Generac Earnings Power Down Due to a Customer Bankruptcy and Product Warranty Issues

Generac Holdings (GNRC 1.26%), which manufactures backup power generators and other energy technology solutions, closed Wednesday's trading session down 7.8% following the release of a weak third-quarter report. A fair portion of that decline was likely due to market dynamics, as the broader market was notably down, too.

The quarter's top- and bottom-line results and the company's significantly lowered full-year guidance were in line with the preliminary results it released on Oct. 19. In other words, the key numbers didn't come as a surprise to investors who follow the company. Wednesday's report, however, contained much more data.

Generac's key numbers

Data source: Generac. GAAP = generally accepted accounting principles.

Core sales, a metric that excludes the impact of acquisitions and foreign currency, increased by about 10%.

The adjusted numbers exclude pretax charges totaling $55.3 million -- $17.9 million worth of bad debt expense related to a larger clean energy product customer that has filed for bankruptcy, and $37.3 million worth of clean energy product warranty-related issues.

That's a whopper of a total charge -- it's nearly half the company's adjusted net income. And the latter issue, in particular, suggests that the company's risk-management controls might need strengthening.

Cash flows were negative in the quarter. The company burned $56 million running its operations in the third quarter, compared to generating cash of $74.4 million in the year-ago period. And free cash flow was negative $73.5 million, compared to positive $42.1 million in Q3 2021.

A cash outflow of $73.5 million in a single quarter is huge relative to the company's cash position. Generac ended the quarter with cash and cash equivalents of $229.9 million. It also has about $1.3 billion in long-term debt.

Sales breakdown by product class and geography

Product class:

• Residential product sales grew by 9% year over year to $664 million.
• Commercial and industrial product sales rose by 20% to $311 million. (Generac also has a relatively small "other" category.)

Geographic segment:

• Domestic sales increased by 18% year over year to $946.6 million, with acquisitions made over the last year contributing about 8% of that growth.
• International sales (which consist primarily of commercial and industrial products) grew by 14% to $182.5 million, and core growth was about 22%. Currency headwinds were significant as the U.S. dollar has strengthened considerably over the last year relative to most other currencies. (Both categories include inter-segment sales, so their total is somewhat higher than the company's total revenue.)

What the CEO had to say

In the earnings release, CEO Aaron Jagdfeld summarized why the third-quarter results fell short of management's prior expectations:

Commercial & Industrial product sales continued to experience strong growth during the quarter, but Residential product sales began to slow as installation capacity constraints in our distribution network led to higher field inventory levels for home standby generators. This has resulted in lower orders than expected from our channel partners even as we've seen sequential improvements in several key metrics for the home standby category. Additionally in the quarter, shipments of clean energy products were negatively impacted by a large clean energy product customer which ceased operations during the quarter.

Jagfeld said the headwinds from its channel partners in the home standby products category are expected to persist through the first half of 2023.

2022 guidance lowered

Data source: Generac.

Updated revenue guidance includes a net favorable impact of about 5% to 7% from acquisitions and foreign currency.

A dim quarter, but long-term growth potential remains bright

In short, Generac turned in a disappointing third quarter, and all signs point to continued challenges in its home standby generator business through the first half of 2023. Beyond that, much will depend upon the state of the economy. A deep or prolonged recession would hurt the company.

That said, Generac's long-term growth potential remains bright, though whether it will realize this potential remains to be seen. The company's backup power business should continue to get a tailwind from the increasing number of climate change-driven extreme weather events, which in turn are increasing the frequency and severity of power outages.

As Jagfeld noted in the earnings release, "As reliance on electricity grows and supply & demand imbalances increase further, Generac will continue to invest in technologies and solutions to lead the evolution to the next-generation grid."

Investors should keep a close eye on Generac's cash flows, as its cash outflows were very large in the third quarter.