; $0.2 million pension settlement charge recorded in the 2017 second quarter in S&A expense. Foreign currency exchange in 2017 is estimated to negatively impact operating profit by approximately $2.5 million or a negative impact of approximately $0.10 per share. On as adjusted and constant currency basis, assuming no change in foreign currency exchange rates from the prior year, 2017 full earnings are now estimated to be in the range of $2.30 to $2.50 per share. Previously, we expected 2017 full year earnings on as adjusted and constant currency basis in the range of $2.50 to $2.70 per share. The revised 2017 full year earnings guidance still anticipates an as adjusted 2017 dilution from the IPC acquisition of $0.10 per share. For the 2016, full year earnings per share totaled $2.59 on net sales of $808.6 million. Our 2017 annual financial outlook includes the following additional assumptions

[Operator:]

[Operator Instructions] Our first question comes from the line of Joe Maxa with Dougherty & Company. Please go ahead.

[Joe Maxa:]

Thank you. Good morning.

[Tom Paulson:]

Good morning, Joe.

[Joe Maxa:]

I wanted to ask to dig in a little bit more to the field service and manufacturing inefficiencies, going to last through the rest of this year and start to improve, I suppose as the year progresses and into Q1. Want to get a little more -- can you just maybe give a little more color on what you’re seeing there and what you need to do to improve it?

[Chris Killingstad:]

This is Chris and I’ll start with the service productivity issue. The thing is that -- one of the things that we’ve realized is that the marketplace is changing and customer base is segmented than it was between industrial and commercial equipment and the offerings that are required to satisfy our customers. So, we’ve come out of our service from an industrial perceptive. Historically, we have increasingly been on establishing a commercial service offering but it really it’s only in the last year that we’ve really taken that on seriously. As part of the restricting, it was to differentiate the two offerings, we need different skill sets for industrial and for commercial. The second thing we did was that -- our customer expectations are increasing and so we evaluated the skill set needed at the ground level, our field service technicians, we have a long tenured service organization and we needed to upgrade that. So, we took care of some of that in the restructuring. We’ve also upped the ante, in terms of what we are requiring from them. We have put GPS in their trucks. So, we’re tracking them; they’re reporting requirements on a daily basis; have become more onerous, I think from their perspective. And so, as we were trying to fill our open trucks from the restructuring, we were finding that some of the long tenured service techs found the new way of doing business was not something they wanted to take part in. And so, we struggled because the attrition that we hadn’t anticipated was offsetting the filling of the service trucks. The other thing we did is that we needed to actually completely reorganize our field service organization from frontline supervisor ranks all the way up to the regional ranks to take care of the way we were going to operate in the future. All of that happened in the second quarter. And as I said, we had unexpected challenges, especially with the attrition, so we didn’t make progress on filling the trucks as quickly as we had anticipated. The good news now is that the supervisor management organization is fully in place, the attrition is pretty much done with and we are making progress in filling the open trucks, and we expect to make progress in terms of both sales -- service sales and service efficiency going forward. The thing is, we don’t know exactly how long it is going to take. And so, we have been prudent in saying that it could take through the end of this year and into really next year. And then, on the manufacturing automation. The good news with all of these initiatives, Joe, is that they’re all performance-enhancing initiatives. You can argue that maybe we took on a little bit too much at the same time with the acquisition of IPC, with the automation initiatives, with restructuring and the service organization. And I think we’ve learned from that but they’re all performance-enhancing initiatives. And on the automation front in our factories, we’ve said to you often that we struggle to find qualified labor in key parts of our factories, so automating functions like welding in our plants. So, one of these issues we had and so we put in two state-of-the-art robotic welding machines, that when up and running at 100%, are going to be fantastic. But, we had some startup issues with those. So, it influenced our ability to push through the parts from fabrication to the assembly lines and therefore left us with the part shortages. The other thing we’ve done is we realized that we need to automate our material flow and factor, and warehouse processes. So, we’ve put in automated warehouse management system and had some hiccups with that in the early going, which both caused some additional cost in the second quarter and also in Europe, it prevented us from getting some volume out the door. The good news with the volume is that that will show up in the third quarter. On that front, we think the worse is also behind us; things have stabilized and we’re going to see improvement. We just don’t know how quickly we can get after it, which is why we’re hopefully being conservative.

[Tom Paulson:]

I’ll just add a really small amount of additional color. About 60% or so of the unfavorableness versus prior year was the service inefficiency related. The next component that mattered the most was the efficiencies in the factory and the least relevant was inflation. And while we’re still concerned about inflation because it is -- there is some risk involved, relative to prior year was the difference where last year we saw basically flat inflation and reasonable pricing. This year, we had more pricing. And we think we are adequately pricing to cover it, but we’re still going to be monitoring that closely the balance of the year.

[Joe Maxa:]

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

[Chris Killingstad:]

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

[Joe Maxa:]

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

[Tom Paulson:]

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

[Chris Killingstad:]

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

[Joe Maxa:]

Actually just one more quickly on the sales synergies with the acquisition. Do you have any initial progress to report on any type of sales you’ve seen between the two companies or what maybe are your initial steps?

[Chris Killingstad:]

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

[Operator:]

Your next question comes from the line of Bhupender Bohra with Jefferies. Please go ahead.

[Bhupender Bohra:]

A question on the service technician side here. In your peppered remarks, I think you mentioned about historically your service technicians have been have been aligned more so on the industrial side of the business and last year, you took a step-up to build on the commercial side of the business. Can you explain where you are? Was that like -- were you too quick or too fast to build on the commercial side that’s what led to this issue in the quarter? If you can just give us some color from industrial…

[Chris Killingstad:]

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

[Tom Paulson:]

We really believe in the strategies we’re executing; if we could do it again, we’d go slower.

[Chris Killingstad:]

Yes.

[Bhupender Bohra:]

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

[Tom Paulson:]

Couple of things are driving that, Bhupender. I mean, one is, we think we did manage to not disrupt customer facing things that we do. We did not shift some stuff that we intended but we think we still satisfy -- we will satisfy customer needs. The other thing that’s different than we saw in -- and after a good Q1 is, we didn’t like the order patterns we were seeing in April and we commented on that on our last conference call. And unfortunately, we didn’t make up a hold that we started to create in April, 8given the expectations. The beginning of this quarter is far different. I mean, our order patterns are stronger, they’re more consistent. We entered the quarter with a reasonable amount of open orders, and importantly, our pipeline is stronger. So, we have lots of reasons to have more confidence. We still think we’re being prudent, but we feel much better about the revenue side of things. And very importantly, we don’t believe we disrupted customers. We did a lot of disrupting to ourselves. But we think we managed to keep customers as happy as we could.

[Bhupender Bohra:]

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

[Tom Paulson:]

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

[Bhupender Bohra:]

Okay. If I can, one more here. If you look at the operating margin, right, 300 basis points down year-over-year. What’s the biggest bucket here, like the service technician issue is? I mean, you mentioned that was like 80% of the whole thing…

[Tom Paulson:]

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

[Operator:]

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

[Chris Moore:]

Maybe we could just stay with the sales momentum a little bit, coming into Q3. So, it sounds like the order patterns coming into Q3 were positive. Historically, it seems like the last six weeks of Q3 or kind of what’s key and I’m trying to understand how the two match up. Is that back of Q3 still the critical point or some order slowed early this quarter or how…

[Tom Paulson:]

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

[Chris Killingstad:]

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

[Chris Moore:]

Thank you. IPC organic growth was quite strong. It’s just -- it’s the mid-tier pricing that they are focused on -- that’s the difference in terms of the organic growth or lack of it, Tennant versus where you have seen at IPC and does that carry forward you think?

[Tom Paulson:]

We’re not really -- we’re certainly not ready to say that. We think there is a time and a place where both of the brands, and both of the kind of customers that we are going after, we would just say -- and we’re certainly not going to commit that IPC is going grow at 8% organically every quarter…

[Chris Moore:]

No, just on a relative basis.

[Tom Paulson:]

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

[Chris Killingstad:]

And you’ve got to remember that IPC, really it’s only in the last two, maybe two-and-half years that they have started to improve their performance. They were coming off a pretty well base. And they have had 12 straight quarters of organic sales growth. But it’s really those 12 quarters, maybe few quarters before that that are important to their recovery. And one of the reasons, we were so interested in buying them because we thought that momentum was sustainable.

[Tom Paulson:]

We certainly don’t want to diminish our importance. We feel more excited than we’ve ever been after a quarter like we had, obviously.

[Operator:]

[Operator Instructions] Your next question comes from the line of Marco Rodriguez with Stonegate Capital. Please go ahead.

[Marco Rodriguez:]

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

[Tom Paulson:]

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

[Marco Rodriguez:]

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

[Chris Killingstad:]

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

[Marco Rodriguez:]

And if I heard you correct, I just wanted to confirm something again on the service inefficiencies that you guys saw in the quarter. I know you guys called that out last quarter as well, but it sounded like this what caught you guys buy surprise was just the attrition levels from I guess trying to meet these new standards. One, did I hear that and understand that correctly? And then number two, it sounds like from your prepared remarks and answers to questions that you sound pretty confident that that is behind you and we shouldn’t see those types of issues going forward, is that correct?

[Chris Killingstad:]

Yes and yes. And there is the only other factor that we didn’t quite anticipate was because we had higher attrition, we had to hire more new people and therefore we had a productivity challenge, as we ramp these people up to levels that we expect them to operate at. And this takes -- it can take up to six months. So, our assumptions was we’d have a smaller pole of new people that we had to train and get up to speed; we actually had a much larger pool because of the attrition. So that was the other factor playing into the performance in the second quarter.

[Marco Rodriguez:]

And the last quick question here just on SG&A and R&D. The numbers came in a bit different than what we had modeled, SG&A fair amount higher and R&D a little bit lower. And I think I’m noticing here that the R&D guidance has also kind of changed a bit. Was there like a shift in expense allocations between R&D to SG&A or this a new spend level for R&D, any sort of color there?

[Tom Paulson:]

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

[Marco Rodriguez:]

SG&A?

[Tom Paulson:]

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

[Operator:]

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

[Chris Killingstad:]

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

[Operator:]

I think we have next question joining the queue, it comes from the line of Bhupender Bohra with Jefferies. Please go ahead.

[Bhupender Bohra:]

Hey, just a question. I don’t know if you have time here on the end markets here. Tom, if you can give us the cadence the orders growth in the quarter? You said that April was pretty bad. When we go into like -- how did the quarter end actually in terms of the orders growth and…

[Tom Paulson:]

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

[Bhupender Bohra:]

Okay. And from end market perspective anything which you thought to run kind of stronger or anything weaker…

[Tom Paulson:]

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

[Operator:]

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

[Chris Killingstad:]

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

[Operator:]

Thank you to everyone for attending today. This will conclude today’s conference call. And you may now disconnect.