form10q_093010.htm



 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

(Mark One)
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the quarterly period ended September 30, 2010
   
 
OR
   
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
 
For the transition period from to

Commission file number 001-34627

GENERAC HOLDINGS INC.
(Exact name of registrant as specified in its charter)

Delaware
20-5654756
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
   
S45 W29290 Hwy. 59, Waukesha, WI
53189
(Address of principal executive offices)
(Zip Code)

(262) 544-4811
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes R No £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes £ No £

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer £
Accelerated filer £
Non-accelerated filer R
Smaller reporting company £
 
(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No R

As of November 8, 2010, there were 67,522,096 shares of the Registrant’s common stock outstanding.
 



GENERAC HOLDINGS INC.
INDEX

 
Page
     
 
 
 
 
 
 
 
 
 
 
 
 
 
 
   
     
 
 
 
 
  31
 
 
PART I. FINANCIAL INFORMATION
 
Item 1.                                Financial Statements
 
Generac Holdings Inc.
 
Condensed Consolidated Balance Sheets
 
(Dollars in Thousands, Except Share and Per Share Data)
 
             
             
   
September 30,
   
December 31,
 
   
2010
   
2009
 
   
(Unaudited)
       
Assets
           
Current assets:
 
 
       
   Cash and cash equivalents
  $ 128,334     $ 161,307  
   Accounts and notes receivable, less allowance for doubtful accounts
    73,787       54,130  
   Inventories
    127,358       123,700  
   Prepaid expenses and other assets
    3,526       5,880  
Total current assets
    333,005       345,017  
                 
Property and equipment, net
    71,852       73,374  
                 
Customer lists, net
    106,047       134,674  
Patents, net
    86,904       92,753  
Other intangible assets, net
    6,781       7,791  
Deferred financing costs, net
    7,020       13,070  
Trade names
    141,148       144,407  
Goodwill
    525,875       525,875  
Other assets
    527       282  
Total assets
  $ 1,279,159     $ 1,337,243  
                 
Liabilities and stockholders’ equity
               
Current liabilities:
               
   Accounts payable
  $ 61,487     $ 33,639  
   Accrued wages and employee benefits
    6,390       6,930  
   Other accrued liabilities
    36,006       52,326  
   Current portion of long-term debt
          39,076  
Total current liabilities
    103,883       131,971  
                 
Long-term debt
    731,422       1,052,463  
Other long-term liabilities
    22,987       17,418  
Total liabilities
    858,292       1,201,852  
                 
Class B convertible voting common stock, par value $0.01, 110,000 shares authorized, 0 and 24,018 shares issued at September 30, 2010 and December 31, 2009, respectively
          765,096  
Series A convertible non-voting preferred stock, par value $0.01, 30,000 shares authorized, 0 and 11,311 shares issued at September 30, 2010 and December 31, 2009, respectively
          113,109  
                 
Stockholders’ equity (deficit):
               
Common stock (formerly Class A common stock), par value $0.01, 500,000,000 shares authorized, 67,522,096 and 1,617 shares issued at September 30, 2010 and December 31, 2009, respectively
    675        
   Additional paid-in capital
    1,132,189       2,394  
   Excess purchase price over predecessor basis
    (202,116 )     (202,116 )
   Accumulated deficit
    (500,271 )     (538,571 )
   Accumulated other comprehensive loss
    (9,610 )     (4,492 )
   Stockholder notes receivable
          (29 )
Total stockholders’ equity (deficit)
    420,867       (742,814 )
Total liabilities and stockholders’ equity
  $ 1,279,159     $ 1,337,243  
                 
See notes to condensed consolidated financial statements.
               
 

Generac Holdings Inc.
 
Condensed Consolidated Statements of Operations
 
(Dollars in Thousands, Except Share and Per Share Data)
 
(Unaudited)
 
                         
                         
   
Three Months Ended September 30,
   
Nine Months Ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
                         
Net sales
  $ 160,666     $ 144,261     $ 431,839     $ 434,284  
Costs of goods sold
    93,304       79,770       258,314       262,078  
Gross profit
    67,362       64,491       173,525       172,206  
                                 
Operating expenses:
                               
   Selling and service
    15,295       14,620       43,416       44,863  
   Research and development
    3,580       2,515       10,784       7,752  
   General and administrative
    5,654       3,671       16,492       11,538  
   Amortization of intangibles
    13,063       13,097       38,745       38,863  
Total operating expenses
    37,592       33,903       109,437       103,016  
Income from operations
    29,770       30,588       64,088       69,190  
                                 
Other (expense) income:
                               
   Interest expense
    (6,540 )     (17,204 )     (20,752 )     (53,652 )
   Investment income
    62       129       172       2,089  
   Gain on extinguishment of debt
          1,235             14,745  
   Write-off of deferred financing costs related to debt extinguishment
                (4,180 )      
   Other, net
    (216 )     (320 )     (791 )     (941 )
Total other expense, net
    (6,694 )     (16,160 )     (25,551 )     (37,759 )
                                 
Income before provision for income taxes
    23,076       14,428       38,537       31,431  
Provision for income taxes
    78       112       237       324  
Net income
    22,998       14,316       38,300       31,107  
                                 
Preferential distribution to:
                               
   Series A preferred stockholders
          (3,709 )     (2,042 )     (9,821 )
   Class B common stockholders
          (25,349 )     (12,133 )     (74,208 )
Beneficial conversion
                (140,690 )      
Net income (loss) attributable to common stockholders (formerly Class A common stockholders)
  $ 22,998     $ (14,742 )   $ (116,565 )   $ (52,922 )
                                 
Net income (loss) per common share - basic:
                               
   Common stock (formerly Class A common stock)
  $ 0.34     $ (8,492 )   $ (2.05 )   $ (30,485 )
   Class B common stock
    n/a     $ 1,055     $ 3,364     $ 3,090  
                                 
Net income (loss) per common share - diluted:
                         
   Common stock (formerly Class A common stock)
  $ 0.34     $ (8,492 )   $ (2.05 )   $ (30,485 )
   Class B common stock
    n/a     $ 1,055     $ 3,364     $ 3,090  
                                 
Weighted average common shares outstanding - basic:
                         
   Common stock (formerly Class A common stock)
    67,094,447       1,736       56,760,150       1,736  
   Class B common stock
    n/a       24,018       3,607       24,018  
                                 
Weighted average common shares outstanding - diluted:
                         
   Common stock (formerly Class A common stock)
    67,231,403       1,736       56,760,150       1,736  
   Class B common stock
    n/a       24,018       3,607       24,018  
                                 
See notes to condensed consolidated financial statements.
                         

 
Generac Holdings Inc.
 
Condensed Consolidated Statements of Redeemable Stock and Stockholders' Equity (Deficit)
 
(Dollars in Thousands, Except Share Data)
 
                                                                               
                                                                               
                                             
 
   
 
    Accumulated Other Comprehensive
(Loss) Income
                   
   
Redeemable
    Common Stock (formerlyClass A Common Stock)     Additional Paid-In
Capital
     Excess
Purchase
Price Over Predecessor
Basis
   
Retained Earnings(Accumulated
Deficit)
        Stockholder Notes
Receivable
    Total Stockholders'
Equity
       
   
Series A Preferred Stock
   
Class B Common Stock
                                Comprehensive
Income (Loss)
 
   
Shares
   
Amount
   
Shares
   
Amount
   
Shares
   
Amount
                             
                                                                               
Balance at December 31, 2008
    7,835     $ 78,355       24,018     $ 765,096       1,736     $     $ 2,356     $ (202,116 )   $ (581,626 )   $ (28,650 )   $ (158 )   $ (810,194 )      
Amortization of unrealized loss on interest rate swaps
                                                          24,222             24,222     $ 24,222  
Repayment of stockholder notes receivable
                                                                129       129        
Cancellation of stock
                            (119 )                                                
Contribution of capital related to debt extinguishment
    1,476       14,754                                                                    
Proceeds from shares issued to management and directors
    50       497                                                                    
Proceeds from shares issued to stockholders
    1,950       19,503                                                                          
Net income
                                                    43,055                   43,055       43,055  
Share based compensation
                                        38                               38        
Pension liability adjustment
                                                          (64 )           (64 )     (64 )
                                                                                                    $ 67,213  
Balance at December 31, 2009
    11,311     $ 113,109       24,018     $ 765,096       1,617     $     $ 2,394     $ (202,116 )   $ (538,571 )   $ (4,492 )   $ (29 )   $ (742,814 )        
Unrealized loss on interest rate swaps
                                                          (5,118 )           (5,118 )   $ (5,118 )
Repayment of stockholder notes receivable
                                                                29       29        
Corporate reorganization
    (11,311 )     (113,109 )     (24,018 )     (765,096 )     28,368,581       284       877,921                               878,205        
Beneficial conversion related to Class B Common and Series A Preferred stockholders
                                        (140,690 )                             (140,690 )      
Accumulated accretion related to Class B Common and Series A Preferred stockholders
                                        (303,305 )                             (303,305 )      
Issuance of Common stock (formerly Class A Commonstock) resulting from the beneficial conversion and accumulated accretion
                            18,002,337       180       443,815                               443,995        
Proceeds from public stock offering
                            20,700,500       207       247,424                               247,631        
Share based compensation
                            449,061       4       4,630                               4,634        
Net income
                                                    38,300                   38,300       38,300  
                                                                                                    $ 33,182  
Balance at September 30, 2010 (unaudited)
        $           $       67,522,096     $ 675     $ 1,132,189     $ (202,116 )   $ (500,271 )   $ (9,610 )   $ -     $ 420,867          
                                                                                                         
See notes to condensed consolidated financial statements.
                                       
 

Generac Holdings Inc.
 
Condensed Consolidated Statements of Cash Flows
 
(Dollars in Thousands)
 
(Unaudited)
 
             
   
Nine Months Ended September 30,
 
   
2010
   
2009
 
             
Operating activities
 
 
   
 
 
Net income
  $ 38,300     $ 31,107  
Adjustment to reconcile net income to net cash provided by operating activities:
               
   Depreciation
    5,777       5,818  
   Amortization
    38,745       38,863  
   Gain on extinguishment of debt
          (14,745 )
   Write-off of deferred financing costs related to debt extinguishment
    4,180        
   Amortization of deferred finance costs
    1,870       2,562  
   Amortization of unrealized loss on interest rate swaps
          18,167  
   Provision for losses on accounts receivable
    1       89  
   Loss on disposal of property and equipment
    31       36  
   Share-based compensation expense
    4,634       28  
   Net changes in operating assets and liabilities:
               
      Accounts receivable
    (19,658 )     6,094  
      Inventories
    (3,658 )     (19,711 )
      Other assets
    1,431       1,369  
      Accounts payable
    27,848       9,421  
      Accrued wages and employee benefits
    (511 )     (14 )
      Other accrued liabilities
    (15,869 )     (33,953 )
Net cash provided by operating activities
    83,121       45,131  
                 
Investing activities
               
Proceeds from sale of property and equipment
    38       56  
Expenditures for property and equipment
    (4,324 )     (2,902 )
Collections on receivable notes
          105  
Net cash used in investing activities
    (4,286 )     (2,741 )
                 
Financing activities
               
Stockholders’ contributions of capital –  Series A preferred stock
          20,000  
Proceeds from issuance of common stock
    248,309        
Payment of short-term and long-term debt
    (360,117 )     (9,500 )
Net cash (used in) provided by financing activities
    (111,808 )     10,500  
 
               
Net (decrease) increase in cash and cash equivalents
    (32,973 )     52,890  
Cash and cash equivalents at beginning of period
    161,307       81,229  
Cash and cash equivalents at end of period
  $ 128,334     $ 134,119  
 
               
Supplemental disclosure of noncash financing and investing activities
               
Contributions of capital related to debt extinguishment
  $     $ 14,754  
                 
See notes to condensed consolidated financial statements
         
 

Generac Holdings Inc.
 
Notes to Condensed Consolidated Financial Statements
 
(Unaudited)
1.  Basis of Presentation

Description of Business

Generac Holdings Inc. (the Company) owns all of the common stock of Generac Acquisition Corp., which in turn, owns all of the common stock of Generac Power Systems, Inc. (the Subsidiary). The Company designs, manufactures, and markets a complete line of backup power generation products for residential, light-commercial, and industrial markets.

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All intercompany amounts and transactions have been eliminated in consolidation.

The condensed consolidated balance sheet as of September 30, 2010, the condensed consolidated statement of redeemable stock and stockholders’ equity (deficit) and condensed consolidated statements of cash flows for the nine months ended September 30, 2010 and 2009, and the condensed consolidated statements of operations for the three and nine months ended September 30, 2010 and 2009 have been prepared by the Company and have not been audited. In the opinion of management, all adjustments, consisting of only normal recurring adjustments necessary for the fair presentation of the financial position, results of operation and cash flows, have been made. The results of operations for any interim period are not necessarily indicative of the results to be expected for the full year.

Expenses are charged to operations in the year incurred. However, for interim reporting purposes certain expenses are charged to operations based on a proportionate share of annual amounts rather than as they are actually incurred.

The preparation of the consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Certain information and footnote disclosure normally included in consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2009.

Initial Public Offering and Conversion of Class B Common Stock and Series A preferred Stock

On February 17, 2010, the Company completed its initial public offering (IPO) of 18,750,000 shares of its common stock at a price of $13.00 per share. In addition, the underwriters exercised their over-allotment option outlined in the underwriters agreement, and purchased an additional 1,950,500 shares of the Company’s common stock on March 18, 2010. The Company received approximately $269,100,000 in gross proceeds from the IPO and over-allotment exercise, or approximately $247,631,000 in net proceeds after deducting the underwriting discount and total expenses related to the offering.

The Company’s capitalization prior to the initial public offering consisted of Series A Preferred Stock, Class B Common Stock and Class A Common Stock. The Series A Preferred stock and Class B Common stock were redeemable in a deemed liquidation in the event of a change of control. The redemption features were considered to be outside the control of the Company and therefore, all shares of Series A Preferred stock and Class B Common stock were recorded outside of permanent equity in accordance with guidance originally issued under EITF Topic D-98, Classification and Measurement of Redeemable Securities (codified under Accounting Standards Codification 480, Distinguishing Liabilities from Equity). Upon closing of the IPO, all shares of convertible Class B Common stock and Series A Preferred stock were automatically converted into 88,476,530 and 19,511,018 Class A Common shares, respectively. The 88,476,530 shares of Class A Common stock were subject to a 3.294 for 1 reverse stock split, resulting in 26,859,906 Class A Common shares related to the Class B Common stock conversion, and the Class A Common stock was re-designated as “Common Stock”. Subsequent to the IPO, the Company has one class of common stock. The share and per share data used in basic and diluted earnings per share has been retrospectively restated to reflect only the 3.294 for 1 reverse stock split immediately prior to the IPO.
 
 
Capitalization summary upon closing of initial public offering and underwriters option exercise:
 
Class A Common stock issued and outstanding immediately prior to the IPO after the 3.294 for 1 reverse stock split
    1,617  
Conversion and 3.294 for 1 reverse stock split of Class B Common stock into Common stock upon closing of IPO
    26,859,906  
Conversion of Series A Preferred stock into Common stock upon closing of IPO
    19,511,018  
Sales of Common stock through IPO
    18,750,000  
Issuance of vested and non-vested Common stock upon closing of IPO
    456,249  
Common stock issued and outstanding after IPO
    65,578,790  
Issuance of Common stock to underwriters due to exercise of over-allotment
    1,950,500  
Total Common stock issued and outstanding as of March 18, 2010
- Completion of IPO
     67,529,290  

The Company determined that the conversion features in the Class B Common stock and Series A Preferred stock were in-the-money at the date of issuance and therefore represented a beneficial conversion feature. Since the Class B Common stock and Series A Preferred stock were convertible upon an initial public offering, conversion was contingent upon a future event and therefore the beneficial conversion feature had not been recorded in the consolidated financial statements as of December 31, 2009. The beneficial conversion feature at the IPO date was $140,690,000 and was recorded at the IPO date as a return to Class B Common and Series A Preferred stockholders analogous to a dividend, which was satisfied through the issuance of Class A Common stock. The beneficial conversion was recorded within additional paid-in-capital, as no retained earnings were available.

The Company used $221,622,000 of proceeds from the initial closing of the IPO to pay down its second lien credit facility in full and to repay a portion of its first lien credit facility. Additionally, in March 2010, the Company used $138,495,000 million of cash and cash equivalents on hand to further pay down its first lien term loan principal. Repayments of the first and second lien credit facilities during the nine months ended September 30, 2010 totaled $360,117,000.

The Company adopted an equity incentive plan on February 10, 2010 in connection with the IPO. At the time of the IPO, 4,341,504 stock options and 456,249 shares of restricted stock and other stock awards were granted to employees and Board members of the Company pursuant to the equity incentive plan.  The stock options have an exercise price equal to the IPO price and vest in equal installments over five years, subject to the grantee’s continued employment or service. The restricted stock awards will vest in full on the third anniversary of the date of grant, subject to the grantee’s continued employment. See further discussion in note 11 – Share Plans.
 
Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) (OCI) includes unrealized losses on certain cash flow hedges and the pension liability. The components of OCI at September 30, 2010 and December 31, 2009 were (dollars in thousands):
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
Pension liability
  $ (4,492 )   $ (4,492 )
Unrealized losses on cash flow hedges
    (5,118 )     -  
Accumulated other comprehensive loss
  $ (9,610 )   $ (4,492 )

 

2. Derivative Instruments and Hedging Activities

The Company records all derivatives in accordance with ASC 815, Derivatives and Hedging, which requires all derivative instruments be reported on the consolidated balance sheets at fair value and establishes criteria for designation and effectiveness of hedging relationships. The Company is exposed to market risk such as changes in commodity prices, foreign currencies, and interest rates. The Company does not hold or issue derivative financial instruments for trading purposes.

Commodities

The primary objectives of the commodity risk management activities are to understand and mitigate the impact of potential price fluctuations on the Company’s financial results and its economic well-being. While the Company’s risk management objectives and strategies will be driven from an economic perspective, the Company attempts, where possible and practical, to ensure that the hedging strategies it engages in can be treated as “hedges” from an accounting perspective or otherwise result in accounting treatment where the earnings effect of the hedging instrument provides substantial offset (in the same period) to the earnings effect of the hedged item. Generally, these risk management transactions will involve the use of commodity derivatives to protect against exposure resulting from significant price fluctuations.

The Company primarily utilizes commodity contracts with maturities of less than 12 months. These are intended to offset the effect of price fluctuations on actual inventory purchases. There were two outstanding commodity contracts in place to hedge the Company’s projected commodity purchases at September 30, 2010. There was one outstanding commodity contract in place to hedge the Company’s projected commodity purchases at December 31, 2009. In October 2009, the Company entered into a commodity forward contract to purchase a notional amount of $1,432,000 of copper.  The contract was effective from October 5, 2009, and terminated on March 31, 2010.  In May 2010, the Company entered into commodity forward contracts to purchase a notional amount of $5,082,000 of copper.  The contracts were effective from May 1, 2010 and June 1, 2010, and terminate on December 31, 2010. Total gain recognized in the consolidated statements of operations on commodity contracts was a gain of $0 and $137,000 for the three and nine months ended September 30, 2009, respectively. Total gains recognized in the consolidated statements of operations on commodity contracts were a gain of $667,000 and $471,000 for the three and nine months ended September 30, 2010, respectively.

 Foreign Currencies

The Company is exposed to foreign currency exchange risk as a result of transactions in other currencies. The Company periodically utilizes foreign currency forward purchase and sales contracts to manage the volatility associated with foreign currency purchases in the normal course of business. Contracts typically have maturities of one year or less.

On February 18, 2010, the Company entered into a ten-month foreign currency average rate option transaction for Euros with a total notional amount of $2,500,000. The primary objective of this transaction is to mitigate the impact of potential currency fluctuations of the Euro on our financial results. The impact on operations for the three and nine months ended September 30, 2010 was a gain of $113,000 and loss of $97,000, respectively.  There were no foreign currency hedge contracts outstanding during the three and nine month periods ending September 30, 2009.

Interest Rates

In 2006, the Company entered into various interest rate swap agreements. The Company formally documented all relationships between interest rate hedging instruments and hedged items, as well as its’ risk-management objectives and strategies for undertaking various hedge transactions. From inception through December 31, 2008, the Company’s interest rate swap agreements qualified as cash flow hedges. For derivatives that are designated and qualify as a cash flow hedge, the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive income (loss) and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the derivatives’ change in fair value, if any, is immediately recognized in earnings. The Company assesses on an ongoing basis whether derivatives used in hedging transactions are highly effective in offsetting changes in cash flows of hedged items.
 
Effective January 3, 2009, the Company, within the terms of the Credit Agreements (see note 7), changed the interest rate election from three-month LIBOR to one-month LIBOR. Because of this change, the Company concluded that as of January 3, 2009, the Swaps no longer met hedge effectiveness tests and were therefore, no longer highly effective as a hedge against the impact on interest payments of changes in the LIBOR interest rate. In 2009, the effective portion of the swaps prior to the change was amortized as interest expense over the period of the originally designated hedged transactions. During 2009, changes in the fair value of the swaps were immediately recognized in the consolidated statements of operations as interest expense.
 
 
The Company’s interest rate swap agreements outstanding as of December 31, 2009, totaling $675,000,000 notional amount of debt, terminated on January 4, 2010. Subsequently, the Company entered into two new interest rate swap agreements during the first nine months of 2010.  The first was entered into on January 21, 2010. The effective date of this swap is July 1, 2010 with a notional amount of $200,000,000, a fixed LIBOR rate of 1.73% and an expiration date of July 1, 2012. The second was entered into on June 29, 2010. The effective date of that swap is October 1, 2010 with a notional amount of $100,000,000, a fixed LIBOR rate of 1.025% and an expiration date of October 1, 2012. We expect to maintain the swaps as highly effective in accordance with ASC 815 (formerly SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities) and, therefore, any changes in the fair value of the swap would be recorded in accumulated other comprehensive income (loss).

The following table presents, in thousands, the fair value of the Company’s derivatives:
 
   
September 30,
2010
   
December 31,
2009
 
Derivatives designated as hedging instruments:
           
Interest rate swaps
  $ (5,118 )   $  
      (5,118 )      
Derivatives not designated as hedging instruments:
               
Commodity and foreign currency contracts
    458       208  
Total derivatives (liability) asset
  $ (4,660 )   $ 208  

As of September 30, 2010 and December 31, 2009, all derivatives that are not designated as hedging instruments are included in other assets in the consolidated balance sheet. All derivatives designated as hedging instruments are included in other long-term liabilities in the consolidated balance sheet at September 30, 2010. There were no derivatives that were designated as hedging instruments at December 31, 2009.

The fair value of the derivative contracts of a $4,660,000 net liability and a $208,000 asset takes into account the Company’s credit risk as of September 30, 2010 and December 31, 2009, respectively. Excluding the impact of credit risk, the fair value of the derivatives at September 30, 2010 was a $4,832,000 net liability, and represents the amount the Company would need to pay to exit the agreements on that date. The impact of credit risk on the fair value of derivative contracts at December 31, 2009 was not material.

 
The following presents the impact of interest rate swaps, commodity contracts and foreign currency contracts on the consolidated statement of operations for the nine months ended September 30, 2010 and 2009 (dollars in thousands):
 
   
Amount of loss
recognized in AOCI for
the nine months ended
September 30,
 
Location of gain (loss)
reclassified from AOCI
 
Amount of loss
reclassified from AOCI
into net income (loss) for
the nine months ended
September 30,
   
Amount of gain (loss)
recognized in net income
(loss) on hedges
(ineffective portion) for
the nine months ended
September 30,
 
   
2010
   
2009
 
into net income (loss)
 
2010
   
2009
   
2010
   
2009
 
Derivatives designated as hedging instruments
                                     
Interest rate swaps
  $ (5,118 )   $  
Interest expense
  $     $ (18,167 )   $     $  
Derivatives not designated as hedging instruments
                                                 
Commodity and foreign currency contracts
           
Cost of goods sold
                374       137  
Interest rate swaps
           
Interest expense
                      16,928  
 
 
3. Fair Value Measurements

ASC 820-10 Fair Value Measurements and Disclosures (formerly SFAS No. 157, Fair Value Measurements) among other things, defines fair value, establishes a consistent framework for measuring fair value, and expands disclosure for each major asset and liability category measured at fair value on either a recurring basis or nonrecurring basis. ASC 820-10 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the pronouncement establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

Assets and liabilities measured at fair value are based on the market approach, which uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

The Company believes the carrying amount of its financial instruments (cash and cash equivalents, accounts receivable, notes receivable, accounts payable, and accrued liabilities), excluding long-term debt, approximates the fair value of these instruments based upon their short-term nature. The fair value of long-term debt was approximately $702,165,000 at September 30, 2010, as calculated based on current quotations.

Assets and (liabilities) measured at fair value on a recurring basis are as follows (dollars in thousands):
 
      Fair Value Measurement Using  
   
Total
September 30, 2010
   
Quoted Prices in Active Markets for Identical Contracts (Level 1)
   
Significant
Other Observable Inputs
(Level 2)
 
                   
Net derivative contracts
  $ (4,660 )   $     $ (4,660 )

 
The fair value of derivative contracts above takes into account the Company’s credit risk in accordance with ASC 820-10. Excluding the impact of credit risk, the fair value of derivatives at September 30, 2010 was a $4,832,000 net liability, and this represents the amount the Company would need to pay to exit the agreements on this date.

4. Segment Reporting

The Company operates in and reports as a single operating segment, which is the manufacture and sale of power products. Net sales are generated through the sale of generators and service parts to distributors and retailers. The Company manages and evaluates its operations as one segment primarily due to similarities in the nature of the products, production processes and methods of distribution. All of the Company’s identifiable assets are located in the United States. The Company’s sales outside North America represent approximately 2% of net sales.

The Company's product offerings consist primarily of power products with a range of power output. Residential products and industrial/commercial products are each a similar class of products based on similar power output and customer usage. The breakout of net sales between residential, industrial/commercial, and other products is as follows (dollars in thousands):
 
   
Three Months Ended September 30,
   
Nine months Ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Residential products
  $ 100,973     $ 89,687     $ 272,838     $ 269,037  
Industrial/Commercial products
    49,554       46,033       131,180       142,506  
Other
    10,139       8,541       27,821       22,741  
Total
  $ 160,666     $ 144,261     $ 431,839     $ 434,284  

 
5. Balance Sheet Details
 
Inventories consist of the following (dollars in thousands):
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
Raw material
  $ 73,899     $ 74,136  
Work-in-process
    354       775  
Finished goods
    57,129       52,726  
Reserves for excess and obsolescence
    (4,024 )     (3,937 )
    $ 127,358     $ 123,700  

Property and equipment consists of the following (dollars in thousands):
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
Land and improvements
  $ 3,934     $ 3,913  
Buildings and improvements
    48,630       48,521  
Machinery and equipment
    28,631       26,500  
Dies and tools
    10,839       9,631  
Vehicles
    830       857  
Office equipment
    6,397       5,712  
    Gross property and equipment
    99,261       95,134  
Less accumulated depreciation
    (27,409 )     (21,760 )
Property and equipment, net
  $ 71,852     $ 73,374  
 
Other accrued liabilities consist of the following (dollars in thousands):
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
Accrued commissions
  $ 4,627     $ 4,211  
Accrued interest
    3,538       17,062  
Accrued warranties – short term
    18,063       17,029  
Other accrued liabilities
    9,778       14,024  
    $ 36,006     $ 52,326  

 
6. Product Warranty Obligations

The Company records a liability for product warranty obligations at the time of sale to a customer based upon historical warranty experience. The Company also records a liability for specific warranty matters when they become known and are reasonably estimable. The Company’s product warranty obligations are included in other accrued liabilities and other long-term liabilities in the balance sheets.

Changes in product warranty obligations are as follows (dollars in thousands):
 
   
For the three months ended September 30,
   
For the nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Balance at beginning of period
  $ 21,178     $ 18,764     $ 20,729     $ 17,539  
Payments
    (3,867 )     (3,847 )     (10,200 )     (10,701 )
Charged to operations
    4,452       4,652       11,234       12,731  
Balance at end of period
  $ 21,763     $ 19,569     $ 21,763     $ 19,569  

The product warranty obligations are included in the balance sheets as follows (dollars in thousands):
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
Other accrued liabilities
  $ 18,063     $ 17,029  
Other long-term liabilities
    3,700       3,700  
Balance at end of period
  $ 21,763     $ 20,729  

7. Credit Agreements

Long-term debt consists of the following (dollars in thousands):
 
   
September 30,
   
December 31,
 
   
2010
   
2009
 
             
First lien term loan
  $ 739,371     $ 920,604  
Second lien term loan
    -       430,000  
      739,371       1,350,604  
Less treasury debt – first lien
    7,949       9,898  
Less treasury debt – second lien
    -       249,167  
Less current portion
    -       39,076  
    $ 731,422     $ 1,052,463  

On February 17, 2010, the Company completed its initial public offering. $221,622,000 of proceeds from the initial closing were used to pay down the second lien credit facility in full and to repay a portion of the first lien credit facility. Additionally, in March 2010, the Company used $138,495,000 of cash and cash equivalents on hand to further pay down the first lien term loan principal. Repayments of the first and second lien credit facilities during the three and nine months ended September 30, 2010 totaled $0 and $360,117,000, respectively.

At September 30, 2010, the Company had a credit agreement which provided for borrowings under a revolving credit facility (the Revolving Credit Facility) and a first lien term loan (collectively, the Credit Agreement). The Credit Agreement requires the Company, among other things, to meet certain financial and nonfinancial covenants and maintain financial ratios in such amounts and for such periods as set forth therein. The Company is required to maintain a leverage ratio (net debt divided by EBITDA, as defined in the Credit Agreement) of 6.25 as of September 30, 2010. The leverage ratio decreases quarterly, and for 2010, the Company has been or will be required to maintain a leverage ratio of 6.75, 6.50, 6.25, and 5.75 for the first, second, third, and fourth quarters, respectively. The Company was in compliance with all requirements as of September 30, 2010 and December 31, 2009.
 

The Credit Agreement restricts the circumstances in which distributions and dividends can be paid by its Subsidiary. Payments can be made to the Company for certain expenses, and dividends can be used to repurchase equity interests, subject to an annual limitation. Additionally, the Credit Agreement restricts the aggregate amount of dividends and distributions that can be paid.

During the three and nine months ended September 30, 2009, affiliates of CCMP Capital Advisors, LLC (CCMP), majority shareholder of the Company, acquired $2,000,000 and $29,898,000 par value of first and second lien term loans for approximately $765,000 and $14,754,000, respectively. CCMP exchanged this debt for additional shares of Series A Preferred stock issued by the Company. The Company subsequently contributed this debt to its Subsidiary. The fair value of the shares exchanged was $765,000 and $14,754,000 for the three and nine months ending September 30, 2009, respectively. These shares had beneficial conversion features which were contingent upon a future event (see note 1). The Company recorded this transaction as Series A Preferred stock of $765,000 and $14,754,000 for the three and nine months ended September 30, 2009, respectively, based on the fair value of the debt contributed by CCMP which approximated the fair value of shares exchanged. The debt was held in treasury at face value. Consequently, the Company recorded a gain on extinguishment of debt of $1,235,000 and $14,745,000, which includes the write-off of deferred financing fees and other closing costs, in the consolidated statement of operations for the three and nine months ended September 30, 2009, respectively.

In previous periods, the Company entered into various interest rate swap agreements (the Swaps) with certain banks. The Swaps, which were effective January 2, 2007, October 3, 2007, and January 3, 2008, had notional amounts totaling $825,000,000, $100,000,000, and $275,000,000, respectively. The total notional amount of $1,200,000,000 declined to $1,100,000,000 at October 3, 2008, further declined to $675,000,000 at January 3, 2009, and terminated January 4, 2010. The Company swapped floating three-month LIBOR interest rates for fixed rates with an aggregate weighted-average interest rate of 5.041% as of December 31, 2009.

The Company entered into two new interest rate swap agreements during the nine month period ending September 30, 2010.  The first was entered into on January 21, 2010. The effective date of the swap was July 1, 2010 and it has a notional amount of $200,000,000, a fixed LIBOR rate of 1.73% and an expiration date of July 1, 2012. The second was entered into on June 29, 2010. The effective date of the swap is October 1, 2010 and it has a notional amount of $100,000,000, a fixed LIBOR rate of 1.025% and an expiration date of October 1, 2012. We expect to maintain the swaps as highly effective in accordance with ASC 815 (formerly SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities) and, therefore, any changes in the fair value of the swap would be recorded in accumulated other comprehensive income (loss).

The fair value of the interest rate swap agreements, including the impact of credit risk, was a liability of $5,118,000 and $0 at September 30, 2010 and December 31, 2009, respectively.

8. Earnings Per Share

The Company’s capitalization prior to the initial public offering consisted of Series A Preferred Stock, Class B Common Stock and Class A Common Stock. The Series A Preferred stock and Class B Common stock were redeemable in a deemed liquidation in the event of a change of control. The redemption features were considered to be outside the control of the Company and therefore, all shares of Series A Preferred stock and Class B Common stock were recorded outside of permanent equity in accordance with guidance originally issued under EITF Topic D-98, Classification and Measurement of Redeemable Securities (codified under Accounting Standards Codification 480, Distinguishing Liabilities from Equity). Upon closing of the IPO, all shares of convertible Class B Common stock and Series A preferred stock were automatically converted into 88,476,530 and 19,511,018 Class A Common shares, respectively. The 88,476,530 shares of Class A Common stock were subject to a 3.294 for 1 reverse stock split, resulting in 26,859,906 Class A Common shares relative to the Class B Common stock conversion, and the Class A Common stock was re-designated as “Common Stock”. Subsequent to the IPO, the Company has one class of common stock. The share and per share data used in basic and diluted earnings per share has been retrospectively restated to reflect only the 3.294 for 1 reverse stock split immediately prior to the IPO.
 
The Class B Common stock was considered a participating stock security requiring use of the “two-class” method for the computation of basic net income (loss) per share in accordance with provision of ASC 260-10 Earnings per share. Losses were not allocated to the Class B Common stock in the computation of basic earnings per share as the Class B Common stock was not obligated to share in losses.

Basic earnings per share excludes the effect of common stock equivalents and is computed using the “two-class” computation method, which subtracts earnings attributable to the Class B preference from total earnings. In addition, earnings attributable to the Series A Preferred preference and the Class B and Series A Preferred beneficial conversion are subtracted from total earnings. Any remaining loss is attributed to the Class A Common shares.
 
 
For the nine month period ended September 30, 2010, diluted earnings per share are identical to basic earnings per share because the impact of common stock equivalents on earnings per share is anti-dilutive. Had the impact not been anti-dilutive, the effect of stock compensation awards on weighted average diluted shares outstanding would have been 230,439.
 
   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Net income
  $ 22,998     $ 14,316     $ 38,300     $ 31,107  
Less: accretion of Series A Preferred stock
    -       (3,709 )     (2,042 )     (9,821 )
Less: accretion of Class B Common stock
    -       (25,349 )     (12,133 )     (74,208 )
Less: beneficial conversion
    -       -       (140,690 )     -  
Net income (loss) attributable to Common stock (formerly Class A Common stock)
     22,998       (14,742 )     (116,565 )     (52,922 )
Income attributable to Class B Common stock
    -       25,349       12,133       74,208  
                                 
Net income (loss) per common share - basic:
                               
Common stock (formerly Class A Common stock)
  $ 0.34     $ (8,492 )   $ (2.05 )   $ (30,485 )
Class B Common stock
    n/a     $ 1,055     $ 3,364     $ 3,090  
                                 
Net income (loss) per common share - diluted:
                               
Common stock (formerly Class A Common stock)
  $ 0.34     $ (8,492 )   $ (2.05 )   $ (30,485 )
Class B Common stock
    n/a     $ 1,055     $ 3,364     $ 3,090  
                                 
Weighted average number of shares outstanding – Common Stock (formerly Class A Common stock):
                               
Basic
    67,094,447       1,736       56,760,150       1,736  
Dilutive effect of stock compensation awards
    136,956       -       -       -  
       Diluted
    67,231,403       1,736       56,760,150       1,736  
                                 
Weighted average number of shares outstanding – Class B Common stock – basic and diluted:
     n/a        24,018        3,607        24,018  

The Series A Preferred and Class B Common stock were only convertible to Class A Common stock immediately prior to an initial public offering. The impact of the conversion of Series A Preferred and Class B Common stock are excluded from the diluted earnings per share calculation for the three and nine month periods ended September 30, 2009, as this contingent event had not yet occurred as of September 30, 2009. The number of shares of Class A Common stock that were issued upon conversion of the Series A Preferred and Class B Common stock was dependent upon the initial public offering price of the Class A Common stock on the date of conversion of February 10, 2010 as well as the unpaid priority return as of that date.
 
9. Income Taxes

The Company is the taxpaying entity and files a consolidated federal income tax return. Currently, the Company is not under examination by any major taxing jurisdiction to which the Company is subject. The statute of limitation for tax years 2009, 2008, 2007 and 2006 is open for federal and state income taxes. Additionally, tax year 2005 remains open for examination by certain state taxing authorities.

At December 31, 2009, the Company had federal net operating loss carry forwards of approximately $161,200,000, which expire between 2026 and 2029, and various state net operating loss carry forwards, which expire between 2016 and 2029.

As a result of ownership changes, Section 382 of the Internal Revenue Code of 1986, as amended, and similar state provisions can limit the annual deductions of net operating loss and tax credit carry forwards. Such annual limitations could result in the expiration of net operating loss and tax credit carry forwards before utilization. The Company had no such limitation as of September 30, 2010, and no limitation was triggered by our initial public offering which was completed on February 17, 2010, or the underwriters exercise of their over-allotment option on March 18, 2010. Future ownership changes may result in such a limitation.

 
10. Benefit Plans

Additional information related to the Pension Plans is as follows (dollars in thousands):

   
Three months ended September 30,
   
Nine months ended September 30,
 
   
2010
   
2009
   
2010
   
2009
 
Components of net periodic pension expense:
                       
Service cost
  $     $     $     $  
Interest cost
    590       584       1,770       1,754  
Expected return on plan assets
    (501 )     (451 )     (1,503 )     (1,353 )
Amortization of net loss
    62       60       183       180  
Net periodic pension expense
  $ 151     $ 193     $ 450     $ 581  

11. Share Plans

On November 10, 2006, the Company adopted the 2006 Management Equity Incentive Plan (2006 Equity Incentive Plan). The 2006 Equity Incentive Plan provided for awards with respect to a maximum of 9,350.0098 shares of Common stock (formerly Class A Common stock) and 5,000 Class B Common shares, subject to certain adjustments. On November 10, 2006, and from time to time thereafter, certain members of management purchased restricted shares of Class A Common stock under the 2006 Equity Incentive Plan for $341 per share and pursuant to restricted stock agreements. One half of the restricted shares vest over time (Time Vesting Shares), with 25% vesting on November 10, 2007 and on the next three anniversaries thereafter, so long as the participant was still employed by the Company or one of its subsidiaries on the applicable vesting date. Upon the occurrence of a change of control of the Company, any unvested Time Vesting Shares immediately vested in full, so long as the participant was still employed by the Company or one of its subsidiaries. The remaining restricted shares immediately vested (performance-based vesting) in full, provided the participant was still then employed by the Company or one of its subsidiaries, upon the occurrence of either: (i) a change of control of the Company that provides CCMP with a certain rate of return with respect to net proceeds received by CCMP from their investment in the Company; or (ii) from and after the date of an IPO, the achievement with respect to shares of the Common stock (formerly Class A Common stock) of an average closing trading price exceeding, in any 60 consecutive trading day period starting prior to the later of (a) the fifth year anniversary of the date of grant of the restricted shares, and (b) one year after the IPO, a certain threshold with respect to net proceeds received by CCMP from their investment in the Company. As a condition to the purchase of restricted shares, members of management executed confidentiality, non-competition and intellectual property agreements.

The fair value of the Class A common stock on the date of issuance was estimated to be $390 per share. As a result of the IPO, the remaining unvested performance-based Restricted Shares became fully vested. As a result, the Company has recorded $0 and $159,000 of stock-based compensation expense related to the accelerated vesting during the three and nine months ended September 30, 2010. The stock-based compensation expense related to the time-based vesting prior to the IPO was $0 and $6,000 for the three and nine months ended September 30, 2010.

The Company adopted an equity incentive plan on February 10, 2010 in connection with the IPO. At the time of the IPO, 4,341,504 stock options and 456,249 shares of restricted stock and other stock awards were granted to employees and Board members of the Company pursuant to the equity incentive plan. Total share-based compensation cost related to the equity incentive plan recognized in the consolidated statement of operations for the three and nine months ended September 30, 2010 was $1,675,000 and $4,469,000, respectively, which is recorded in operating expenses in the condensed consolidated statement of operations.

Stock Options - The stock options have an exercise price equal to the IPO price of $13.00 per share, and vest in equal installments over five years, subject to the grantee’s continued employment or service. The options expire 10 years after the date of grant.

 
The grant-date fair value of each option grant is estimated using the Black-Scholes-Merton option pricing model. The fair value is then amortized on a straight-line basis over the requisite service period of the awards, which is generally the vesting period. Use of a valuation model requires management to make certain assumptions with respect to selected model inputs. Since there was no history for the Company’s stock, expected volatility was calculated based on an analysis of historic and implied volatility measures for a set of peer companies. The average expected life was based on the contractual term of the option using the simplified method. The risk-free interest rate was based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life assumed at the date of grant. The compensation expense recognized is net of estimated forfeitures. Forfeitures are estimated based on voluntary termination behavior, as there is not sufficient history of actual share option forfeitures at this time. The weighted-average assumptions used in the Black-Scholes-Merton option pricing model for 2010 are as follows:
 
   
2010
 
Expected stock price volatility
   
50
%
Risk free interest rate
   
2.94
%
Expected annual dividend per share
 
$
-
 
Expected life of options (years)
   
6.5
 

The weighted-average grant-date fair value of options granted during 2010 was $6.84 per option. There have been no options exercised during 2010.

 A summary of option activity as of September 30, 2010 and changes during the nine months then ended is presented below:

 
Shares
 
Weighted-
 Average
 Exercise Price
 
Weighted-
 Average
 Remaining
 Contractual Term
 (in years)
 
Aggregate
 Intrinsic
 Value
 ($ in thousands)
 
Outstanding as of December 31, 2009
­-
 
$
-
           
Granted
4,341,504
   
13.00
           
Exercised
-
   
-
           
Expired
-
   
-
           
Forfeited
(130,245
)  
(13.00
)          
Outstanding as of September 30, 2010
4,211,259
   
13.00
 
9.4
 
$
2,695
 
Exercisable as of September 30, 2010
-
   
-
 
-
   
-
 

As of September 30, 2010, there was $22,337,000 of total unrecognized compensation cost, net of expected forfeitures, related to unvested options. The cost is expected to be recognized over the remaining service period, having a weighted-average period of 4.4 years. Total share-based compensation cost related to the stock options for the three and nine month periods ended September 30, 2010 was $1,276,000 and $3,191,000, respectively, which is recorded in operating expenses in the condensed consolidated statement of operations.

Restricted Stock - The restricted stock awards will vest in full on the third anniversary of the date of grant, subject to the grantee’s continued employment. The fair market value of the award at the time of the grant is amortized to expense over the period of vesting. The fair value of restricted share awards is determined based on the market value of the Company's shares on the grant date. The compensation expense recognized for restricted share awards is net of estimated forfeitures.


A summary of the status of the Company's restricted share awards as of September 30, 2010 and changes during the nine months then ended is presented in the table below:

Restricted Stock Awards
Shares
 
Weighted-Average
 Grant-Date
 Fair Value
 
Non-vested as of December 31, 2009
-
 
$
-
 
Granted
437,499
   
13.00
 
Vested
-
   
-
 
Forfeited
(9,844
)  
(13.00
)
Non-vested as of September 30, 2010
427,655
   
13.00
 

As of September 30, 2010, there was $3,786,000 of total unrecognized compensation cost, net of expected forfeitures, related to non-vested restricted share awards. That cost is expected to be recognized over the remaining service period, having a weighted-average period of 2.4 years. Total share-based compensation cost related to the restricted stock for the three and nine month periods ended September 30, 2010 was $399,000 and $997,000, which is recorded in operating expenses in the condensed consolidated statement of operations.

During the three and nine months ended September 30, 2010, 0 and 21,406 shares of fully vested stock were granted to certain members of the Company’s board of directors as a component of their compensation for their service on the board. Total compensation cost for these share grants was $0 and $281,000 for the three and nine months ended September 30, 2010, respectively, which is recorded in operating expenses in the condensed consolidated statement of operations.

12. Commitments and Contingencies

The Company had a previous arrangement with a finance company to provide floor plan financing for selected dealers. The Company received payment from the finance company within a few days of shipment of product to the dealer. The Company participated in the cost of dealer financing up to certain limits. The Company has agreed to repurchase products repossessed by the finance company. The Company’s financial exposure when repurchasing product is limited to the difference between the outstanding balance due and the amount received on the resale of the repossessed product. Under the previous arrangement, in the event of default, the Company is liable for up to 50% of the financed balance. Effective February 27, 2009, the previous arrangement between the Company and the finance company was terminated. The amount financed by dealers which remained outstanding under this previous arrangement at September 30, 2010 and December 31, 2009 was approximately $126,000 and $427,000, respectively. Minimal losses have been incurred under this agreement, and a minimal reserve for future losses has been recorded.

Effective May 29, 2009, the Company entered into a new floor plan financing arrangement with a different finance company. This arrangement is similar to the previous arrangement, however, the Company does not indemnify the finance company for any credit losses it incurs. The amount financed by dealers which remained outstanding under this new arrangement at September 30, 2010 and December 31, 2009 was approximately $9,354,000 and $6,966,000, respectively.

In the normal course of business, the Company is named as a defendant in various lawsuits in which claims are asserted against the Company. In the opinion of management, the liabilities, if any, which may result from such lawsuits are not expected to have a material adverse effect on the financial position, results of operations, or cash flows of the Company.
 
 
Item 2.                                Management’s Discussion and Analysis of Financial Condition and Results of Operation

This report contains forward-looking statements that are subject to risks and uncertainties. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “should,” “can have,” “likely,” “future” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events.

The forward-looking statements contained in this report are based on assumptions that we have made in light of our industry experience and on our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances. As you read and consider this report, you should understand that these statements are not guarantees of performance or results. They involve risks, uncertainties (some of which are beyond our control) and assumptions. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors could affect our actual financial results and cause them to differ materially from those anticipated in the forward-looking statements. The forward-looking statements contained in this report include estimates regarding:

·  
our business, financial and operating results and future economic performance; 
 
·  
proposed new product and service offerings; and 
 
·  
management's goals, expectations and objectives and other similar expressions concerning matters that are not historical facts.
 
Factors that could affect our actual financial results and cause them to differ materially from those anticipated in the forward-looking statements include:
 
·  
demand for our products; 
 
·  
frequency of major power outages; 
 
·  
availability of raw materials and key components used producing our products; 
 
·  
competitive factors in the industry in which we operate; 
 
·  
our dependence on our distribution network; 
 
·  
our ability to invest in, develop or adapt to changing technologies and manufacturing techniques; 
 
·  
our ability to adjust to operating as a public company;
 
·  
loss of our key management and employees; 
 
·  
increase in liability claims; and 
 
·  
changes in environmental, health and safety laws and regulations.
 
Should one or more of these risks or uncertainties materialize, or should any of these assumptions prove incorrect, our actual results may vary in material respects from those projected in these forward-looking statements. A detailed discussion of these and other factors that may affect future results is contained in Generac’s filings with the Securities and Exchange Commission, including in Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.
 
Any forward-looking statement made by us in this report speaks only as of the date on which we make it. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
 
Overview

We are a leading designer and manufacturer of a wide range of backup power generation products for the residential, industrial and light-commercial markets. As the only significant market participant focused exclusively on these products, we have one of the leading market positions in the standby generator market in the United States and Canada. We design, engineer and manufacture generators with an output of between 800W and 9mW of power. We design, manufacture, source and modify engines, alternators, automatic transfer switches and other components necessary for our products. Our generators are fueled by natural gas, liquid propane, gasoline, diesel and Bi-Fuel™. Our products are available through a broad network of independent dealers, retailers and wholesalers.

 
Business drivers and measures

In operating our business and monitoring its performance, we pay attention to a number of industry trends, performance measures and operational factors. The statements in this section are based on our current expectations.

Industry trends

Our performance is affected by the demand for reliable back-up power solutions by our customer base. This demand is influenced by several important trends affecting our industry, including the following:

Increasing penetration opportunity.    Although there have been recent increases in costs of installed standby generators in the residential and light-commercial markets (driven in the last two years by raw material costs), these costs have declined overall over the last decade, and many potential customers are not aware of the costs and benefits of backup power solutions. We estimate that penetration rates for installed standby residential products are approximately 2% of U.S. single-family detached, owner-occupied households with a home value of over $100,000, as defined by the U.S. Census Bureau's 2007 American Housing Survey for the United States, and penetration rates of many light-commercial outlets such as restaurants, drug stores, and gas stations are significantly lower than penetration of hospitals and industrial locations. We believe that by expanding our distribution network, continuing to develop our product line, and targeting our marketing efforts, we can continue to build awareness and increase penetration for our standby generators.

Effect of large scale power disruptions.    Power disruptions are an important driver of consumer awareness and have historically influenced demand for generators. Disruptions in the aging U.S. power grid and tropical and winter storm activity increase product awareness and may drive consumers to accelerate their purchase of a standby or portable generator during the immediate and subsequent periods following a power disruption, which we believe may last for six to twelve months for standby generators. While there are power outages every year across all regions of the country, major outage activity is unpredictable by nature and, as a result, our sales levels and profitability may fluctuate from period to period.

Impact of business capital investment cycle.    The market for commercial and industrial generators is affected by the capital investment cycle and overall durable goods spending, as businesses either add new locations or make investments to upgrade existing locations. These trends can have a material impact on demand for industrial and commercial generators. However the capital investment cycle may differ for the various industrial and commercial end markets (including industrial, telecommunications, distribution, retail health care facilities and municipal infrastructure, among others). The market for generators is also affected by general economic conditions, credit availability and trends in durable goods spending by consumers and businesses.

Operational factors

We are subject to various factors that can affect our results of operations, which we attempt to mitigate through factors we can control, including continued product development, expanded distribution, pricing and cost control. The operational factors that affect our business include the following:

New product start-up costs.    When we launch new products, we generally experience an increase in start-up costs, including engineering expenses, air freight expenses, testing expenses and marketing expenses, resulting in lower gross margins during the initial launch of a new product. Margins on new product introductions generally increase over the life of the product as these start-up costs decline and we focus our engineering efforts on product cost reduction.

Effect of commodity and component price fluctuations.    Industry-wide price fluctuations of key commodities, such as steel, copper and aluminum and other components we use in our products, can have a material impact on our results of operations. We have historically attempted to mitigate the impact of commodity and component prices through improved product design, price increases and select hedging transactions. Our results are also influenced by changes in fuel prices in the form of freight rates, which in some cases are borne by our customers and in other cases are paid by us.


Other factors

Other factors that affect our results of operations include the following:

Factors influencing interest expense.    We anticipate that interest expense will decrease in 2010 versus 2009 because, during the nine months ended September 30, 2010, we used the net proceeds from our initial public offering and available cash on hand, to repay a substantial portion of outstanding indebtedness. The expiration of certain interest rate swap agreements in January 2010, together with reduced Libor rates versus 2009, will also decrease interest expense in 2010.  In addition, new interest rate swaps entered into in January and June 2010, which are described further under the Liquidity and Financial Condition section, will mitigate the risk of interest rate volatility on a portion of our debt.

Factors influencing provision for income taxes.    Because we made a Section 338(h)(10) election in connection with the 2006 CCMP transactions described below, we have $1.4 billion of tax-deductible goodwill and intangible asset amortization remaining as of December 31, 2009 that we expect to generate cash tax savings of $557 million through 2021, assuming continued profitability and a 38.5% tax rate. The amortization of these assets for tax purposes is expected to be $122 million annually through 2020 and $102 million in 2021, which generates annual cash tax savings of $47 million through 2020 and $39 million in 2021, assuming profitability and a 38.5% tax rate. Additionally, we have federal net operating loss, or NOL, carry forwards of $161.2 million as of December 31, 2009, which we expect to generate an additional $56 million of federal cash tax savings at a 35% rate when and if utilized. Based on current business plans, we believe that our cash tax obligations through 2021 will be significantly reduced by these tax attributes. However, any subsequent accumulations of common stock ownership leading to a change of control under Section 382 of the U.S. Internal Revenue Code of 1986, including through sales of stock by large stockholders, all of which are outside of our control, could limit and/or defer our ability to utilize our net operating loss carry forwards to offset future federal income tax liabilities.

Seasonality.    Although there is demand for our products throughout the year, in each of the past three years approximately 20% to 25% of our net sales occurred in the first quarter, 22% to 25% in the second quarter, 25% to 29% in the third quarter and 25% to 30% in the fourth quarter, with different seasonality depending on the timing of major outage activity and distribution stocking patterns in each year. We maintain a flexible production schedule in order to respond to outage-driven peak demand, but typically increase production levels in the second and third quarters of each year.

Transactions with CCMP

In November 2006, affiliates of CCMP Capital Advisors, LLC, or CCMP, together with affiliates of Unitas Capital Ltd., (Unitas), and members of our management, purchased an aggregate of $689 million of our equity capital. In addition, on November 10, 2006, Generac Power Systems borrowed an aggregate of $1,380 million, consisting of an initial drawdown of $950 million under a $1.1 billion first lien secured credit facility and $430 million under a $430 million second lien secured credit facility. With the proceeds from these equity and debt financings, together with cash on hand at Generac Power Systems, we (1) acquired all of the capital stock of Generac Power Systems and repaid certain pre-transaction indebtedness of Generac Power Systems for $2.0 billion, (2) paid $66 million in transaction costs related to the transaction and (3) retained $3 million for general corporate purposes. For additional information concerning these and other historical transactions with CCMP, see “Item 1—Business—History—CCMP transactions” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

During the three and nine months ended September 30, 2009, affiliates of CCMP Capital Advisors, LLC (CCMP), majority shareholder of the Company, acquired $2,000,000 and $29,898,000 par value of first and second lien term loans for approximately $765,000 and $14,754,000, respectively. CCMP exchanged this debt for additional shares of Series A Preferred stock issued by the Company. The Company subsequently contributed this debt to its Subsidiary. The fair value of the shares exchanged was $765,000 and $14,754,000, respectively, for the three and nine months ending September 30, 2009. These shares had beneficial conversion features which were contingent upon a future event (see note 1). The Company recorded this transaction as Series A Preferred stock of $765,000 and $14,754,000, respectively, for the three and nine months ended September 30, 2009, based on the fair value of the debt contributed by CCMP which approximated the fair value of shares exchanged. The debt was held in treasury at face value. Consequently, the Company recorded a gain on extinguishment of debt of $1,235,000 and $14,745,000 respectively, which includes the write-off of deferred financing fees and other closing costs, in the consolidated statement of operations for the three and nine months ended September 30, 2009, respectively.
 
 
Corporate reorganization

Our capitalization prior to the initial public offering consisted of Series A Preferred Stock, Class B Common Stock and Class A Common Stock. Our Series A Preferred Stock was entitled to a priority return preference equal to a 14% annual return on the amount originally paid for such shares and equity participation equal to 24.3% of the remaining equity value of the Company. Our Class B Common Stock was entitled to a priority return preference equal to a 10% annual return on the amount originally paid for such shares. In connection with the initial public offering, we undertook a corporate reorganization which gave effect to the conversion of our Series A Preferred Stock and Class B Common Stock into the same class of our common stock that was sold in our initial public offering while taking into account the rights and preference of those shares, including the priority returns of our Series A Preferred Stock and our Class B Common Stock and the equity participation rights of the Series A Preferred Stock. A reverse stock split was needed to reduce the number of shares to be issued to holders of our Class A and Class B Common Stock to the number that correctly reflected the proportionate interest of such stockholders in the Company, taking into account the number of shares of common stock to be issued upon the conversion of our Series A Preferred Stock and the number and value of shares of common stock to be issued and sold to new investors in the initial public offering. We refer to these transactions as the “Corporate Reorganization.” For additional information about the Corporate Reorganization, see “Item 7—Managements’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K filed for the fiscal year ended December 31, 2009.

Initial public offering

On February 17, 2010, we completed our initial public offering of 18,750,000 shares of our common stock at a price of $13.00 per share. In addition, the underwriters exercised their option and purchased an additional 1,950,500 shares of our common stock from us on March 18, 2010. We received a total of approximately $247.6 million in net proceeds from the initial public offering and underwriters' option exercise, after deducting the underwriting discounts and expenses.

The Company adopted an equity incentive plan on February 10, 2010 in connection with the IPO.  A registration statement on Form S-8 was filed registering the 6,637,835 shares of common stock issuable under the equity incentive plan.  At the time of the IPO, 4,341,504 stock options and 456,249 shares of restricted stock and other stock awards were granted to employees and Board members of the Company pursuant to the equity incentive plan.  The stock options have an exercise price equal to the IPO price and vest in equal installments over five years, subject to the grantee’s continued employment or service. The restricted stock awards will vest in full on the third anniversary of the date of grant, subject to the grantee’s continued employment.

Immediately following the Corporate Reorganization, the IPO and underwriters' option exercise, we had 67,529,290 shares of common stock outstanding.

Subsequent repayment of debt

In February 2010, we used $221.6 million in net proceeds from the initial closing of the IPO to pay down our second lien term loan in full and to pay down a portion of our first lien term loan. In addition, in March 2010, we used $138.5 million of cash and cash equivalents on hand to further pay down our first lien term loan. As a result of these pay downs, at March 19, 2010, the outstanding balance on the first lien credit facility had been reduced to $731.4 million, and our second lien credit facility had been repaid in full and terminated. This reduction in debt will have a significant impact on cash flows as a result of lower debt service costs in future periods, based on current LIBOR rates. There were no further pay downs on our first lien credit facility during the three months ended September 30, 2010.
 

Results of operations
 
Quarter and nine months ended September 30, 2010 compared to quarter and nine months ended September 30, 2009
 
The following table sets forth our consolidated statement of operations data for the periods indicated:
 
   
Three Months Ended September 30,
   
Nine months Ended September 30,
 
(dollars in thousands)
 
2010
   
2009
   
2010
   
2009
 
                         
Net Sales
  $ 160,666     $ 144,261     $ 431,839     $ 434,284  
Cost of Goods Sold
    93,304       79,770       258,314       262,078  
Gross profit
    67,362       64,491       173,525       172,206  
Operating Expenses:
                               
Selling and service
    15,295       14,620       43,416       44,863  
Research and development
    3,580       2,515       10,784       7,752  
General and administrative
    5,654       3,671       16,492       11,538  
Amortization of intangibles
    13,063       13,097       38,745       38,863  
Total operating expenses
    37,592       33,903       109,437       103,016  
Income from operations
    29,770       30,588       64,088       69,190  
Total other expense, net
    (6,694 )     (16,160 )     (25,551 )     (37,759 )
Income before provision for income taxes
    23,076       14,428       38,537       31,431  
Provision for income taxes
    78       112       237       324  
Net income
  $ 22,998     $ 14,316     $ 38,300     $ 31,107  
                                 
Residential products
  $ 100,973     $ 89,687     $ 272,838     $ 269,037  
Industrial & Commercial products
    49,554       46,033       131,180       142,506  
Other
    10,139       8,541       27,821       22,741  
Net sales
  $ 160,666     $ 144,261     $ 431,839     $ 434,284  

Net sales.    Net sales increased $16.4 million, or 11.4%, to $160.7 million for the three months ended September 30, 2010 from $144.3 million for the three months ended September 30, 2009. This increase was driven by an $11.3 million, or 12.6%, increase in sales of residential products due to our initiatives to increase distribution and awareness for our residential products, coupled with a shift in buying patterns by our distribution partners towards more in-season buying versus pre-season buying.  In addition, industrial and commercial product sales increased $3.5 million, or 7.6%, mainly due to improvements in our focused end markets and expansion of our distribution for these products.

Net sales decreased $2.4 million, or 0.6%, to $431.8 million for the nine months ended September 30, 2010 from $434.3 million for the nine months ended September 30, 2009. This decrease was driven by an $11.3 million, or 7.9%, decrease in sales of industrial and commercial products due to overall weakness in U.S. non-residential construction activity during 2010 together with year-to-date declines in sales to national account customers.  The decrease was offset by a $3.8 million, or 1.4%, increase in residential product sales for the same reasons described with respect to the third quarter in the paragraph above. Year-to-date residential product sales growth has been tempered by a challenging residential investment environment coupled with a reduced benefit from major power outages.

Costs of goods sold.    Costs of goods sold increased $13.5 million, or 17.0%, to $93.3 million for the three months ended September 30, 2010 from $79.8 million for the three months ended September 30, 2009.  Raw material costs increased $11.5 million year-over-year due to an increase in sales volume, as well as by higher commodity costs, primarily steel, copper and aluminum, as we saw a continued increase in commodity costs during the three months ended September 30, 2010 versus the prior year quarter.  Direct labor, overhead, and inbound freight costs also increased $2.0 million, year over year, resulting from the increase in sales.

Costs of goods sold decreased $3.8 million, or 1.4%, to $258.3 million for the nine months ended September 30, 2010 from $262.1 million for the nine months ended September 30, 2009. Raw material costs decreased $3.3 million year-over-year due to a decrease in sales volume, lower year-over-year commodity costs in the first quarter of 2010, as well as engineering and sourcing cost reductions implemented during 2009.  Inbound freight costs, direct labor and variable overhead costs also decreased $0.5 million year over year on lower sales.
 
 
Gross profit.    Gross profit increased $2.9 million, or 4.5%, to $67.4 million for the three months ended September 30, 2010 from $64.5 million for the three months ended September 30, 2009, primarily due to an increase in sales volume which included a residential sales mix change to lower kilowatt products.  In addition, we saw a continued increase in commodity costs during the three months ended September 30, 2010 versus the prior year quarter.  During the third quarter 2009, pricing for our key commodities were at recessionary low points.  Since then, pricing for copper, steel and aluminum has increased substantially.   As a percentage of net sales, gross profit decreased to 41.9% for the three months ended September 30, 2010 from 44.7% for the three months ended September 30, 2009.

Gross profit increased $1.3 million, or 0.8%, to $173.5 million for the nine months ended September 30, 2010 from $172.2 million for the nine months ended September 30, 2009, primarily due to the factors affecting cost of goods sold described above. As a percentage of net sales, gross profit increased to 40.2% for the nine months ended September 30, 2010 from 39.7% for the nine months ended September 30, 2009.

Operating expenses.    Operating expenses increased $3.7 million, or 10.9%, to $37.6 million for the three months ended September 30, 2010 from $33.9 million for the three months ended September 30, 2009. Selling and service expenses increased $0.7 million due to higher variable selling expenses related to our increase in net sales.  Research and development expenses increased year over year by $1.1 million from increased product development and engineering resource investment. General and administrative expenses increased $2.0 million mainly due to $1.7 million of share based compensation expense recorded during the three months ended September 30, 2010 for the time vesting of stock option, restricted stock and other stock awards issued in connection with our IPO.  General and administrative expenses also include additional administrative costs incurred as a result of becoming a public company in the first quarter of 2010.

Operating expenses increased $6.4 million, or 6.2%, to $109.4 million for the nine months ended September 30, 2010 from $103.0 million for the nine months ended September 30, 2009.  Selling and service expenses decreased $1.4 million due to lower variable e