Good day and welcome to the Pioneer Power Solutions, Inc. second quarter 2017 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Brett Maas from Hayden IR. Please go ahead, sir.

Thank you and welcome. The call today will be hosted by Nathan Mazurek, Chairman and Chief Executive Officer and Tom Klink, Chief Financial Officer. Following this discussion, there will be a formal Q&A session open to participants on the call. We appreciate having the opportunity to review the second quarter financial results. Before we get started, let me remind you this call is being broadcast over the Internet and the recording of the call and the text of management's prepared remarks will be available on the company's website. During this call, management will be making forward-looking statements. These statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the cautionary text regarding forward-looking statements contained in the earnings release issued yesterday and in the posted version of these prepared remarks, both of which apply to the content of the call. I would now like to turn the call over to Nathan Mazurek, Chairman and CEO. Nathan, please go ahead.

Thank you Brett. Good morning and thank you all for joining us today for our conference call. This was a very strong quarter for Pioneer. We reported record revenue for both the second quarter and the first six month periods and ended the quarter with a near record backlog. In addition, we delivered increased operating income, improved adjusted EBITDA and generated significant free cash flow. These strong results were exclusively from our core end markets, including, among others, renewable energy, wastewater treatment, data centers, distributed generation and microgrid deployments. Demand for our solutions across our entire business remains strong. It is important to note that these results do not reflect any meaningful increase in infrastructure spending or any rebound in the oil and gas sector. Any rebound in these sectors would be incremental to our existing demand. It also doesn't reflect the contribution of the recently announced generator service agreement with a major drugstore chain or the two specialty transformer wins previously announced with large North American utilities. The first agreement is a 30-month contract, which we expect to generate annualized revenue of up to $2 million through 2019. This agreement not only represents significant new revenue, but just as important as with a new large utility customer, which expands our presence among major utilities. The second win is another three-year supplier agreement with a municipally owned power and utility provider for a large North American city. This competitive procurement, which involves both fitting and prototype testing, is a testament to our ability to continue to develop robust customized solutions for our customers. We expect this agreement to contribute to our 2018 financial results in a meaningful way and generate up to $1 million in annualized revenue. These wins will begin contributing to our results in the second half of…

Thank you Nathan and good morning everyone. Second quarter revenues were a quarterly record of $30.9 million, up 3.2% compared to $29.9 million in the second quarter last year. Gross profit for the second quarter was $6 million or 19.3% gross margin compared to $6.3 million or 20.9% gross margin in the year ago quarter. For the quarter, selling, general and administrative expenses decreased 6.5% on an absolute dollar basis to $4.5 million compared to $4.9 million in the second quarter of 2016. As a percentage of revenue, SG&A expenses decreased to 14.7% of revenue in the second quarter of 2017 compared to 16.2% in the second quarter of 2016. The second quarter of 2017 included $172,000 in restructuring and other nonrecurring expenses compared to $337,000 for these categories in the second quarter of last year. Operating income for the second quarter of 2017 increased 18% to $1.6 million, including these nonrecurring expenses compared to $1.4 million inclusive of nonrecurring expenses in the second quarter of 2016. Our effective tax rate for the second quarter of 2017 was a negative 46.3% of pretax income as compared to 75.7% for the same quarter last year. The change in tax rate was due primarily to the utilization of foreign tax credits and the reconciliation of our 2016 actual income tax expense to the provisions previously recorded. Net income for the quarter increased to $1.3 million or $0.15 per basic and diluted share compared to $194,000 or $0.02 per basic and diluted share in the prior year's quarter. Adjusted EBITDA increased to $2.5 million during the quarter or 8.1% of revenue compared to $2.2 million or 7.2% of revenue in the second quarter of 2016. Non-GAAP diluted EPS increased to $0.21 per share in the second quarter of 2017 compared to $0.18 in…

Thank you Tom. Operator, I would like to now open the call for questions.

[Operator Instructions]. And we will take our first question from Matt Koranda with ROTH Capital.

Good morning guys.

Good morning Matt.

Hi Matt.

I just wanted to start up with a couple Q2 specific questions. In terms of the gross margin drivers during the quarter, could you delve into those a little bit more? I noticed in the prepared remarks or I think in the release at least, you guys mentioned essentially a less medium voltage and an increase in some of the dry type transformers, which are a little bit lower margin, but could you help us understand just the puts and takes on margins here?

Certainly, Matt. Tom here. So on the sales for the quarter in dry type distribution, they were skewed heavily into the brand label agreement. The brand label agreement has lower gross margins, but it also has lower SG&A expenses as we make those sales. There are none really to speak of in the SG&A on that area. So that's probably the biggest single driver on the dry type transformers. On liquid filled transformers, they continue to perform strong. Its sales were up and its margins really held at the same percentages that they have historically been at. We continue to work through at our switchgear facility some low voltage switchgear jobs that had less than desirable margins. At this point, there's still a little bit of that in our backlog, but we are expecting that to be completed by the end of this year that we won't have those tailwinds anymore.

Okay. Got it. And I think, well, let's talk about the tax benefit this quarter for a second. And just what drove that? And how much noise, I guess, should we expect for the remainder of the year? Or should we just be modeling sort of the normal statutory tax rate?

If you take out the noise, I am looking at it on a year basis. For the year, our tax rate averaged 31.3%, it would have been its normalized rate, once you take out the effect of deemed dividends, foreign tax credits and the reconciliation on the 2016 return. So those, in summation, are about 42% of reduction in our effective tax rate. So I believe, if you model it at 31%, you will be in line with what we would expect.

Okay. Got it. In terms of the outlook maybe, Nathan, I guess the EBITDA for the first half of the year is tracking a little bit below the low end of your $10 million to $11 million range you guys have provided. And if we model revenues at the midpoint of your guide for the year, which I think it seems very achievable given what you guys have announced, it does still imply that EBITDA margins should tick up a little in the back half of the year, maybe above the 9% mark. Anything that you can point out, just in terms of what's coming down the pike for the second half that drives those margins up into the 9% range in the back half of the year?

Right. And you are talking in an absolute terms, you are talking. We are tracking, right now, a little bit below. I mean, if you took the second quarter alone, we are tracking exactly at the lower end of the EBITDA guidance. But basically what's trending up for us for the second half of the year is the mix at the switchgear business. So we expect them to actually contribute positive EBITDA to us for the balance of the year, significant enough that it affects the EBITDA picture. Overall for us, another significant improvement in tightening in the critical power margins for the second half of the year as there's way more service business that's loaded as the large drugstore chain kicks off in September, which gives the service business an additional boost. And given what we have done with the equipment side of the critical power business in which we have already been booking equipment orders to be shipped during the second half of this year, both the sales and the margin on equipment should improve. Those would be the big movers of why we think we are going to achieve the EBITDA guidance.

Okay. Very helpful. What does the weakening U.S. dollar mean for the outlook? I know you guys do the planning on a $0.74 basis for Canadian dollar. It's now, I guess, sitting at $0.79. I would assume that should be relatively helpful to your margins in general, but help me understand kind of the puts and takes there?

You do understand, yes, that the weakening U.S. dollar, it's helpful to us. The liquid filled business still, the majority of its profit is in Canadian dollars and it is a super profitable business. So if the Canadian and U.S. dollar were at par, we would pick up a huge amount of income, but any weakening of the U.S. dollar against the Canadian dollar is a benefit to us.

Okay. All right. Very helpful. Help me understand, I think you had just mentioned in the back half of the year, we will start to see the benefit of that new service contract and that should help with margins. Could you help us understand just sort of the benefits? Or maybe the dollar impact to the critical power solutions segment in the back half of the year? And what that implies for revenue?

Yes. Right. I mean, that's just one. I mean, that's 200 locations times X. For the back of the year, that's $500,000 approximately of additional service revenue, which is extremely profitable for us. Again, we are talking about going from $2.5 million of quarterly EBITDA to $2.7 million, $2.8 million type. So every few hundred thousand dollars is extremely important to achieving those kinds of goals. We are moving those kinds of steps. That and taking an equipment business, both in sales and revenue, even expanding it by a couple of million dollars, albeit at a much stronger margins in critical power that kicks in a much more significant contribution than they have contributed for the first half of the year. Equipment's been a negative for the first half of the year, it's declined in sales, given the company we were representing and therefore was not contributing even last year at a stronger sales revenue, was not contributing much to us from [indiscernible] that point of view, from a profit point of view. So we think both of those are going to improve significantly in the second half of the year as they really did last year as well.

Got it. Let's really quickly, I know you mentioned and you talked about it a couple of times in the call here, the new generator launch. But could we just zoom out for a second and maybe could you talk a little bit about sort of the rationale behind that? And how long has that been in the works? And essentially, I take it, my interpretation of your comments is, this is generally driven at providing equivalent quality or better quality equipment at a better margin for Pioneer. But were customers asking you guys for specific solutions or just a little bit more color on sort of the rationale behind the introduction?

Yes. It's probably a year in the making. We had an equipment. We are distributing only an equipment line that we were limited by territory. So we are constricted immediately just by that. Our growth is limited to a specific territory. As much as we try, one can only grow so much in a particular territory in a given time frame. We also were limited based on the manufacturer we are working with. We were also limited in scope. We didn't have prime power. Everything we did was for backup power. And we worked on it for about a year. Working, as you say, obviously, we didn't want to do anything that's not going to give us as good a quality and we want a broader scope of product, not a more limited scope of product. And we finally, together with one primary manufacturer, came up with a system where we are going to brand label it. We are brand labeling it Pioneer. Our territories on an exclusive basis have almost quadrupled and on a nonexclusive basis, the world is our oyster, but primarily the United States here. We also now have product that goes into prime power, where people are really using these engines to run them 24/7 as opposed to the backup standby system. As an example, we were typically booking last year, call it, $600,000 a month of equipment sales, somewhere there, call it $550,000 to $600,000 of equipment sales. In June, really the first month that we went sort of even in stealth mode to the market with our own, our bookings were $1.2 million. So that's a little bit more than double what we typically did and the largest piece of that was an $850,000 order, where we are providing prime power for a North Dakota industrial user that is separating themselves from the grid and is going to be using eight natural gas engines to provide the bulk of their power. That market, that state and this type of product was not available to us until June of this year. So we think we have done. We have taken as we said in the prepared remarks. We have taken what was really a dormant, a stagnant line for us that was just sort of feeding, hopefully feeding the service business and turned it into its own dynamic, growing, profitable business for us. So we are very enthused about that change to the critical power business.

That's great. I guess, have you guys attempted to or is there any kind of decent market data out there on what having the prime power solution does to your addressable market? I mean, obviously in the bookings it would imply that given the run rate you were at versus what you did in June, that you would probably at least double the opportunity set, but could you help us understand how you are thinking about that?

Yes. Maybe, there is market data, I know, that separates standby versus prime. Standby still is going to be the bulk of that business. And that's the everyday bread and butter of the equipment. That's what we are distributing. That's what gets the highest volume as to what goes on especially from an interaction point of view. But we were basically shut out of the larger kinds of jobs that take what we call Tier 4 Final type engines that have met all the requirements of the EPA and others to be able to run 24 hours a day. Can we do a job like that every single month? I don't know. But we are definitely, from a quoting point of view, it's becoming bigger and bigger part of the business that we are looking at. And just by increasing the territory, we are rolling out now North, South Dakota, Kansas, Missouri, Colorado, Wyoming. We could do anything. We would have to spend a lot more money than we like to spend at once. But we are trying to contiguously, through existing personnel, agents, sub-dealers and so forth, be as smart and as aggressive as we can in going after these new opportunities.

Okay. Maybe just one last one from me and sticking with the service business. I think it seems well known that given recent industry commentary that CapEx spending on backup power from the telecom majors is down and that's been down for the last several years, I guess. But how does that impact the quotation activity that you see on new service contracts that come up for bid from some of the national telcos? And are there still opportunities that you are seeing in the pipeline? And how is that shaping up for the rest of the year?

Yes. I would say it has little or no effect on the service business. I mean, the service business is still, I mean, service business is huge. We are focused as you, in particular, know from working so hard on this is that we are focused on the multi-location user, which, for us, is telecoms and retailers. And their need to have this service doesn't end. Can we be competitive? Are we doing a good job? Can we win more of the particular telcos' business? That's on us. But there's no stopping there. Even among the retailers, I don't want to start saying who we are dealing with, but whether it's sort of a broad retailer or home improvement chains or the large Costco-like people, those are the kinds of opportunities we are looking at. We had a big win with the drugstore chain, for us, first national drugstore chain that we are dealing with. It's taken way more months. But that's the nature of a lot of these things, for it to kick off in a manner that provides actual revenue to us. That's not really going to start in any real form until September, which is what it is. But we are dealing with a super large drugstore chain and we found that, over the last couple of years, that our best opportunities are growing within those. We do more and more with people like Verizon and Target. And then this particular chain, they have just acquired 1,000 more stores from a competitor, where the hope is that over the next year or two, we get to get a bigger slice of their pie. So I mean, that's a long answer to your question. But whatever they are doing from a CapEx point of view, we don't see that affecting the service business. In the first quarter of 2018, we are expecting a onetime kind of crazy boost to the service revenue and that's because one of our large service customers is the official telecommunications provider for the Super Bowl, which takes place in Minneapolis, Minnesota this year. And the amount of work and effort and man-hours that we are being asked to expend in January and February, it's quite high and which should be quite profitable for the business.

All right. Very interesting. I will leave it there. Nice job guys.

All right. Thanks Matt.

We will take our next question from Joshua Horowitz with Palm Investments.

Hi guys. Congrats on a very strong quarter.

Thank you Joshua.

A question for you. If you look at the guidance, where is there additional upside to those numbers? What segments of the business could really surprise you based on the momentum that you are seeing?

Yes. I don't think that there is going to be really any big surprises. For a big portion of our business, we kind of have an idea of how it's going to fall out already for the second half of the year. So what's expected though is, we are expecting much higher margin from the switchgear part of our business and we are expecting higher revenue and margin from the critical power business, probably a little additional margin on the dry type, but not significant enough that it's going to have a big impact. But those changes are not surprises. That's based on efforts and work and jobs that are in place right now. So that's kind of how we see the guide. That's why we are still confident in achieving the guidance.

Understood. If you look out to 2018 and compare it to this year, what percentage of your revenue do you think is more of the recurring nature based on some of the service contracts? Is it something substantially more meaningful than 2017?

I don't know. Of course, you have to decide what you mean by substantial. But I mean it's not $10 million more of service business in 2018. It's not of that nature, yet. And recurring to us is, there is a lot of contracts, they are both for service and equipment, whether they be for transformers and recurring is another big word. But I would say that overall half of our business is extremely stable and extremely steady and the real effort is what goes on, on the other side.

Got it. And just finally, if you look out at your peers and what's happening in the marketplace, I am curious if there is a general way that companies like yours are valued when you see transactions that are tuck-ins or whether the deals are big or small, frankly? Is it based on some pro forma EBITDA? Is it sales? Is it based on certain contracts or certain customers? And how does your valuation stack up to that?

Yes. I mean, we are little bit of a hybrid. There is no direct competitor that competes in all our segments. And you know the business better than we do. Is it a private equity type valuation? Is this strategic type valuation? You see every day companies that are industrially focused in our world that are doing poorly that for some reason end up being bought at very high prices and some others that are left on the vine to die. So I don't know enough to give you a good answer. We believe that on a valuation basis our company is undervalued right now. And that if we were to engage in a formal sales process, the value would be much higher for the whole and even much higher for the parts.

Got it. Well, thank you very much. You guys continue to hit all your numbers and execute and do everything you say you are going to do and keep it up. It's certainly interesting. It continues to be a very interesting story and it sounds like there's some good momentum going into the second half. Thank you.

Thank you Josh.

[Operator Instructions]. We will go to our next question from Siggy Eggert with GeoInvesting.

Hello. First of all, congratulations on a good quarter. I am very, very interested in the prime power products that you mentioned and you mentioned that you already had a North Dakota based industrial company engaged there. I am wondering about the targeting for that product. Is that very similar to your existing client base? And if not, how is the customer base you are targeting with that product different from your existing client base?

Excellent question Siggy. A lot of it is the same client base. It's some of the same contractors and others that are trafficking in, in standby power. Where it's different is, in particular, the case of that job itself is that was really driven much more by an EPC firm, much more by an engineering firm. As you can imagine, it's a lot more complicated a proposition for the ultimate customer than just buying some backup power. If they are making a seismic shift in their business, they are deciding to get off the grid and they are deciding to, for whatever their reasons are, financial, want to control their own power in a more particular way that they are going to generate their own power on a significant level. So it really is going to take more effort with a lot of the engineering firms and it's also going to have, the sales cycle and the execution cycle are going to have longer gestation periods. We are used to dealing on backup power in terms of weeks and this is really more in terms of months, as we are really one piece of a much larger project. We are on standby power. You are the project for the most part.

Right. So it seems a little bit like you used the opportunity of already having done a good job for your customers to up-sell them as you can. Do I see that correctly?

No. In many cases, it is. In the case of this particular job that we took at the end of June which ships, I think, in the third quarter of this year or maybe the first month of the fourth quarter. But in that case, it was a really our agent in North Dakota who has the relationship with the ultimate customer and the timing of us being able to get the product scope available at the right time to be aggressive with the engineering firm. We would not have, without making the changes we did, we would not have had a product to sell. It would have been nothing for us to talk about. We might as well have been making socks. There is nothing. We had nothing to offer before.

Okay. You talked already a little bit about sales cycle and how the run up a prime power-related product has a longer cycle. Can you give us a little more color on the time frame here and compared to the legacy products?

Yes. I mean, the legacy products, we typically bid and I don't really consider them legacy because they are going to continue to be an important part of our business. We hope to be able to grow that business and have a better margin at it. So it's not legacy. It's every day for us. It's what pays for everything. But on the prime power side, customer makes these kinds of decisions. Typically, they are larger user of power, whether they are in the case, I think in the case we are dealing with, it's an ethanol plant or whatever it is. They are larger users of power. It's a big change for them. There is not one engine or two engines involved, but you are dealing with multiple sets. You are dealing with a lot of equipments to control and transfer and protect the power that they are now going to be generating. It's going to take a longer time for the contractor and the user to really get the site ready and to have all the other equipment vendors and coordinate what's turned into a much larger construction job than just pouring a pad and installing a backup generator and either having a gas hookup or not or going diesel or whatever you are going to use. Ironically, in the case of this job, it's all diesel and because they are in a very remote area and want to go that way. Again, so it was a longer sales cycle product process. It was a longer approval process. And not only is it sort of a few months after receipt of order that you actually ship, but there is a lot of project management involved during that time, which we typically do not have on the backup side of the business. There really is very little project management to do.

All right. Okay. Thank you.

Thank you Siggy.

I have one more question, actually, relating to the drugstores. You mentioned that you had this big one with a drugstore chain. It was the first drugstores chain that you do business with here. Is there any particular reason why a drugstore chain is more attractive than any other store chain? And do you see more potential in drugstore chains in particular?

Yes. I mean, there is not too much difference between a drugstore chain and another kind of retailer, how they backup or whatever it is that they do. Overall, the telecom type, the cell tower owners, providers, leasers are more profitable for us than the large retail type chains for us. Drugstore, dresses, big warehouse distribution store, Home Depot, Costco, those are all the same. It doesn't make a difference. That dynamic is the same. They are in urban areas. There is more traffic. There is a lot of people. There is always parking issues. There is delivery issues. There is lot of human beings trafficking in and out that you have to be aware of. In the case of telecom sites, they are typically more remote. There are very few human beings. They are very happy to see you. There is no delivery and whatever. It's a more commercial, industrial type of a visit. But otherwise, we don't care. You are selling Percocet, you are selling perfume, it's all the same.

All right. I was just wondering. All right. Congratulations again on a great quarter and thank you for taking my questions.

With pleasure, Siggy.

That concludes our question-and-answer session for today. I will now turn the conference back to management for any final remarks.

Okay. Thank you all for your time and support and we look forward to updating you again on our next call. Thank you.