Orion Energy Systems, Inc. F2Q09 (Qtr End 09/30/08) Earnings Call Transcript

Nov. 5.08 | About: Orion Energy (OESX)

Orion Energy Systems, Inc. (NYSEMKT:OESX)

F2Q09 (Qtr End 09/30/08) Earnings Call Transcript

November 4, 2008, 5:30 pm ET

Executives

Erik Birkerts – COO

Neal Verfuerth – President and CEO

Scott Jensen – CFO and Treasurer

Analysts

Eric Prouty – Canaccord Adams

Eric Stine – Northland Securities

Jeff Osborne – Thomas Weisel Partners

Glenn Wortman – Sidoti & Company

Operator

Good afternoon, and welcome to the Orion Energy Systems second quarter 2009 earnings conference call. Your lines have been placed in a listen-only mode until the question-and-answer segment of today's call. This call is being recorded. If you have any objections, you may disconnect at this time.

I will now turn the call over to Mr. Erik Birkerts. Erik, you may begin.

Erik Birkerts

Thank you, Nathan, and thank you for joining us for Orion Energy Systems Fiscal 2009 Second Quarter Conference Call. With me on the call today are Neal Verfuerth, President and CEO, and Scott Jensen, CFO.

Neal will begin by providing some highlights from the quarter as well as describe progress within our business. Scott with then provide financial detail on the second quarter, and I will spend time at the conclusion of the call discussing our expectations for the remainder of our fiscal year before we open up the line to take your questions.

Before we begin, I will read the Safe Harbor Statement. Our remarks that follow, including answers to your questions, include statements that we believe to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements are generally identified as such because the context of such statements will include words such as “believe,” “anticipate,” “expect,” or words of similar import. Similarly, statements that describe future plans, objectives, or goals are also forward-looking statements.

These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in our press release issued this afternoon and furnished to the Securities and Exchange Commission on Form 8-K and Form 10-K filed with the SEC on June 27, 2008 and other filings we make with the SEC.

Except as described in these filings, we disclaim any obligation to update these forward-looking statements, which may not be updated until our next quarterly conference call, if at all.

Now, I'd like to turn the call over to Neal.

Neal Verfuerth

Thanks, Erik. I'd like to welcome everyone to our Orion Energy Systems Fiscal 2009 Second Quarter Conference Call. There is much happening on the national scene today, given the election, so we appreciate the time you're all spending with us this afternoon.

For the second quarter of fiscal 2009, we reported revenues of $18.8 million versus $18.4 million in the second quarter of fiscal '08. Net income for the quarter was $453,000 compared to $1.1 million in the same period last year, and earnings per diluted share were $0.02 versus $0.05 in fiscal 2008.

I'd like to emphasize upfront that we felt it prudent to revise our guidance given the uncertainty surrounding the economy. However, we expect to remain profitable, cash flow positive and maintain a strong balance sheet over the second half of our fiscal year.

We believe our fiscal strength positions us well to continue to build Orion's long-term enterprise value for our stakeholders. Because of this, we're going to continue to buyback our shares.

During the second quarter, we made further progress in executing against our core strategy of capturing the sizeable retrofit market opportunity. As you may recall from previous calls, we see the retrofit market opportunity at greater than $9 billion, and we are focused on aggressively pursuing it.

We are proud that in the second quarter of the fiscal year 2009 we've installed our high performance Phase 1 lighting platform in over 300 facilities, an increase over the 276 facilities we completed in the first quarter.

Our installed base of customer facilities now numbers over 4,000 facilities and represents over 670 million square feet of space. With an available market estimated at over 20 billion square feet, illuminated by the legacy HID lighting, we are still very much in the front end of our opportunity.

We reduced our annual – we reduced for our customers' annual energy demand by 128 million kilowatt hours and since 2001, we've reduced customer energy consumption by over 387 megawatts. Not only do we help our customers save money, but our technology also delivers a workable solution to the capacity and distribution issues facing the electric industry today.

Our customer additions within the quarter will reduce their carbon footprints for over 87,000 tons of indirect CO2 emissions annually. Since 2001, we've removed over four million tons of indirect CO2 emissions. This not only benefits the environment, but may also result in incremental revenue opportunities for our customers and for Orion when the market for emissions credits gains further momentum.

Given that, I've been very engaged with the sales team this quarter. I'd like to comment on some of the efforts to capture the retrofit market. With regard to new customers acquired during the quarter, we witnessed across a broad base a new customer versus signing of any high profile multi-site rollout agreements.

For example, in the second quarter, we worked with 11 new national account customers, retrofitting 18 locations in 12 States. Now that we've proven ourselves to these customers, we can see upsell opportunities as well as potentials for additional multi-site rollout agreements to address remaining North American footprints.

During the second quarter, we also sold over 1,000 units into various independent Anheuser-Busch distributors. In total, we've retrofitted 30 independent AB distributors, and will continue our efforts to work across this large network of independent distributors.

Given that these distributors are a tight fraternity our success highlights brand equity we continue to build within our customers organizations with our technology and project management competencies.

The quarter also witnessed our further penetration into our existing customers. We've added 101 new locations for existing national account customers already doing business with Orion. These new locations cover 47 national account customers in 29 States and three Canadian Provinces. As an example, on our last call, we mentioned that we were preparing to begin shipments of our wet-rated fixture to a major brewing company.

I'm pleased to report that in addition to other products, we've shipped 420 of these new fixtures to this brewer and are continually producing and shipping many more as we work across facility footprint as part of a defined rollout schedule.

The total revenue potential still in front of us for this brewer is upwards of $5 million for this fiscal year in addition to other products. We anticipate shipping more than 7,000 wet-rated fixtures.

We also continued our rollout progress with Coca-Cola Enterprises retrofitting over 15 facilities during the quarter. We also rolled out facilities with a publicly traded engine manufacturer and a large food service company we referenced on the last call.

Perhaps the most exciting is the performance of our wholesale business. On our last earnings call, we discussed some of the investments of time and effort we've devoted to our partners during the first quarter. We also announced on that call that we've hired a new director of partner development. I am pleased to report that these investments are now bearing fruit.

For example, we witnessed a strong growth by our VAR partner network. VAR sales for the six month that ended September 30th exceeded prior year's sales for the same period by 83%.

Some of our key partners that become seasoned to the extent that they are now selling and managing national account rollout projects. Marquee names with whom our partners are currently working with include SC Johnson, Unilever, Thermo Fisher and Kimberly-Clark, amongst others.

Our contractor network has experienced similar strong performance. Sales through contractor partners for the six month ended September 30th exceeded prior year sales for the same period by 79%.

The quarter also witnessed expansion in the size of our contractor network as we added 46 new contractor partners. The network of these contractors that have done business with Orion on a recurring basis now numbers over 320 companies.

During our first quarter call, we also mentioned that key personnel had spent time conducting energy management workshops on behalf of some of our partners. I'd like to highlight that one of our newest partners secured an order for over 1,700 of our Phase 1 units from a national account lead cultivated in one of these workshops, clearly, time well invested.

These are just some examples of what Orion is doing to capture the retrofit opportunity. As we continue to grow our customer base and further submit our customer relationships, we are uniquely positioned to off-sell into these relationships with our Phase 2 InteLite Wireless Controls as well as our Phase 3 Apollo Light Pipe.

I'd like to highlight two recent success stories to highlight the future potential of these initiatives. The first one is Apple Computer, commonly known as the standard bearer for intelligent design. They're installing a wireless touch screen InteLite control integrated system that includes 110 of the compact module light fixtures, the equal amount of the Apollo Light Pipes, and the front end screen in a computer in one of their California facilities.

Moreover, as part of this project, Apple has agreed to allow Orion to use this facility to demonstrate and improve the energy savings impact and light quality delivered by the integrated system.

PepsiCo, at their facility in Brazil, implemented a complete energy management system, recaptured this fiercely contested opportunity by demonstrating our technology leadership and had outperformed other competitors being considered.

This energy efficient facility, which has deployed our wireless touch screen InteLite control system and over 200 of our compact modular fixtures, and a lesser amount of Apollo Light Pipes is expected to service a model for future PepsiCo facilities. The energy management best practices from this facility are also expected to be shared with other commercial facilities in the surrounding area.

These two success stories demonstrate the superior technology and thought leadership that helped differentiate Orion as a vertically integrated energy solutions company that is unique from other lighting companies.

Despite the positives during the quarter, we do recognize that the economy is worsening, and we are witnessing some customer pullback. Given this, we are feathering back on our hiring plans and may not pursue hiring up to the 70 person target we discussed previously.

Our first priority is to devote more time and attention to making our sales team and overall operations more efficient and effective, and making sure we have the right mix of people.

To this end, we finished the quarter with 62 sales people within our sales organization. As part of improving our talent pool, we parted ways with about eight people and hired six new people. On our last call, we discussed the fact that we've added 13 sales associates in the first quarter.

We also mentioned the additional of a national sales manager to assume the day-to-day management training and coaching responsibilities for our new sales personnel. These new hires are coming on line quickly under the tutelage of our national sales manager.

With only two exceptions, these new hires are with us and have not only begun the process of building pipeline, but they have also demonstrated they can close business and contribute revenues.

Moving forward, we will continue to interview and hire strong sales people, but will do so selectively and at a less rapid pace than originally planned. Again, the focus will be on effectiveness, and our target annual revenue contribution is approximately $1.5 million for each team member.

Before turning the call over to Scott, I'd like to spend a few minutes discussing the Orion Virtual Power Plant which we launched officially in mid-October, which we think will prove to be a valuable tool to combat the economic headwinds we see in front of us.

To begin with, the Orion Virtual Power Plant is an energy supply contract, not a lease, in which Orion commits to deliver a set amount of megawatts, essentially energy savings at a fixed rate. Rather than discuss how we structure the arrangements, let's highlight the benefits to our customers and to Orion.

First of all, the Orion Virtual Power Plant qualifies as an operating expense to our customers rather than capital expenditure, thereby removing the need for companies to tap their capital budgets, many of which are frozen today, to deploy Orion technology – excuse me, to deploy Orion technology.

Secondly, given the fixed rate megawatt payment is substantially less than the current electric utility rates, our customers benefit from free cash flow that remains after making their payments to us.

In essence, our customers benefit from cost savings and incremental cash flows without having to make upfront investments or capital outlays, a compelling value proposition in today's economy. Orion benefits because we're able to capture sales that would otherwise not have happened due to capital constraints.

As of today, we have three customers with over $9.7 million megawatts under contract, and we expect to continue building momentum with more Orion Virtual Power Plant wins in the months ahead.

We have the option of selling the recurring megawatt payments to a third party and recognizing the value of the deal upfront. However, these contracts also have the potential of building a base of recurring revenue stream for Orion which we believe is potential positive for our investors.

If we pursue the recurring revenue option, we would recognize the value of the deal on a monthly basis across the megawatt delivery period. From an accounting and reporting standpoint, this will lessen near-term revenues, but may lead to more stable and predictable revenue streams over time.

We are not in a position today to forecast how many of our future deals will be structured at a Virtual Power Plant. We will be reporting on a consistent basis the number of megawatts we have under contract and delineating the impact these contracts will have on the revenue recognition so there is full visibility.

With that, let me turn the call over to Scott to take you through financial results in more detail. Scott?

Scott Jensen

Thank you, Neal. Our reported revenues for the second quarter were $18.8 million compared to revenues of $18.4 million in the same period of fiscal 2008. $17.3 million or approximately 92% of the quarter revenue was driven by product sales, while service revenue accounted for 8% of our total revenues.

As Neal mentioned earlier, the tremendous success of our wholesale channels in the quarter impacted our normal service revenue mix, as those sales in our wholesale channel are product only.

Our gross margin for the quarter was 33.8% versus 34.3% in the comparable prior year. Gross profit dollars for the quarter were $6.3 million, consistent with the prior year quarter gross profit dollars. Our gross margin continues to be impacted by factory capacity costs. We do expect that this will improve as sales volumes increase in the second half of the year. On a positive note, we have not experienced margin pressure around pricing for product or services.

G&A expenses for our second quarter were $2.9 million or 15.4% of revenue versus the prior year of $1.9 million or 10.4% of revenues. This increase in G&A expenses can be primarily attributable to $450,000 of cost related to 10 additional headcounts versus the prior year in our accounting, IT, human resources and admin support functions, along with executive and director compensation plan changes.

Additionally, in the quarter, we incurred public company costs of $600,000, including $150,000 for the class action litigation and increases in our audit, legal, investor relations, consulting and our Sarbanes-Oxley Section 404 compliance project.

Sales and marketing expenses for the quarter ended September 30th were $2.8 million or 14.8% of revenues, compared to $1.9 million or 10.5% of revenues in the prior year. Spending increases were due to compensation cost increases from the 15 headcount adds in our sales and marketing functions, along with an increase in expenses for direct mail marketing efforts into our wholesale channel.

R&D expenses for the second quarter were $373,000 or 2% of revenues, down from $443,000 or 2.4% of revenues in fiscal 2008. Our R&D expenses declined due to decreased sample and material costs as our wireless Phase 2 product moves into production stages, along with a headcount reduction of one. We view this decrease in spending as a short-term aberration and we are continually focused on expanding our technology base.

Income from operations for the second quarter was $298,000 versus $2 million in the prior year. Net interest expense for the quarter was $41,000 versus $329,000 in the same period in the prior fiscal year.

Net income for our second quarter was $453,000 or $0.02 per share on a weighted average, fully diluted shares outstanding of $29 million compared to net income of $1.1 million or $0.05 per share for the same period in the prior year based on $20.4 million weighted average, fully diluted shares outstanding.

Our reported revenues for the six months ended September 2008 were $34.9 million compared to revenues of $35.1 million in the same period of fiscal '08. This decrease can be primarily attributable to the softer sales we experienced in the first two months of fiscal 2009 and the previously discussed lengthening of our sales cycle.

Our gross margin for the first six months of fiscal 2009 was 33.1% versus 33.9% in the comparable prior year. Our gross profit for the first half was $11.5 million compared to $11.9 million in fiscal '08.

G&A expenses for the first half were $5.5 million or 15.8% of revenue versus prior year of $3.5 million or 9.9% of revenue. For the year-to-date, we have incurred approximately $700,000 of public company costs and $250,000 of legal expenses related to the class action litigation. These costs have had an impact of 2.6 points on our operating margins and a fully diluted EPS impact of nearly $0.02 per share.

Sales and marketing expenses for the six months ended September 30th were $5.4 million or 15.6% of revenues compared to $4 million or 11.5% of revenues in the prior year.

Compensation costs and stock option expense related to the headcount additions was $800,000 and had an impact of 2.3 points on our operating margins and a fully diluted EPS impact of nearly $0.02 per share.

R&D expenses for the first half were $791,000 or 2% of revenues down from $880,000 or 2.5% of revenues in fiscal '08.

Our operating loss for the first six months was $190,000 versus income from operations of $3.5 million in the same period in the prior year. Our year-to-date loss was driven by our soft first quarter.

Net interest expense for the first six months was $108,000 versus $624,000 in the same period in fiscal 2008. Net income for the first six months was $487,000 or $0.02 per share on a weighted average, fully diluted shares outstanding of $29.6 million compared to net income of $1.8 million or $0.09 per share for the same period in the prior year based on $19.8 million weighted average, fully diluted shares outstanding.

Turning the balance sheet, as of September 30th 2008, we had a total of $46.4 million in cash and equivalents on hand compared to $78.3 million at the end of our fiscal year ended March 31, 2008.

As a reminder, a large portion of this decrease is due to a different classification in our financial statements for the $17 million of investments in short-term government agency bonds with improved yield versus our cash and money market investments.

All of our agency bonds have continued to mature at par value and none of our cash is invested beyond 250 days with 70% of our cash and investment portfolio being highly liquid with maturity dates of 90 days or less.

Our accounts receivable portfolio continues to be very strong, primarily, consisting of our national account customers and our wholesale partners. Additionally, we decreased our inventory by $1.1 million from the prior quarter as we continue to focus on improving our inventory turns.

In the second quarter, we repurchased over 1.4 million shares of common stock at a cost of $8.1 million. We believe that this action makes a strong statement regarding management's opinion on the valuation of our stock in the marketplace, and we will continue to repurchase shares where we believe it adds accretion to shareholder value.

For the year-to-date, we've generated $2.4 million in positive cash flow before balance sheet changes as a result of our net income and non-cash expenses.

Before I turn the call over to Erik, I would like to discuss our outlook for the remainder of fiscal 2009. Given the rising uncertainty that has impacted the global financial markets and the indications for a broader prolonged recession, we believe it is prudent to reevaluate our full-year guidance.

Based on this analysis, we now expect fiscal 2009 total revenue growth to be in the range of 0% to 9% over last year which equates to approximately $81 million to $88 million in annual sales for the year.

We believe that this revised guidance incorporates the continued headwinds we are facing as well as the softer start to our fiscal year. While we continue to aggressively attack the large HID retrofit market, given the current environment, we believe it's prudent to take a more cautious stands with regard to our expectations.

We now expect our EPS guidance to be in the range of $0.06 to $0.11 on fully diluted shares of $28.5 million. The expected reduced revenue volume puts more gross margin pressure on our manufacturing facility which is already highly cost leveraged.

However, as Neal mentioned earlier, we are scaling back on some of our original sales headcount plans, and we are evaluating other operational efficiencies and cost reduction opportunities.

With that, let me turn the call over to Erik to take you through in more detail our expectations for the second half of this fiscal year. Erik?

Erik Birkerts

Thanks, Scott. I'd like to take a few minutes to provide more color on our revised guidance range. As Scott mentioned, we are seeing impacts from the economy that were difficult to anticipate when we developed our previous guidance range, and we feel it is now best to take a stance of more prudence and caution in evaluating our near-term prospects for growth.

Working from the midpoints of the guidance ranges, we have further reduced our revenue expectations for fiscal 2009 by approximately $17 million, going from $102 million previously to $85 million as of this point now.

The largest adjustments correspond to a reduction in revenues anticipated from our national account rollouts and a reduction anticipated from our ability to create and convert new pipeline, a component of what we have called our Go Get business.

About 40% of the $17 million revision corresponds to a reduction of revenues tied to our national account rollouts. We did witness the unanticipated loss of several million dollars of projected revenues due to plant closures of which we were notified.

The remainder of the reduction was the result of our decision to pull projects out of the forecast due to uncertainty around customer budgets and project start dates, most of which were attributable to economic uncertainty.

These projects have not been canceled and may still come to fruition this fiscal year or possibly next fiscal year, but to be conservative, we have removed them from our forecast due to the unknown.

Bear in mind that for those customers that are working through budget issues, we are introducing the Orion Virtual Power Plant as a workaround solution. As Neal mentioned upfront, we will be communicating our successes with the Orion Virtual Power Plant as we move forward.

Originally, we had forecasted that about 25% of our second half revenues would come from new business creation. Unfortunately, the economy is also impacting our ability to generate this new business at the velocity we had originally forecast.

In particular, we are seeing delays and deferrals by new customers considering projects that have not been previously budgeted. Frankly, we are seeing customers make decisions very slowly, if at all, as they take stock of their overall company funding position.

We have all seen many companies have pulled down their credit line so as to secure readily available cash stockpile. They are not moving quickly to spend it, even on projects with very attractive ROIs.

We have accounted for this market development in three ways. One, by cutting our closing ratio assumptions to about 30% from north of 50% previously; two, by further extending the time frame that it will take to close deals; and three, by lowering our pipeline creation estimates as our sales people are having a little bit more difficulty securing appointments given the tight spending environment. Needless to say, we are not seeing – or we are seeing very few deals close within 60 days as we had in the past.

Let me emphasize, however, that we have not lost any significant business to competitors. The revisions and guidance are due to the general economic factors outlined above. With respect to competitors, we have not witnessed any significant changes in behavior. It's business as usual on this front.

Let me now review the breakdowns of where we see our revenues coming from moving forward. As you will recall from previous calls, there are four primary components to our forecasting model.

One, the first component is the national account rollouts. The second component is the conversion of our existing or legacy pipeline. The third component is the creation and conversion of new pipeline. And the fourth component is our VAR or partner business.

Again, working from the mid range target at $85 million, we see a little more than half of the remaining $50 million deliverable coming from our national account rollout schedule. Q3 and Q4 should see much activity on this front, more so than during Q1 and Q2. At this point, we feel this rollout schedule has been conservatively adjusted.

Regarding the second component of our model, we have now worked off the majority of our legacy pipeline, and we anticipate only a few million dollars more of revenues this year from this component.

As discussed above, our ability to create and convert new pipeline has been most significantly impacted by the macro environment. Whereas before we were expecting upwards of 25% of second half revenues tied to this component, we have adjusted it downwards to about 15% contribution. As I mentioned earlier, this adjustment accounts for about 60% of our guidance revision.

Finally, we are pleased with the performance of our VAR partners and expect that they will contribute about 25% of the remaining revenue target in fiscal year. Although our partners see economic factors impacting their ability to generate new business, our conversations with them indicate that their existing pipelines are well vetted and solid.

However, in our 0% growth scenario, we have incorporated the risk of lower sales volumes from our VAR channel, and this explains the delta between the $85 million mid-point that we just discussed and the $81 million low end of the range.

With that, I'd like to turn the call back to Neal for some closing remarks.

Neal Verfuerth

Thanks, Erik. With the second half of our fiscal 2009 is likely to be challenging given the current macro environment, we're determined to build long-term value for our stakeholders. We will continue to make thoughtful investments to further the growth of our business.

However, we will rigorously pursue operational expense efficiency to ensure that we remain profitable and deliver quality earnings. We remain optimistic about the long-term future of our business and believe the key themes surrounding our value proposition remain intact and will serve us well as the economy ultimately improves.

Those being, we consider Orion to continue to be the leading provider of energy management solutions to the very large commercial industrial market. We have been successful in this market for over 10 years and our customer wins and track record demonstrates our leadership in this arena.

We believe we have the best products to sell into this market. Moreover, we have the engineering and project management expertise to ensure that the customer projects unfold on schedule as promised whether at a single facility or across hundreds of facilities compromising the real estate footprint.

We have a world-class manufacturing facility. This is a significant competitive advantage in that we can produce and ship a product in under two weeks on average. In the business of energy efficiency, time is money.

Finally, we believe we have leading sales organization, sales methodologies, and partner network in the market. Time and time again, in direct competition, our team is better able to demonstrate the superior performance of our product and to intelligently discuss energy efficiency for prospective customers.

To conclude, we believe in the long-term value of Orion, and we will continue to pursue our share repurchase program.

Operator, we'd like to now open up the call for questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions) Our first question will come from Eric Prouty with Canaccord.

Eric Prouty – Canaccord Adams

Great. Good evening. Guys, maybe you might have touched on this earlier, but a bit more detail around your gross margin. With the sales slowdown, you've obviously brought on some new equipment, etcetera. Can some of your efficiencies offset additional overhead to allow you to maintain your gross margin going forward as the sales rate growth slows down a bit?

Scott Jensen

Yes, Eric, this is Scott. Yes, just to maybe take a step backwards. Our product gross margin in the quarter was 33.6%. In the first quarter, it was 33.2%. So, we did have a little bit of improvement there, specifically around getting more product going through the facility with the revenue uptick. And we do have opportunity ahead of us, so that's certainly a fair assessment of the capacity that we have in the facility right now. And recognizing that and in our effort to drive profitability, we've got some manufacturing efficiency projects continually in place in the quarter, early in this recent quarter. We put in some conveyer to help increase output and efficiencies in our assembly area and really looking at streamlining processes and doing more with less people. So we believe we have some opportunities there to improve gross margin.

And then I guess I also want to touch on the question you didn't specifically ask, but on the service margin side, our gross margins for the quarter on services were 35.2% and we were very pleased with the margins we're making on the service side right now. That was up from 28.6% in the first quarter.

Eric Prouty – Canaccord Adams

Great. And then, actually on the services side, again during this slow period where decisions might be – take a little longer to sell product, is there any other way of using some of your bench strength from a services standpoint, from a consultative standpoint, to generate a little revenue as people decide whether or not they want to go ahead with full blown installations?

Neal Verfuerth

Yes, we've done a couple of things, Eric. This is Neal. How are you doing? We've used these folks for doing some work on behalf of our customers for getting all of their EPAC information, document it and put together for them, for doing energy audits, going back on installs and doing some additional what we call fine-tuning and recommissioning of sorts.

And furthermore, we're also using these folks to help train our new channel partners, so that we can leverage these relationships and their locations geographically to be more efficient as we move into the future with these national account rollouts because they're all in markets. So our guys are not only creating revenue, but also transitioning in part of their time to being teachers of the next group of folks that we want to help roll through our national accounts.

Eric Prouty – Canaccord Adams

Great. And then just one final question. As your folks are out there selling the lighting solutions, are you seeing any demands or requests for additional energy efficient products that is getting you guys thinking of the products you might be able to either sell in conjunction with your lighting solutions or maybe to go back and upsell into an existing client base?

Neal Verfuerth

Absolutely. Again, this is Neal, Eric. There is discussion right now with our customers looking at maybe some gas saving opportunities with controls, and we're already positioning our control systems to have the ability to expand for natural gas savings and doing simple control systems. Given the fact that less than 2% of the buildings in America, according to DOE, have central control systems, it's very easy for us to build out our new front end to accomplish some nice setback routines and save natural gas. And even, in fact, this savings into our Virtual Power Plant business model. So we have a lot of running room there.

Erik Birkerts

Hey, Eric, this is Erik Birkerts. One of the things we really consider to be a real competitive differentiator for us over the long-term is that, I mean, today we're running against the retrofit opportunity and capturing facilities and building an installed base. But, what we're really working hard to do is create a sales and distribution engine in an installed base customer, so that we can start bringing other energy efficiency technologies to the market and selling them into that customer base and through the sales and distribution engine.

And I know that when I've been on the road, there has been a lot of questions, what's our long-term sustainability for the business model? But that's a key piece. We're not just a lighting company. Over the long-term, we're really going to be driving new energy efficiency technologies into the market. Today, lighting is just the lowest hanging fruit.

Eric Prouty – Canaccord Adams

Sure. It makes sense. And guys, good job with the buyback, always good to see that, companies putting that into place and then using it up. So, hopefully we can continue to see some share buying there in the market. And I'll turn it over to the next question. Thanks a lot.

Neal Verfuerth

Thank you, Eric.

Operator

And our next question will come from Eric Stine from Northland Securities.

Eric Stine – Northland Securities

Hey, guys. Just one question, and this is from early in the call, just bookkeeping. Can you just discuss again your total sales people and the number that you added in the quarter?

Erik Birkerts

Yes. So, Eric, we ended up the quarter with 62 people in our sales organization. And across the quarter, we parted ways with eight people which were primarily on the project management and inside sales support side versus field sales people. And we hired six new people. In terms of new sales people in the field, within the quarter, we parted ways with one, and we added one. So, that number has been constant.

Eric Stine – Northland Securities

Okay. Can you guys discuss what the breakdown was per month? I know that September, especially, the last two weeks were pretty rough. I just want to get a sense of that, and then just what you have seen in October.

Scott Jensen

We prefer not to get, I guess, that granular, Eric. This is Scott. Order pattern has been good in October, and we've used that information to formulate our current guidance model.

Eric Stine – Northland Securities

Okay. Fair enough on that. Can you discuss your hedging? I'm just trying to get an idea of the length of those contracts and when you might start to see some benefit from materials costs coming down?

Neal Verfuerth

Yes. Sorry, Eric. You're talking on our purchase side?

Eric Stine – Northland Securities

Yes. I switched gears a little bit there. But, yes, just trying to get an idea, with materials costs coming down here significantly, when that might start to show up (inaudible).

Neal Verfuerth

Yes, our aluminum costs, our contracts in aluminum usually reset at the beginning of the calendar year. So, we do have the opportunity, depending on how much inventory we need to work through, to have some cost savings there on the purchase side. Our reflector material were locked in for all of next year, so we won't see any cost decreases or increases in that material, so we'll be able to hold costs steady.

Eric Stine – Northland Securities

Okay. And then I guess my last question would just be regarding the remainder of the year. Do you care to discuss just how you see it pulling out? Is it fair to assume that may be more heavily weighted towards the third quarter with the year-end budget?

Erik Birkerts

Yes. As we've always talked about, Eric, at the end of the third quarter we see – which corresponds to our customers' year-ends, we see budget dollars, and then we also see budgets reloaded in what is our fourth quarter and their first quarter. I mean as we see it playing out, it's both quarters are – we're seeing them fairly equally weighted.

Eric Stine – Northland Securities

Okay. And then – and just to clarify, you were talking about your – within your national account base, you're being conservative there, not necessarily that you've lost projects, aside from the closings, the plant closings, but those are things that you're pushing out potentially show up next year. You're just choosing to push those out to be more conservative in the current environment?

Erik Birkerts

Yes. I mean, Eric, there's about $4 million of what was pulled out. I guess we're being pretty cautious here given our revision. And I think if I wanted to be a little bit more aggressive, I would have assigned a probability weighting and said there is a 40% or 50% probability of this business flowing back in this year. But I just decided to play it safe and just assigned it 0% probability and pulled it out completely. That doesn't mean that it's gone for good. It may still hit this year or it may hit next year. It's just we don't have enough certainty around it to include it.

Eric Stine – Northland Securities

Okay, fair enough. I will jump back in the line. Thanks.

Neal Verfuerth

Thank you.

Erik Birkerts

Thanks, Eric.

Operator

Our next question will come from Jeff Osborne with Thomas Weisel.

Jeff Osborne – Thomas Weisel Partners

Hey, good evening, guys.

Neal Verfuerth

Hey, Joe.

Jeff Osborne – Thomas Weisel Partners

You seem pretty excited during the prepared comments about the waterproof fixtures and the Anheuser-Busch distribution channel. I was just curious if you had a sense that there would be for those two projects in particular, because the waterproof you mentioned a $5 million order in the fiscal year. Would that come in all in 3Q or both 3Q and 4Q? I'm just trying to get a sense of visibility that Erik talked about in the national accounts channel. It seems to be that two breweries are a very large piece of it.

Erik Birkerts

Yes. I mean, broadly speaking, we're pushing hard to get a big chunk of that Q3. There is some stuff rolling over into Q4 with the wet rated fixtures. And then, the independent distributors, those are just a matter of working down the list of several hundred of them. So it's just as soon as we can get to them and assuming that they've got the appetite to do the project. So, that's just – there's no set defined timetable on those other than us just actively working across them.

Jeff Osborne – Thomas Weisel Partners

Very good. And then you gave some detail which I didn't have the historics to back into sequential changes. But in the release about six-month year-over-year changes in the VAR channel, I believe in the past you've talked about partners and VARs contributing about 25% of the revenue mix. Given the changes that we saw on services revenue this quarter, can you talk about what that was in particular in this quarter as a percentage of the total revenue?

Erik Birkerts

For the VARs?

Jeff Osborne – Thomas Weisel Partners

Yes, assuming it higher.

Erik Birkerts

Yes, it was right around $6 million for the second quarter.

Jeff Osborne – Thomas Weisel Partners

Okay. And then, Scott, can you just touch on the tax rate little bit higher than we were thinking. You talked last quarter about 38%. I think you came in close to 44%. What should we be thinking about for the rest of the year, assuming you're over the profitability hurdle?

Scott Jensen

Yes, Jeff, good question. Right now, as you mentioned, we're at 44%, and the biggest driver of that effective tax rate is as we've lowered guidance and taxable income, we've got a component of our nondeductible stock option expense related to ISO stock options. That's an add back, and we can't deduct for tax purposes. So, that's had about a 6% increase – or six points of that 44% rate. I believe, last year, it was closer to two. So, that's the primary driver right there.

The other, we've been conservative also around some federal R&D credits. Our spending was down a little bit through the first half of the year. We expect it to increase, but on a year-over-year basis, it's going to be down. So we've taken a conservative approach on the tax credit. And then we're also still working through the quantification and verification stages of some of the State tax credits that we got earlier this year related to hiring.

Jeff Osborne – Thomas Weisel Partners

Okay.

Scott Jensen

Big piece is the ISO.

Jeff Osborne – Thomas Weisel Partners

So the four or five analysts are all on the same page, should we be thinking about 44% for the rest of the year, just given the reduced profitability profile, and then maybe something a little bit lower, maybe 40-ish but higher than the 38% prior for next year? Is that fair?

Scott Jensen

That's probably a fair conservative approach.

Jeff Osborne – Thomas Weisel Partners

Okay. And then, the last question I had is can you just talk about the Coke channel? You mentioned 15 facilities. I think there is 450 cumulative facilities that you were targeting. Is that project kind of winding down now, or do you have any visibility in that Coca-Cola Enterprises channel for Q3 and Q4?

Erik Birkerts

We've got money in our rollout schedule that we think Coke had communicated to us that they're going to be doing a healthy several million dollars of business with us, but all in including some of the business that's going to roll into fiscal year '10. We've got about 90 more facilities to do, CCE North America. Then there's – Coke's a pretty big entity. There's CCE Canada, there's independent Coke bottlers, there's Coca-Cola Mexico, and then there's Big Coke. So, there's opportunities across those entities as well.

Jeff Osborne – Thomas Weisel Partners

Okay. And the last real quick one, Scott. Was there – would you think the VAR percentage mix should stay the same and i.e., should we be thinking about the services gross margin as sustainable for Q3, Q4?

Scott Jensen

I think our expectation, Jeff, is that the VAR mix will be higher on an annual basis, but not as high as it was in this most recent quarter. So it will definitely impact that service product component, but probably not more than two points. And then I guess I just want to add a comment, going back. The ISO issue on our tax rate, we did recognize that that was negatively impacting us and, as a company, we've eliminated the granting of ISO stock options because of the negative tax consequences. So we're still granting them, but being a little smarter from a tax standpoint.

Jeff Osborne – Thomas Weisel Partners

Very good. Thanks much.

Operator

Our next question will come from Glenn Wortman with Sidoti & Company.

Glenn Wortman – Sidoti & Company

Yes, good evening, everyone.

Erik Birkerts

Hey, Glenn.

Glenn Wortman – Sidoti & Company

Aside from just the Coca-Cola facility you talked about, are you guys starting to see any commitments for fiscal '10?

Erik Birkerts

There is some business that's rolling over. I mean, on the last call, we talked about the large industrial products manufacturer that we signed. That's upwards of potentially a $9 million deal, and that's – the vast majority of that is hitting fiscal year '10. Then, there are other parts of Coca-Cola that I referenced earlier on Jeff's question, that those are hitting primarily in fiscal year '10. So, we're starting to see fiscal year '10 beginning to take shape, but we're not in a position yet to really talk in detail about it.

Glenn Wortman – Sidoti & Company

And just as far as the sales team, so I know you have 62 now. Would you anticipate adding further sales people? I know Neal had touched about it in his prepared comments, but should we be modeling higher sales expenses going forward? Or how should we be thinking about that?

Erik Birkerts

Yes, Glenn, what we're doing right now is really concentrating on refining the mix of talent because basically, in this environment, that the skill set of who can sell and who can't is different. So, frankly, we're pairing some people, and then we're selectively hiring other people who have the skill sets required. I think you'll probably see that we may yet – we may hire a few more field sales people in the month ahead, but I don't see us pushing towards hitting that 70 target anytime soon this quarter or even maybe beginning in the fourth quarter, if we see the economy beginning to turn.

Glenn Wortman – Sidoti & Company

Alright. Thank you very much, guys.

Operator

And Mr. Birkerts, we have no further questions at this time.

Erik Birkerts

Okay. Thank you.

Operator

And that does conclude today's presentation. Thank you for your participation. Have a great night.

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