Norm Asbjornson - Chief Executive Officer Scott Asbjornson - Chief Financial Officer, Vice President of Finance Gary Fields - President.

Joe Mondillo - Sidoti.

Good afternoon, ladies and gentlemen, welcome to the AAON Incorporated Second Quarter Sales and Earnings Report Conference Call. There will be a question-and-answer period after management's brief presentation. This call will last approximately 45 minutes to an hour. I'd now like to turn the meeting over to Mr. Asbjornson. Please go ahead, Mr.

Asbjornson..

Good afternoon. Norman Asbjornson here, I'm hosting this thing. Before we go forward, I would like to read the forward-looking disclaimer.

To the extent any statement presented herein deals with the information that is not historical, including the outlook for the reminder of the year, such statement is necessarily forward-looking and made pursuant to the Safe Harbor provisions of the Securities Litigation Reform Act of 1995.

As such, it is subject to the occurrence of many events outside AAON's control that could cause AAON's results to differ materially from those anticipated. Please see the Risk Factors contained in our most recent SEC filings, including the Annual Report on Form 10-K and the Quarterly Report on Form 10-Q. Thank you. I'd like to introduce our CFO, Mr.

Scott Asbjornson..

Welcome to our conference call. I would like to begin by discussing the competitive results of the three months ended June 30, 2017 to June 30, 2016. Net sales were down 1% to $101.3 million from $102.3 million, sales decreased primarily due to changes in product mix despite increased volume.

Our gross profit decreased 3.3% to $31.7 million from $32.7 million. As a percentage of sales gross profit was 31.3% in the quarter just ended compared to 32.0% in 2016. The decrease in gross profit is primarily due to increased raw material prices.

Selling, general and administrative expenses increased 13.4% to $12.0 million from $10.6 million in 2016. As a percentage of sales SG&A increased to 11.8% of total sales in the quarter just ended from 10.3% in 2016. The overall increase from SG&A was primarily due to increased warranty expenses.

The company has been working on modifications and refinements to its warranty policy. These modifications more clearly define what qualifies as warranty claim and puts a deadline for when claims maybe submitted. This has increased our warranty reserve and increased our warranty expense for the three months ended June 30, 2017.

Income from operations decreased to 11.4% to $19.7 million or 19.4% of sales from $22.2 million or 21.7% of sales. Our effective tax rate decreased to 30.2% from 33.9%, the company's estimated annual 2017 effective tax rate excluding discrete events is expected to be approximately 36.0%.

The difference between our expected effective rate and our actual effective rate is due to excess tax benefits from stock compensation. For the three months ended June 30, 2017 and 2016, the company recorded $1 million and $0.4 million respectively in excess tax benefits as an income tax benefit.

Net income decreased to $13.8 million or 13.6% of sales compared to $14.7 million or 14.4% of sales in 2016 and diluted earnings per share decreased by 3.7% to $0.26 per share from $0.27 per share. Diluted earnings per share were based on 53,151,000 shares versus 53,575,000 shares in the same quarter a year ago.

The results of the six months ended June 30, 2017 to June 30, 2016. Net sales were down 0.2% to $187.4 million from $187.7 million, sales decreased primarily due to changes in product mix to smaller and less expensive units. Our gross profit decreased 3.1% to $56.7 million from $58.5 million.

As a percentage of sales gross profit was 30.2% in the six months just ended compared to 31.1% in 2016. The decrease in gross profit is primarily due to increased raw material prices. Selling, general and administrative expenses increased 15.5% to $22.5 million from $19.5 million in 2016.

As a percentage of sales SG&A increased to 12.0% of total sales in the six months just ended from 10.4% in 2016. The overall increase in SG&A was primarily due to increased warranty expenses we mentioned earlier. Income from operations decreased 12.6% to $34.1 million or 18.2% of sales from $39.0 million or 20.8% of sales.

Our effective tax rate decreased to 30.0% from 33.1%. The company's estimated annual 2017 effective tax rate excluding discrete events is expected to be approximately 36.0%. For the six months ended June 30, 2017 and 2016, the company recorded $2.0 million and $1.1 million respectively in excess tax benefits as an income tax benefit.

Net income decreased to $24.0 million or 12.8% of sales compared to $26.3 million or 14.0% of sales in 2016. Diluted earnings per share decreased by 4.3% to $0.45 per share from $0.47 per share. Diluted earnings per share were based on 53,176,000 shares versus 53,564,000 shares in the same period a year ago.

Looking at the balance sheet, we will see that we had a working capital balance of $104.5 million versus $101.9 million at December 31, 2016. Cash and investments totaled $51.8 million at June 30, 2017. Investments have maturities ranging from 1 month to 12 months. Our current ratio is approximately 2.9 to 1.

Our capital expenditures were $16.8 million, we originally expected capital expenditures for the year to be approximately $42 million, but have now raised it to $48.5 million to accelerate acquisition of sheet metal equipment.

The company had stock repurchases of $10.4 million year-to-date, shareholders equity per diluted shares that was $0.09 at June 30, 2017 compared to $3.85 at 31, 2016. We continue to remain debt free.

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

Good afternoon. While net sales were down 1% in the quarter, sales decreased due to changes in product mix despite the increased volume, potential on the water-source heat pump has come along a bit slower than what we had originally forecast due to getting some industry certifications completed.

We are well on our way to those completions into two step process, the first step is completed, the second step is in process now and it is imminent. So, the water-source heat pump is, this is probably running a few weeks behind the schedule that we originally intended.

So, the [indiscernible] business in the various market segments, replacement markets versus new construction, we find the ratios remaining very similar to what they were in the first quarter and we do quite a lot of replacement business in the K-12 markets at this time of the year and that's been very strong for us.

Commercial and retail, we don't have very much retail penetration with our products; we do have some in the commercial market that's reasonably noteworthy. Office buildings remain steady as they were in the first quarter. Medical and the healthcare have both picked up a bit for us in recent months.

The good thing about that is, as medical and healthcare tends to use our larger tonnage units, so we should see a bit of a shift back towards a few more larger tonnage unit. Education primarily K-12 that's what's been responsible for the smaller units.

They tend to run in the smaller end of our scale with high number of quantity of units but low dollars per unit comparatively. We still got probably two more months of very heavy production of the K-12 market. Manufacturing has been steady, lodging has been steady, municipalities have been steady as well.

A couple of areas that we would categorize as much smaller more unique niche markets have been what we call mission critical, some may know as them like data centers and this sort of market. We've made some significant in-roads on that with some of our products.

The encouraging thing is the backlog at June 30, 2017 was $83.5 million that's up from $69.3 million at the same point a year ago.

So, we have the orders in the door and they are in processing and with some of the management changes we have had in the manufacturing, the personnel changes that transition has moved along quite well, and Norm will speak to that a bit more here. So, I'm going to turn it over to Norm..

Okay. For the remainder of 2017, first of all, I kind of should summarize a little bit what has been occurring within AAON. We've had an enormous amount of things on the table to be managed and one of the things is management change over.

There were a lot of us my age that were getting toward the end of our career and some of those people decided to leave us this past year.

These were very critical people within our organization, the head of our manufacturing a gentleman, who is 76 years old and have an excess of 40 years experience about 30 of which [indiscernible] and 30 of which was here.

Stayed on from last summer when he wanted to retire until March of this year, simply because of the number of management challenges we had around here with all the things we got on our plate to get change and all the changes we were doing. So, he left in March.

Another gentleman who began to expect to leave quite so soon was a 58-year-old gentleman who was our shop floor supervisor, managed the people on the factory floor in our Tulsa facility for many years and he had somewhere around 30 years of experience doing that.

He told us last fall -- late fall, that he wanted to retire, we asked him to likewise stay around and he stayed till March both of them are big fishermen and I think that played a little and what they talk they should do.

At any rate that we bought on our new set of people to run the overall management, market or the manufacturing as well as the operation on a day-to-day basis at the floor level. These we made quite a significant shift.

The one gentleman drops down into low 30s age wise and with limited amount of time he is beneficiary of having an engineering education and conjunction with masters in business administration, very smart, very ambitious, very capable person, but he doesn't have a lot of years of experience.

So, this being a very complicated company to run and manufacturing problem similar to a lot of others. There is a lot that isn't quite so apparent that for somebody to pass it off to the new generation, things that just happen sort of there is a matter of fact and the person doesn't even realized to making those decisions.

But, when new person takes over, they suddenly find there is some more decisions been made rather than all that they talked. And that result as you lose a little of efficiency in your management. A similar thing happened to us in the floor manager position, a similar educational thing; engineer with a Masters in Business Administration took over.

Again, very, very capable individual very much able to do it but again short on industry experience. So, with those two things combined you can see we had some difficulty in managing our personnel, and we further complicated this by the fact that if you can recall back to the fourth quarter of last year.

We had kind of a slowdown in our order input in the fourth quarter, which resulted in a somewhat lower backlog when we came into the year.

And therefore, had an effect on our first quarter and to compensate for that when people left some of them were good people left for whatever reason, but then when we got two of the people who were leaving we decided we were going to take out some of the low performers and we did that also at -- just our personnel to out business in the first quarter.

Then, business started picking up in the first quarter, well, in the end of the fourth quarter right in that area and when they came back up by the end of February that we were back in the market and starting to replace people.

Well, we have been replacing people on a serious basis ever since but we were running at about 4% unemployment here in Tulsa, you don't have a lot of good people to select from. And we have been trying to pay to our personnel and so -- it's been a slow and torturous path for us to get the type of people we want as fast as we could.

And to manage them with two new managers, so altogether it slowed down our growth. So, what happens, we don't make the volume and we have a significant increase in our backlog. That was all okay in it for a long time and then we were starting to get the backlog too high and thereby affect our customers who want it structured.

We have the life disappoint you have for the past few couple of weeks and been at that point when they warrant more -- they wanted that a little faster. So, we are encumbered by not being able to ship by the customers all want their products. So, the burden is on our back to get it out the door.

Well, the latter part of this quarter, our new personnel started coming into their own pretty well as we always did the management of the new personnel.

So, the last couple of weeks we had quite good production, but that wasn't sufficient to pick-up the whole quarter and consequently we came out as we came out and we were running really strong now and anticipate running strong for the rest of this quarter.

So, it was necessary change in personnel just like the end of Gary Fields was necessary change we've had a huge reduction in the age level of the management of the company which is very positive thing going forward and that we no longer encumbered by a lot of people my age being in command around here, it's now been taken over by much younger generation, very capable generation.

I admire what they are doing, I'm still around, helping where I can and advising where I can and I'm just very pleased with what's going on here management wise.

So, we haven't [indiscernible] we had a little softening of management, while the transition was underway but it's head into I believe even stronger management than we have had in the past including myself, I will throw myself into that loop too. I think Gary is trying to do things that I was not able to do.

So, I think the management situation is outstanding, I think we got a little bump here. I think things are coming along well in all of that. Now, one thing that we have been talking about that needs a little further amplification is the water-source heat pump.

Those of you, who have been around realized that it was in August of 2015 that we decided finally to go into the water-source heat pump, but business wide we're building our own product.

We played with purchasing three different companies before that over a few years timeframe before the 15, August before 2015 and shows that that was a good -- we were going to have pay too much and we were going to get some [indiscernible] product and we are going to get at for the manufacturing facilities.

And we decided we can improve in all of that we can cost the company less money. We could get very current up-to-date product and we can get a very current up-to-date technical manufacturing. Now, let's talk about that a little bit. The water-source heat pumps products that we designed and had been widely received very well.

And there is an industry newspaper that is called Air Conditioning news that as a contest on -- all the different products that are manufactured in our industry, different types of products and they categorize them by different categories.

And they put the money -- and total 81 different entrances in floors and I'm not a contractual issuer how many categorizes but then remember categories. The category that we won in two different categories but the one I'm going to talk about right now is the water-source heat pump.

The water-source heat pump data [is like gold] [ph] and there are some gold, there is silver, there is a bronze for the first, second and third so to speak. We got to go with water-source speed pump.

How does that happen? Well, it happens judged by the information we put out there as to what the product is, but since all leased products that are out there are pretty new products and therefore don't have a lot of history. That is not -- they can't be judged on history because the people building on and probably haven't seen or used some of them.

So, what they do is they survey the various people who are holding on it which is all the basic, the most part it's a contracting trade doing mechanical work in the industry [Technical Difficulty] contractors dominated. And what they do is respond if they have any thoughts as to what -- when the product should win.

Again, they choose one of those responses and they published that along with these entrants so that the other people have the advantage of seeing what one of the recipients of the product have to say about the product.

The gentlemen who choose to do that for us was, the northeastern part of the United States, rather small state up there and he [send certain things] [ph] saying that he did renovation on a office building, purchased approximately 1/3rd of the unites that were in the building and put new units into that.

And here is a primary thing that he thought was the outstanding feature was one that we weren't even pushing that hard. We were pushing the feature, but not that hard. The feature they choose to say was -- reason that he choose to buy the product was because of its weight. We built the unit out of aluminum.

We used aluminum in one of the heavy products which is the evaporator coil and we have a significant weight advantage over our competition and pushing these units up into the ceiling in a replacement job, is a little bit of problem that you can well imagine.

So, he bought it based upon the weight and the savings he would incur by having it lightweight. So, that was a nice thing that we heard that because we thought there were lot of reasons for them buying, that it was stronger and weight, but he choose to say the weight.

So, the units been well received, so why are we selling more, why isn't it making a big impact on our P&L statement. As was mentioned by Gary, we are waiting for AHRI certification, now, what is that? That's a certification as to the efficiency of the unit.

And we had anticipated being further along and doing that faster, but in order to get that done, you have to submit all the electronic information of course the capacity and the unit under varying conditions, you have to submit a whole lot of information and then after you done that. So, you have tied down all loose ends.

You tell what kind of a compression you are using, every compound added. And you have all this multitude of different units to do. Well, as we had noted before we had $16 million worth of sales last year in larger tonnage equipment which were already in our ball steel things that we were already doing.

And these small units we are bringing in, while they were dominant volume makers in the industry, we still had $16 million of that. Well, it all happens -- we didn't have to have that weight before once we wanted to register the small tied sheets, we had to also include those which were within the realm of registering on the bigger tonnage.

So, we had to not only get the 2 to 5 ton of built, we are introducing right now but we had to get all the other products out of that $16 million which were applicable. So, it was a formidable challenge we hadn't anticipated having quite as much work to do and we had a little more time to do it.

And then, we are at the mercy of the industry, AHRI to move the ball forward because we turn it over and that goes into the court. They didn't respond real fast, tell us what the money was and what units they wanted to check and find out how they work and verify what we said in our literature was correct.

And finally, they gave us that a little over week ago and they gave us 30 days to prepare all that equipment. They come in then and we had to have multiples every product they ask for and they check what they take one out of each of the three of the things that we have to build for every sites and they cashed it.

So, we are still in that process of it. We anticipate but of course a lot of this dependent on our fast age, our moons on the testing; somewhere between 50 and 90 days from now we should have our certification. As you might suspect over competition are making a very big thing out of the fact that we don't have certified energy efficiencies.

So that has been somewhat of an incumbent. The other thing is that about half of our sales force already has a product line. And so, they have the choice of either staying with the product line or we going with that.

We have been given a chance by the vast majority of them if they are going to go with us, but they are not going to cut their sales down from what they are using right now when we aren't quite up with all of our products ready for them.

And we are very, very close right now, but there are a couple of places where [indiscernible] don't have the new product out there. So, they are starting to move over and move their business just, but we are in that transition now.

That [indiscernible] all not been too bad though in our eyes, so we haven't pushed this because as we mentioned we came up with a new weight of manufacturers' product. What we did was, we could have come out with a product and manufactured in ways that were similar to what we were doing right now and similar to what everybody else is doing.

But, we are trying to gain an advantage and so we said let's see how far we can go to automating the manufacturing process. Towards that end, what we did was, when I looked for automated equipment all over the world which would produce some of this automation.

We pretty much bought stuff from all over the world and four of the different processes, fabrication of sheet metal, fabrication of corporate cutting and forming of the installation and delivery system to make the availability of the product at the assembly line happen.

We bought some very large automated software driven towers and all those four things had software of their own device, we had to write a software to read that, we had to write a software to run the unit and that took us a lot of effort to [Technical Difficult] we are now at the point where its debugged them very well, we now are very still running into bugs, first we were running into more than few minutes, we don't know we run into a bug about every second or third day and we will probably have bugs for sometime to come, but it's not upwards workable situation.

So, we have been building units on every size and every voltage, all putting and then stock, we have approximately 1700 units in stock right now.

That has been noticed, I suppose, you might have noticed that we have a little higher inventory level than we had before a lot of that is either parts that we want for the water-source heat pump or else it's the actual finish goods for water-source heat pump.

And a little bit from the fact that we anticipated being able to ramp up our legacy product faster than we were able to and so we have a little more product semantic thing. All of that will start liquidating down some what, but we will continue to have higher inventory than historical because we have a new product line.

So, those are some of the things that need to be talked about there. Now, we have by the fact that we have the backlog increase if we create that backlog through and pull us down, we would be about 7.4% greater than we would -- than we are now, if we have pulled our back down to where it was.

So, we got a little bit of a slush fund in there to gets and go. The water-source heat pump is just now starting to as we had been indicating for long time; it would be latter 2017 before it started really moving forward.

We are still inline to have that start happening, but maybe it's going to happen a couple of months later than we thought, but it's going to start happening the latter part of this year. 2018, it's going to start moving a little bit better.

So, in addition to our normal legacy products growth which have been growing very nicely whatever number you want to choose out of our backlog and actual thing? And we anticipate that growth to continue and be modified somewhat as what water-source heat pump comes up to speed during 2018.

Those profit, of course, is contingent to fund our running [indiscernible] a lot of the things we have been doing, we have been cleaning up and getting things over and you got to recognize that this start up that we are talking about, we are doing that we are funding that as we go.

So, what we would have had to pay for the companies we looked that were somewhere up in the $300 million and $400 million. We are doing that out of cash flow right now. We are not damaging our backlog of money hardly at all. We are back doing pretty well on that.

So, I think it as the biggest stockholder which I am, I may extremely pleased with the way which they are effecting me and I trust most of you to see a similar thing. Although, I'm always disappointed, I'm a very greedy individual and wish it would have been better, but wasn't. Carryforward, however, I think it's going to be very, very good.

Capital expenditures for 2017, we came into the area talking about the low $40 million or $42 million and because of what we see happening, we thought it was wise for us to move forward on some of the capital expenditure we had slated for 2018 and namely some cheap mill fabrication equipment and we had announced previously an increase from the $42 million to about $48.5 million on our capital expenditure expectations even though we are as Scott [Technical Difficulty] point below that for the first half that we are doing and we are going to get quite a lot of capital expenditures in the last half year getting ourselves ready both in the manufacturing of product as well as bringing in the new cells, test cell for our new R&D lab which will be going online approximately this time next year.

Those of you who knew their way up, suffice to say it's a 162,000 square foot lab going to cost us right now about $33 million and we will be state-of-the-art and leading-edge technology, have capabilities beyond that either we know of any laboratory anywhere in the world.

So, [indiscernible] goes into it, last part of 2017 in excellent shape with a new management, the younger management in place, getting seasoned looking very optimistic. I open it up for questions..

[Operator Instructions] Your first question comes from the line of Joe Mondillo [Sidoti]..

Hi, Norm, Scott. Good afternoon..

Hello Joe..

So, I wanted to try to get a better idea of exactly what was going on with the management and production disturbances related to that. What was the timing of all this, does this go back a couple of quarters because you mentioned that both these individuals were going to retire last year, but then they got extended. So, I guess they were there.

So, in that time period, I assume the production of your orders and such weren't that disturbs, was this just a second quarter issue? And also were you turning down orders throughout this time period or was it just the case in point where production was just not as efficient and lead times got extended a little bit more.

Any further color on the timing the extent of the issues that this caused?.

Joe, this is Gary Fields. So, the two gentlemen we spoke of Bob Ferguson, Ed Johnson both retired in March. So, the transition -- that the two young man that took their places really began transitioning back in probably November, December to some extent shadowing both Bob and Ed. But, the last day for Bob and Ed was the same day, it was in March.

So that the entire quarter -- second quarter was produced by the two new young men. So, as you can imagine the first few weeks was a little bit I like the way you called it, disturbance, that's a good way to categorize it. And it was like there was a ripple in the water kind of disturbance, but it wasn't big splash, it was just a ripple.

Well, that's began to smooth out and we did extent lead times to your point that's why the backlog grew. We have extended lead times probably on average two weeks in some cases three weeks from what we had historically been producing.

Now, we are beginning to gain steam on that and actually as Norm had mentioned it's grown much stronger and they are running at pace ahead of anything we have ever done. So, they had some catching you to do and they have done that. And they have actually gotten ahead of the curve now to some degree.

And the other thing that they had a little more focus on getting some efficiencies as they saw them. And so there was some -- again, a little disturbance in that and trying to get people to change their culture a bit just some new efficiencies. And I think it made great headway.

We get a daily report telling us how we are doing on a year-to-date basis every morning and we have been in the green for a little bit now..

Talking about being in the green, it either flashes a red to us that we are not progressing or it flashes a green to us that we are progressing that measure several things bought our company and tells us that every morning before we come to work. So, we know how we are doing. We get a daily report of the computer telling us how we are doing.

We are in the green which means we are advancing pretty consistently now..

And it compares to the previous year, which of course 2016 was a record year..

How would you compare -- or how would you look at the industry overall, because it seems like listening to some of your peers that things have slowed a little bit, it's tough to tell exactly how you would have done the things where running smoothly.

It sounds like you would have done better, but I don't know what you are talking 200 or 300 basis points of growth or 500 to 1000 basis points, it sounds like maybe the former, do you sense in the first half of that overall the industry had slowed a bit at all?.

Well, I think the industry as a whole has, that our segments of the industry that are anywhere between flat to very, very slightly up. Norm and I were just looking at the water-source heat pump report for the first six months of this year versus the first six months of last year. And overall, it was up -- I think it was 1% ….

1.4%..

Yes, 1.4%. So, it's -- that's not much. I haven't examined our core products being the rooftop unit, but I haven't looked at the same report, but at the last time I did look at it, we were either -- most categories were flat, some of them were slightly behind..

Very definitive form to tonnage size, somewhat significantly hit, somewhere pretty flat and somewhere down. So depends for which part of that market tonnage wise you have your strength as to how it was affecting..

I think in fact that our backlog is that significantly, see can you do the math there and say we produced very close to what we did in 2016, so far. We are just a little bit behind that as far as what's going out the door, but the backlog has grown and say you can put the math to that and analyze what might occur as we produce that backlog..

When you look at your order in take trends, do you feel like throughout the first half of the year up until now that things have started to slowly get better in terms of the order trends?.

Exactly, our order intake trended up beginning with the first month of the year, it actually started turning around towards the end of the fourth quarter, but we have again using that green and red scenario, we have stayed in the green virtually everyday all year long on order intake.

I mean there is some days that will be a little behind, but when you start getting enough data points out there. Then the trend for order in take is actually -- it's been up very nicely..

Of course suffering as units out to board and that's when we have been talking a lot about but why that was.

And now, as we said, we are now running it faster, we have ever run, so all the troubles which we had -- most of all, earlier part of this year either not having orders from the fourth quarter or from the fact that we managed our workforce and then had to replenish it. They are pretty much behind us now..

Okay. And I know it's probably tough to sort of address first also just in terms of the gross margins.

You mentioned a little bit I think how mix has been a little unfavorable in terms of smaller unit, but I also assume that these production issues have weight on efficiencies and now that things are sort of better and it sounds like mix may even be -- you mentioned healthcare maybe sort of transitioning to maybe a little more of a favorable mix.

Do you anticipate gross margins to start to improve on the year-over-year basis, again, in the back half of the year?.

Gary?.

Yes. The margins are being impacted as well the commodity cost and the component cost, and commodity cost are going up with respect to copper.

And so, we are trying to offset some of that with getting the efficiencies back up in the actual assembly process and hopefully if commodity costs will stabilize, we will be able to evaluate what that impact is going to be going forward and we maybe putting in some price increase later in this year..

Okay. Okay. I will hop back in queue right now. I have a few more questions, but I will let somebody else in. Thanks..

Thank you, Joe..

[Operator Instructions] You have a follow-up from Joe Mondillo..

All right..

Welcome, Joe..

Hello. Couple of other questions. So, number one for the water-source heat pump, do you have anything in backlog and if so can you quantify what you have in backlog related to that..

We have variable backlog. We have been producing about as fast we get them the NIM. And we have been spending time putting additional units in stock.

And as I have mentioned those stock is up around 1700 units right now, which is real high precision for anybody in this industry, normally most people carry a very low stock, what are the reason their own reason.

We have decided to carry a higher stock that we can benefit by having a bigger stock and leveling out our production and doing a number of things that we think will make money for us. So, it's not that we are getting what we announced early on was we were intending to go up to as much as 2300 units in stock, where we have got 1700 mark.

Those are slowly but surely starting to materialize faster and we are not going to speed up line up any sooner, we really have to because it allows us to keep our cost down, when we do have one of these shutdowns because the software problem, we don't have too many people standing around when we fixed the software problem.

So, it's working out quite well for us to bring it up into speed at a minimum cost. We are losing a little bit on the revenue line but we are saving in the bottom line at the same time. So, we are trying to trade that thing so that we get the revenue and bottom line performance working to the best part of the way..

Okay.

And I know you were talking of that this first production line was -- the goal was in terms of low hanging fruit within the industry was to achieve $50 million of revenue give or take on this production line and then later in 2018, you are going to open up a new another second production line and that will sort of capacity wise will get you the same -- so, that gets you to sort of that $100 million that you have been sort of talking about or targeting.

I'm just wondering where we are at in terms of that first production line and I know your goal was by the end of this year to get to an annualized run rate and exiting the year getting to that sort of $50 million, I think.

Where are we that's the achievable or is that sort of -- that pushed into 2018 in terms of the first production line, any insight and in terms of those target numbers and timing wise would be helpful..

When we talk about the production line and turn the order input over to Gary. Gary is taking over that part of the dialog. One of the things we are concentrating on is internal ratios including production. We are going to have three production lines for water-source heat pump. They are all on what we call line six, the line six of AB&C.

It's A that's running right now and that is as you say want to take us up to $50 million or little or actually a little more than that. But, one of the features the way we are doing this is quite - maybe a little different than anybody else's set-up line. A line is for small tonnage units.

B line is going to be a different kind of a line, it's going to be a line for bigger tonnage units and for taking problem units off from line A -- go up from the A line.

So, if we get a problem unit on the line we are not going to slow the production down, we are just going to left that problem unit slide off and on to the B line and let the B line fix it up, because the A line is a high volume line, the B lines are low volume lines, so you will get a more cost effective method of correcting whatever problem is in that particular unit which will lay the line out.

So the A line runs from north to south, B line sits right on -- and the difference takes the unit directly off from the underlying rather than going to the test them and outside they go right on to the B line. The C line is going to run from south to north and also will end at the B line also, so it will be dumping all on the B line.

So, the C line is going to be the very high volume line, the B line is going to be a slow boiling big unit and effective line. So, it’s a little bit of an approach where we are using it to drive the productivity up late. B line is under construction right now, it's about 50% production -- 50% manufacturing right now.

It was the physical portion of that is pretty well done and it's now as to have the equipment put in place and start it up. So, that will probably be done in another couple of months and be active.

So that will speed the A line by taking off ones that have problems in them and it will also give us the ability as we design out the bigger stuff which is low volume stuff that we will have a place to build in.

And then, somewhere around the end of the year, we will start construction on the C line which will be high volume line lying from south to north and then ending at the B line also.

So, by this time next year, we will somewhat deploy this probably we will have all three lines up and running which will give us the capability of getting up to somewhere around a couple of 100 units a day that's rather modest [hovering] [ph].

Understand the way we run our shop here, everything else in this place on the sheet mill department are historical equipment. We run 24 hours a day, 7 days a week to get maximum usage out of the money we got invested in all that machinery.

The assembly line we run 12 hours a day, 7 days a week, it's got adequate assembly capability to keep up with that sheet metal operation.

And then at the water-source heat pump, we are running at 5 days a week, 8 hours a day, at the first time and we will for sometime to come, becomes it's got problems and it needs to have the engineering department, upper management and people like that around here to help with its problems and we don't want to run it over the weekend, but we don't have all those people, they will be able to do it.

Ultimately, it will go to probably a 12-hour, 7-day a week operation once -- it's running well and we don't have consensus about meeting any of the supported personnel mill around here on weekend. And of course, we can always take it up to -- like we do a machine mill at 23-hour a day and 1-hour down for maintenance.

So, we got a lot of latitude for what we do..

Okay. Thanks Norm. That's very informative and really great color in terms of that.

Gary, could you comment just in terms of the -- so, we got a pretty good idea of what the daily sort of run rate this production line can do? Can you sort of give some color on the order in take that you are starting to bring in and how you are -- are you controlling the speed of that or the floodgates opened up at this point and it's how -- how that's going?.

Okay. We have been controlling the speed. And still continue to control it to some extent by turning on only models and options that we have fully vetted out that we've had test runs up. So, that's really been the throttle. Approximately each month for the last three or four months about once a month, we open that valve just a bit more.

Right now, I'm going to say that we still have some closure to the valve and it's because -- probably two or three different reasons, one of which, on a product of 2 tons through 5 tons, when you go for a project quote, it seems like there is always a handful of 6, 8, 10-10 units in there. Well, those are what we intend to build on 6b.

So, we still don't have the ability to turn those on with a cost effective product. We have in our historic products we have some ability to build those, but it's not cost effective. So, I didn't want to turn that valve open too much, what we are doing is managing that on a kind of case-by-case basis.

So, let's just say that a project has got a preponderance of 2 through 5, 10 units that we are prepared to build with 6a. Then that project has got a very small percentage handful of units that we intend to build on 6b to be ideal.

But, we have another method building them in our historic product then we go ahead and open that up and look at that project. And we secured a couple of projects doing that. So, we are playing still project-by-project on those kind of opportunities.

Then there are some options that are desirable options market want options that we are still vetting out in all of our processes, testing and building that we've yet to turn on. Those are probably like the final little half-ton or three quarters of a turn left and about to turn it to which you call in the flood gates open.

So, we are running about 90 days behind what I originally thought we would be -- we have been able to open up the flood gates. Once we get the AHRI certification complete which as Norm said earlier, we anticipate some time in the 50 to 90 day timeframe.

Once that is complete, we will also completed some testing and pre-runs on some of these other desirable options. So what I'm saying is, about 90 days at the most from turning the valves wide open. So, right now we still manage the opportunities on a case-by-case basis.

And we are looking at to make sure that they are not delivery sensitive because we don't want to commit to delivering something that we are not fully prepared to deliver.

So, we have several opportunities that are -- fourth quarter opportunities that we have already secured that our reps have secured, of course, they haven't send the orders into us yet because they are going through their processing.

But, there is several very nice orders that have been secured and so to say that the run rate is going to be [Technical Difficulty] $50 million annualized run rate. We might possibly hit a run rate like that at the very tail end of the year. But, I'm still somewhat skeptical of that. I think that we are going to have some ramp up.

But there have been some developments that have been very favorable. One of the things we mentioned many times is half of our reps represent a competing line.

One of our reps on the West Coast sent us a letter yesterday or the day before and said that he had dropped that competing line because he felt like we were far enough along to serve his needs and he is 100% on board with us with no conflict, while that's the second one that's done that actually.

The other one was right here in Oklahoma to the west of us had done the same thing. So we are going to see these people converting their existing business to us as fast as they feel like we are ready to do it. And when we prove that we are ready to do it by delivering, these guys don't talk to each other.

So, for instance this West Coast sales channel that just made the conversion that dropped the competitor. He has brought us an opportunity that we were looking at right before this conference call that should we capitalize on that opportunity which we are going to try very hard to make sure we do.

Should we capitalize on that and deliver that for him? Then, that news will spread very fast. So, I think this is kind of like you got all the fire woods stacked up in the fire place; you have got all the kindling underneath it and we are just now lightening the match to it..

Okay. And regarding that sort of reps transitioning from competitors' line to your line at this point in time where the production line is and how much you are willing to sort of go out there and take orders.

In terms of that transition of reps to your product line, are you -- is that sort of in line with your expectations, are you at all disappointed on the speed of that or is that sort of in line and you just need more time of production and getting the certification and you expect that will continue to progress?.

I'm going to say the latter. I'm going to say, I'm disappointed in the timeline as it occurred because some of the restrictions that we have had with the approval from the agency approval and then getting our software vetted out.

We had been probably a little more optimistic -- I certainly was a little more optimistic than what prove to be realistic as far -- how long it would take to get some of those preparations vetted out.

So, the way I'm looking at is, as we probably versus the timeline that I had in my mind, we are probably just take everything that we have been saying and move it forward in the range of 90 days. But, it's all occurring as far as their endorsement -- our sales channels endorsement of our product, I could not be happier about that.

I mean they are absolutely endorsing the product. And we've had delivery of a decent number of units and installations of them, and we have got some feedback from that.

And by and large it's been very favorable feedback, of course, like any newer introduction, there has been a few little snags here and there that as given us an opportunity to work them out. But, that's also a good reason to say rather than having opened about too much too soon then it might not be so manageable.

But this way, the small little -- I really call them inconveniences they have been about the same ripple in the water that the management change was. It's not tumultuous, but it's a little irritable. And so, we have managed to work those out in a very nice pace.

So it's preparing us, in other words, to summarize it this way, we are building a very, very firm strong foundation under this business. It's very solid and we have got very solid support.

So, I'm as optimistic as I've ever been and becoming more so every minute because we accomplished some things that -- some of them were a bit speculative as far as how we could automate some of the software, some of this has never been accomplished before.

And so, while you are optimistic that you've got all of the right people in place to make this happen, it's been never been done before to some extent. And now we have accomplished quite a few of those things, they are now in the rear view mirror..

Okay, great. Thanks a lot. I appreciate that. Just one last question with WHP, at this point in time, would you say the overall operations with all the costs that are baked in whether there are production costs or any other sort of one-time like up -- start-up type cost.

Is the business profitable or is it -- I would imagine it's probably a drain on the overall company at this point in time.

But, can you comment on that at all?.

At the present time our volumes are low and you are correct. It is not adding to our margins. We aren't quantifying the magnitude of that at this point but it is a drag on our profitability at the moment. But, not a major drag because we don't have a whole lot of investment we needed in the first place. It was a very low cost to get into it.

It's mainly been intellectual, capital, time and resources relative to that..

One thing that should be said here, when we do start cranking up the volume, what's probably going to happen, is we are going to get to be a profitable entity before very long to where it's moving, there won't be room moving at the same percentage profitability that are historical product will be, so as it ramps up it will be a bigger and bigger chunk of volume at a lower margin and so we have [Technical Difficulty] margin for a little bit as it props up, whether it will have a positive effect on our bottom line total dollars of profitability..

But, long-term we do anticipate the margins will be comparable with our legacy product line..

We did a lot of studying earlier on and once we get there everything all the kings worked out of this and everything running full blast, we have every expectation that it will meet this previous profitabilities that we have experienced over the years.

But, there will be a time in here when we are cranking it up, we are probably run the volume up, the revenue start increasing and we might suffer a little bit on the percentage of profit but the profitability will move up also.

So, we were transferring dollars, real dollars on the bottom line but out of lower margin that we are getting some of them at a lower margin..

Great. Understandable. I just had two other questions, Scott, in terms of the SG&A, I may have missed this but is there a new way you can quantify sort of these one-time like warranty expenses, it seems like that is sort of behind us and going forward your SG&A should be sort of more normal as in compared to historical levels.

Is there anyways you can quantify what sort of not normal in the second quarter?.

Well, I mean we did have an increase in the reserve from the beginning of this year.

So that's part of what you see within the first six months of this year is an increase in our reserve just do to the general cyclical nature of our sales because when you do have warranties it tend to be earlier in your shipments so as our sales are going up, the warranty reserve that's necessary is going to go up because you have more recent sales volume.

So that will of course decline as your sales volume goes down generally towards the latter part of the year.

The other part though is, the part that you are talking about the one-time portion which we think somewhere around about $1 million worth of that expenses around the one-time increase that we experienced and most of that is a timing issue people accelerating some claims, resolving some old outstanding issues and reviewing how we handle some prior situations and getting the assets through.

And we believe that is all behind us at this point..

Okay.

And how much did the reserve increase?.

666,000, I believe it is since the beginning of this year..

Okay.

And I mean that may trend down but that's not going to fully go away, right?.

It follows with what your charges are against that reserve of course, and also with the volume. So, if our volume increases further going forward, then we are going to have the reserve going up accordingly..

And this is related to water-source heat pump or other new product?.

Product in general -- it's rooftop..

The warranty incident of water-source heat pump in dollars is not even measurable at so low..

Okay.

But, related to that though as that business ramps up, do you anticipate that will become some what of a substantial expense because it is a new product and you are not -- you are going to have to reserve for something, right?.

It depends upon what you mean by substantial. Let us tell you this, because of the nature of the product being a high volume low cost product one of the things which we agree upon round here which is maybe a exaggeration of what we agreed. We are going to build perfect product.

We weren't going to have, we weren't going to have anything but we are out just to warranty part would be things that worn out not for our failure and all those kinds of things. And so we're paying a lot of attention to the component that we selected. We did an enormous amount of work on the manufacturing methodologies.

For instance when it gets to the end of the production line, we hook on refrigerant sensing devices, we hook on electrical sensing devices, we push a button and the computer run test.

If the computer in its run test, which runs it through all the variations it should run through to check everything finds that it doesn't pass the big red sign comes up, we have some 50 screens big large several inch television screens around this manufacturing process, we use for communication and it comes [Technical Difficulty] failure.

And when it comes up with that all of our product lines, if we don't allow the computer, the computer generates our name plate -- prints our name plate upon the completion of our check. And all the other things we have human beings doing this checks. In this case we have the computer doing the check.

If the computer fails the unit, it will refuse to print the name plate, without a name plate we cannot ship units. So, human beings are taken out of the picture, they don't have the ability to override the machinery. And thus, we will not get something out the door that computer won't pass.

If it fails, they have to take it, fix it and it has to go through the computer again. And if the computer fails it again, it's the same sequence. They got to get it where the computer will pass it and print the name plate; otherwise it doesn't go out the door.

And the degree of absoluteness that we put into this system to make sure that the computer doesn't get fooled is the best we know how to do.

So, we are very, very confident we are shipping an extremely good product out the door because we recognize with high volume making one little mistake on a high volume item can be an enormously costly thing, and so, to every degree that we know how to eliminate that we have done so. So, no, we don't think we are going to have a big issue on warranty.

Well, some stop it's under warranty wear out, yes, it will. And those things will be serviced under the warranty cost. So, we were thinking that our warranty cost as a percent of sales is going to be very low..

Okay.

Sounds like any warranty that was to be put to reserve, the customer should pay for it Norm, it sounds like you had such a good product there?.

We think that once people realize what they are getting then we will be able to get at a very nice price for our product because I think there will be a lot of very satisfied customers. From the basic concept, the way it's been booked together [Technical Difficulty] looks..

It sounds so good. Just one last question for me and I appreciate you guys taking the time here today and bearing with me.

The taxes Scott, they were little on the low side, I think you even mentioned in your prepared remarks about that going forward though the back half of the year going into 2018, what can we sort of think about in terms of a tax rate?.

Well, we can't totally predict that nowadays because we do have to account for that beneficial impact when people exercise stock options. And we can't control who is going to exercise when and what the impact of that is going to be.

So, we've had the lower tax rate because it's reflecting people who have been exercising equity compensation giving us a beneficial tax situation. And there is really no way for us to project that..

Outside of that is a normalized rate still around 36% or so..

Normalized is 36% and so far this year, we have had I believe it was $2 million versus $1.1 million last year..

Okay. All right. Well, again, I really appreciate it. Thanks for bearing with me and taking my questions guys..

Well, thank you, Joe. We hope we have answered your questions..

And there are no further questions at this time..

Okay. All right. Well, thank you ladies and gentlemen, we appreciate your time you taken to join us with our quarterly report. I hope that we have answered all your questions as you might have believed here, we have been in a little bumpy time here, but we are very optimistic about where we are going and feel very comfortable with what is going one.

We don't see any big ripples in the economy yet even though there is -- as we all know a lot of the turmoil out there, but it doesn't seem to be slowing the economy much. So, we look pretty optimistic. Thank you..

That does now concludes today's call. And now you can disconnect your lines..