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Echelon Corp (NASDAQ:ELON)

Q3 2008 Earnings Call

November 6, 2008 2:00 pm ET

Executives

Annie Leschin - IR

Ken Oshman - Chairman and CEO

Chris Stanfield - EVP and CFO

Analysts

Carter Shoop - Deutsche Bank

Michael Carboy - Signal Hill Capital

Ben Schuman - Pacific Crest Securities

Bud Leedom - California Equity Research

Richard Verdi - Sturdivant & Co.

Joe Maxa - Dougherty & Company

Bill Gibson - Nollenberger Capital

Justin Cable - Global Hunter Securities

Operator

Good day, everyone, and welcome to the Echelon Corporation’s Third Quarter 2008 Results Call. Today’s call is being recorded.

At this time, I’d like to turn the conference over to Annie Leschin. Please go ahead, ma’am.

Annie Leschin

Thank you, Operator, and good afternoon, everyone. Thank you for joining us for our third quarter 2008 Earnings Call.

I would like to take just a moment to introduce myself and say that I will be heading up Echelon’s Investor Relations going forward and we look forward to meeting you in upcoming events.

With me on today’s call are Ken Oshman, Chairman and Chief Executive Officer and Chris Stanfield, Executive Vice President and CFO. They will both present prepared remarks.

By now, you should have received a copy of the press release that we issued earlier today. If you would like a copy, please visit our website at www.echelon.com.

Before we begin, I would like to let everyone know that Echelon will be participating in the Stephens 2008 Fall Investment Conference in New York City on November 18. As other events are scheduled in the quarter, we will make additional announcements.

I would like to remind everyone that during the course of this call, we may make statements relating to our business outlook, future financial and operating results, accounting matters and overall future prospects. These forward-looking statements are based on certain assumptions and are subject to a number of risks and uncertainties. We encourage you to read the risks described in our press release, dated November 6, 2008, as well as in our SEC reports including our third quarter 2008 report on Form 10-Q to be filed soon and our 2007 report on Form 10-K for a more complete disclosure of the risks and uncertainties related to our business.

The financial information presented on this call reflects estimates based on information that is available to us at this time. Actual results could differ materially. Echelon undertakes no obligation to update or revise these forward-looking statements.

I’d now like to turn the call over to Ken Oshman.

Ken Oshman

Thank you, Annie, and good morning, everyone, and thank you for joining us. I’ll begin the call with a few brief comments on our third quarter performance, including highlights from our two product lines, LonWorks infrastructure, which we refer to as LWI products and Networked Energy Services, which we refer to as NES products and then discuss the current market environment and the factors affecting our long-term business outlook.

The third quarter highlighted the success of our long-term vision to see LonWorks’ technology successfully applied across a variety of markets. With a record quarter, LonWorks products saw strong volume shipments and a number of new design wins, which we believe will seed our future growth.

NES revenues also met our guidance for the quarter, though revenue was down sequentially as our successful projects in Sweden have completed their ramp and new volume projects have just begun their ramp.

Overall, we were pleased with our performance in the quarter as we slightly exceeded our revenue guidance with sales of $29.5 million. With stronger than forecast, gross margins of 46.4% and tight control over operating expenses, we saw a net loss of $5.4 million or $0.13 per share, substantially better than our guidance.

Our cash position was strong ending the quarter at $94.9 million in cash and marketable securities and no borrowings.

Let me begin by talking about our NES product line. We won a number of projects this quarter that have begun to fill our pipeline for the fourth quarter and beyond. These included several contracts in Denmark, as well as smaller strategic wins in Germany and France. We also had additional orders and shipments to Duke Energy and to our project in Russia.

With the recent selection by the Danish utility, NRGi, Echelon is now the leading supplier to the Danish advanced meter market with nearly 55% market share. The smart metering market in Denmark is estimated to be approximately 3 million meters in total, roughly half of which have already been awarded. With the other half not yet tendered, we believe this represents a remaining opportunity of about $150 million for which Echelon is well positioned given the advantages of its NES product line, as well as our market-leading incumbent status.

After many years of hard work, to penetrate markets such as Denmark and others, it is very exciting to be able to speak of Echelon as the incumbent against which others must compete. As we discussed on other calls, all of the large wins we’ve announced recently in Denmark require our next-generation 3.1 polyphase meter scheduled to begin shipping in the next few weeks.

With the slower than originally anticipated ramp rate, fourth quarter revenue from Danish projects will be lower than expected just a few months ago. Nevertheless, the total amount of meters and resulting revenue over the life of the contract remains unchanged. It’s purely a timing issue.

Echelon’s success in Denmark is particularly noteworthy for two reasons. First, there is currently no law compelling Danish utilities to deploy smart metering systems. Second, as with every new market we enter, Echelon was not the incumbent supplier and did not win any of the initial projects which went to entrenched suppliers. From this position, we’ve become the leading player in the Danish market over the course of just a few years.

We believe our success is due to a number of factors, including first, our strategy of selling the NES system with partners rather than meter-centric direct distribution. Secondly, our superior system capabilities that drive down deployment costs enable more services and provide a compelling business proposition and return on investment for utilities. And thirdly, our field proven performance and reliability which we believe is unmatched in the industry.

Unlike competing systems, Echelon’s NES products go beyond the meter in simple two-way communication to extend a utility’s ability to utilize the meter and network to improve service quality, connect to other devices and offer new and innovated services, all of which results in a very low cost infrastructure investment.

In Denmark, for example, our value-added partner, Eltel, is taking advantage of the open interfaces with our 3.1 meters to provide wireless connectivity using ZigBee to in-home devices such as gas meters.

As we saw in the Swedish market, the clear advantages of our NES products ultimately lead to our success. This is a pattern that we hope to replicate everywhere we sell.

Another important win announced during the third quarter was a project with Hassfurt, a medium-sized utility in Germany. As with Denmark, Germany currently has no comprehensive law requiring the mass deployment of advanced meters to all homes, though there is a law that requires new and remodeled homes to be equipped with smart metering by 2010. Having completed a successful pilot, Hassfurt’s decision to deploy the NES system itself was a significant one made more for economic reasons than for regulatory ones. Although, a small project with just 10,000 meters over three years, we believe this is a very strategic win for Echelon providing an entrée into the large 40 million meter German market.

As many utilities look to modernize their infrastructure, another important factor driving Hassfurt’s decision was the need to improve the way it interacts with its customers. By laying the groundwork for a smart grid as opposed to just a smart metering network, the NES system provides a platform that helps the utility operate more effectively through reduced costs and to better communicate with their customers.

Yesterday, we announced another small, but strategic win with a consortium of French electricity distributors. Echelon’s NES system was selected by the group for deployment of up to 90,000 homes over the next four years. Adding to our momentum in Europe, this win provides an entry into yet another large market where we believe this win will position us well for other opportunities.

Finally, I’d like to spend a few moments talking about our project at Duke Energy in the U.S. Shipments continued in the third quarter with more underway in the fourth quarter. We’re working closely with Duke and we’re pleased with the progress being made though we’d always like to see things move more quickly.

An important component of that process is public utility commission approval. While Duke has made clear that it has not yet finalized contracts or completed selection of vendors for volume deployments, it has filed for approval of its smart grid program in Ohio, where it serves about 690,000 customers and in Indiana, where it serves roughly 775,000 customers. In each of those filings, Duke has indicated it anticipates working with Echelon.

Just last week, Duke issued a press release related to their filing stating that a settlement agreement had been reached with most intervening parties with the staff of the PUC of Ohio and the Ohio Consumers’ Council, a very important milestone towards approval of their plan.

In total, our partners world wide have won projects or have active pilots at nearly 100 utilities and these utilities serve almost 60 million customers. Thus far, the projects and trials that we won at these utilities have fully deployed and including options will amount to roughly 2.25 million meters. Clearly, the NES opportunity for growth in 2009 and beyond is very large and is still growing.

Now, I would like to turn to our LonWorks products. In its strongest quarter yet, LonWorks was driven by both business in Europe and the Americas. A number of design wins that we have been working with for months and in some cases years entered volume production in the quarter. We saw strength in virtually every application area where our products are deployed. Energy, in particular, continues to play a central role in driving LonWorks sales.

As energy management and conservation grow an importance and companies and governments look for ways to control their energy expense in carbon footprint, we believe LonWorks will benefit. We are already seeing this today with the emergence of new application such as advanced street lighting systems, centralized energy management and monitoring of small buildings and demand response systems.

Intelligent street lighting applications are gaining momentum as over 50 cities in Europe, ranging in size from small villages to large cosmopolitan cities, are now running pilot programs with our LonWorks products. Key European partners such as Philips with their LonWorks-based Star Sense 2 street lighting system are increasing their sales forces to sell their systems. Our secure and reliable power line technology is also generating significant interest in the United States.

The growing emphasis on new street lighting technology such as light emitting diodes and store lighting systems which are also starting to ramp using LonWorks-based devices will only add to the opportunities in this market.

Energy-related applications and distributed facility such as chain stores, bank branches, and public buildings are also showing good promise. In these applications, the ability to remotely and securely manage and control sites is essential. And that’s where our products excel.

This quarter, our partners successfully installed LonWorks systems into a large number of branch banking offices in order to enable energy management and remote maintenance. Our partners have also begun several other branch management pilots and expect to continue with more deployments in 2009.

We’ve also seen the beginnings of home energy monitoring applications with the introduction in Europe of home products incorporating LonWorks. Our power line technology represents the lowest cost, most reliable, robust, and easy to install technology. Utilizing the existing network in power lines requiring no new wires for any device plugged into an electrical socket.

The emerging street light and other energy-related opportunities, combined with a number of other design wins that we expect to enter volume production soon, should result in further penetration of our LonWorks products. As such, we anticipate another good quarter for our LonWorks product line. The one potential concern is the current financial crisis. While, we have yet to see any indication of a slow down, we are monitoring the possible impact of the financial crisis on new building construction and retrofits. One of the primary markets for LonWorks products.

These projects are often decided and funded years in advance of our revenue. So, we are more of a lagging indicator. Mitigating this concern is increased use of LonWorks products for energy-related applications of course.

In summary, we were pleased with our performance in the quarter and believe that we’ve made great strides in penetrating key markets with our NES and LonWorks product lines.

The superior characteristics and performance of our products versus the competition remain clear. We will continue to focus our efforts on growing market share, investing for the future and positioning ourselves to take advantage of the long-term growth of the smart grid, which in our view extends well beyond the traditional utility infrastructure to every device that has an electrical heartbeat.

The challenge we have is predicting the pace at which customers, especially utilities, will move forward in both the awarding of contracts and the deployment timeframe over the length of the contracts. We’ll continue to announce contracts and awards as they are made, and highlight regions or areas that we see developing.

I would like to thank the entire Echelon team around the world for their diligent efforts and their hard work.

And now I would like to turn the call over to Chris Stanfield, our CFO, to elaborate on our operating results.

Chris Stanfield

Thanks Ken. Now I would like to review our financial performance during the quarter and provide some commentary on our outlook for the fourth quarter. Please note that all references to non-GAAP amounts excludes stock-based compensation. For ease of reference, we have prepared a complete non-GAAP statement of operations for the three and nine-month periods ended September 30, 2008 on the Investor Relations section of our website.

Revenues for the quarter ended September 30, 2008 were $29.5 million, compared to $24.7 million for the same period in 2007. Both NES and LonWorks revenues improved year-over-year highlighted by particular strength in our LonWorks infrastructure with revenue in the quarter of $14.7 million, versus $13.1 million a year ago. Though down sequentially, NES revenue increased year-over-year to $9.4 million from $8.6 million last year.

Additionally, revenue from our Enel project grew 80% year-over-year to $5.5 million from $3 million last year.

Non-GAAP gross margin for the quarter was 46.4%, compared to 41.4% for the same period last year. This was substantially due to favorable overhead absorption variances and improved gross margins in our NES products.

Non-GAAP operating expenses were $16 million compared to $15.2 million in the third quarter of last year. This was $1.3 million below our guidance and was due to a variety of factors, including a delay in the timing of certain expenditures and unanticipated reduction in operating expenses occurred overseas, due to favorable exchange rates and a conscientious attempt to keep our costs in line given current economic conditions.

Interest and other income was 1.1 million versus 1.4 million in the same period last year. This lower amount was due to a decrease in our interest income resulting primarily from a reduction in the average yield on our investment portfolio. This was partially offset by currency translation gains, resulting from the fall of the euro and pound sterling in relation to the dollar in September, as the financial crisis took hold.

The GAAP net loss for the third quarter was $5.4 million or $0.13 per share. This compares to a net loss of $5.7 million or $0.14 per share for the same period in 2007. On a non-GAAP basis, the net loss for the quarter was $1.7 million or $0.04 per share compared to a non-GAAP net loss of $4 million or $0.10 per share for the third quarter of 2007.

Moving on to the balance sheet; we ended the quarter with cash, cash equivalents, and short-term investments of $94.9 million, a decrease of $10.8 million from last quarter. Regarding cash flow, net cash flows provided by operating activities were $2 million for the nine-month ended September 30, 2008. In the third quarter of 2008, Echelon repurchased approximately 533,000 shares, achieving our goal of buying 750,000 shares for the year.

Turning to guidance; as Ken mentioned, though just a quarter ago, we were confident in our outlook for the remainder of the year, the timing of deployment has not occurred at the pace we expected. Though this will not impact the overall size of these projects, it will affect our fourth quarter.

We now expect total revenue for the fourth quarter of 2008 to be in the range of $36 million to $38 million, with LonWorks infrastructure accounting for approximately $14 million and NES about $19 million, leaving the remainder for Enel.

We anticipate non-GAAP gross margin to be in the range of 39% to 40% for the quarter and non-GAAP operating expenses to be approximately $17 million. Finally, we estimate our GAAP loss per share will be 0.13 to $0.16 per share and our non-GAAP loss per share will be $0.06 to $0.08.

Looking to 2009, we have not seen -- yet seen much impact from the credit crisis. Our projects continue to move forward and we remain confident in our position in the marketplace. We do, however, believe that should the credit crisis continue for an extended period, both our LonWorks infrastructure and NES product lines could be impacted. As a result, it is difficult for us to forecast the entire year until we have clear information and visibility. Our perspective at the moment is for modest revenue growth next year across both of these product lines.

I will now turn the call back to Ken for questions.

Ken Oshman

Hello. This is Ken. We will turn it back to the operator.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Carter Shoop with Deutsche Bank.

Carter Shoop - Deutsche Bank

Good afternoon. Wanted to first follow-up in regards to the definition of modest growth in each division. I personally think a modest growth being in kind of the mid to high single digit range on a year-over-year basis. Is that the way you guys think of modest -- or how should investors think about that commentary?

Ken Oshman

We think of modest as modest and we are not -- in this economic world, it’s hard to put a number on modest. But I would tell you that we think that our NES business will grow the most rapidly of our parts of our business. And the LonWorks infrastructure business will grow a little more slowly and actually we are projecting, because of what they need, we are projecting a slight contraction in our Enel revenues next year. But we do believe overall, we will have modest growth.

Carter Shoop - Deutsche Bank

That’s helpful. And would you expect the LWI business to remain in a similar type of growth rate that you are expecting for the full year of ‘08?

Ken Oshman

We have in this economic environment, we just -- it’s just awfully hard at this moment for us to talk about growth rates, really talk about growth rates and compare them to this year for next year. And I think we’d just like to leave it at that.

Carter Shoop - Deutsche Bank

Fair enough. I’ll let another analyst to go after that one.

Ken Oshman

Thank you.

Carter Shoop - Deutsche Bank

When we think about profitability with Echelon here, at what revenue level are you guys hoping to approach profitability?

Ken Oshman

Carter, when I talk about profitability, I talk about it at the operating profit line.

Carter Shoop - Deutsche Bank

Okay.

Chris Stanfield

And I talk as you know on a non-GAAP basis. And I would expect its somewhere between 150 million and $160 million of total revenue as a company. We should be able to obtain a breakeven on a non-GAAP basis at that line.

Carter Shoop - Deutsche Bank

So for the mid point of December quarter guidance, that’s about 148 million, I’m looking for a 6 to 8% non-GAAP loss. Are there current restructuring programs you have in place to help you approach that profitability level?

Chris Stanfield

No. We do not have any restructuring programs. We have, first and foremost, strong programs with respect to cost reductions. And I think I’ve told you on a number of occasions. When we entered the NES business, our margins were slight. They’ve improved consistently over time, as I indicated in my prepared remarks. And we think that leverage will go into the future. We also have a large portion of fixed costs within our operating -- within our cost of goods sold that we believe we can control and manage. And as you can observe in our own results, we have been working aggressively to manage our operating expenses, but there are no restructuring programs.

Carter Shoop - Deutsche Bank

Last question, could you provide a break out of the LWI business in the most recent quarter, at least in rough figures, how that business broke out between HVAC, lighting, demand response applications, et cetera?

Chris Stanfield

No. I can’t do that, because as you know we sell to companies and companies use our products in a variety of applications. What I can tell you is that we, of course, saw strong revenues in many areas and Ken I think highlighted in his comments the growth area -- if you look to sort of a common attribute of customers that are doing the best for us, there are some energy aspect or energy management aspect to their business.

Carter Shoop - Deutsche Bank

Thank you.

Operator

(Operator Instructions). We will now take a question from Michael Carboy with Signal Hill Capital.

Michael Carboy - Signal Hill Capital

Good morning, ladies and gentlemen. Ken, I’d like you to elaborate a little bit on the issue of European pilots. You’d mentioned in particular in Germany, the program seemed to be -- pilot program seemed to be coming to fruition or completion, I should say, quicker than expected based on economic consequences rather than perhaps operational impact. Are you seeing that as the increasing driver of business activity in Europe? And can you quantify that in any way, shape or form?

Ken Oshman

Hi. Thanks very much, Michael. Let me say that we are really excited about opportunities in Germany. But what I said was that there is really no regulatory imperative at this point, which actually makes the Hassfurt win and deployment even that much more exciting to us, because these guys said, “Look, it’s going to be better economically for us to go ahead and deploy the NES system across our entire talent rather than messing around one at a time with retrofits and new buildings.” So, they saw an economic incentive to go on and do a full deployment, which I believe is the first full deployment anywhere in Germany of an entire utility.

To do a full deployment across their entire city, not the biggest city in the world, but nevertheless, its damn good, example we think. And so that’s really what I was saying. And I hope that explains it.

Michael Carboy - Signal Hill Capital

What I am trying to get at, Ken, is...

Ken Oshman

Yes.

Michael Carboy - Signal Hill Capital

...what incremental economic advantage did Hassfurt realize vis-à-vis...

Ken Oshman

Okay.

Michael Carboy - Signal Hill Capital

...the other options they might have explored. It sounds like the economic angle here was very important one to them. And if can you quantify that?

Ken Oshman

Right. So let me explain the alternative economic approach or the alternative technical approach. Rather than deploying the entire city, you could say, house one moves in on block eight and house 18 moves in on block 42, and you could send an installation crew to each of those houses on the day that they had to get there to install a meter. And that one way trip, that one little trip itself, probably triples the cost of the installation of the meter.

And then, additionally you are probably -- if that’s all you are going to do, you’re probably going to install some simple “smart” meter and I use “smart” in quotes, because it’s not much of a smart meter, but it’s just a simple meter that has the GPRS connection back to the central office. Because you just had this one meter, you don’t have anything going, you got this one. And that’s not an expensive meter itself. But more importantly, it’s just a simple meter. It’s not an NES-like rich, powerful system. And so, the net result is, you look at it and you say to yourself, if you’re Hassfurt, “Hey, why don’t we just go do the whole thing. Right now, it’s going to cost us a third as much, we are going to have five times the capabilities.”

Michael Carboy - Signal Hill Capital

Got it.

Ken Oshman

I don’t know if that makes any sense, but that’s sort of the logic, I hope it does.

Michael Carboy - Signal Hill Capital

No. That makes sense. You had touched on this issue of European penetration market share and certainly Echelon has been known for its European presence. I’m wondering if you could just briefly review for us the major European market opportunities and the degree to which they are penetrated at this point by advanced AMI infrastructure and then what your market share in those three or four countries might be.

Ken Oshman

Well, I’ll try, but let me just say that the most penetrated market, the most mature market is Sweden. Well, actually, Jeff Lund, is sitting here and he reminded me that the most penetrated market is Italy. Okay. We have installed 27 million devices in Italy. So the most penetrated market is Italy and it’s probably 99% complete at this point and has been doing very well for a long time. It is not a great market opportunity in the future because it’s pretty expensive. The second most penetrated is probably Sweden. It’s not fully deployed. It’s not fully done. But it’s probably pretty well done. It was made up of large utilities and many, many, many small utilities. We did not really have a good way to market to the many, many small utilities, but in the large utilities, we probably got on the order of a third of the marketplace or a little more.

And the next most I would say penetrated market at least in terms of contracts in place and so on, is probably Denmark. It’s may be about 50% penetrated. I don’t know how much is -- Sweden is actually done, but let’s say, 70%. Denmark is probably 50% of which we’ve got more than half of that market share. There is very little penetration otherwise that I can think of. There is some in Finland and that is going to represent a continuing opportunity. Norway has announced that it intends to -- it has no -- there’s no penetration of anything in Norway. There are about may be 3 to 5 million customers in Norway. But they have announced that they want smart metering in by something, 2012 I believe, something around 2012, they want to have smart metering finished. So a large market that has -- that is absolutely a difficult market because of the regulatory environment in which nobody owns anything necessarily is the English market. But the English market, the legislative branch and the Minister of Energies have said they intend over the next 10 years to turn that into a smart metering market and they realize they have a regulatory problem and they’re going to get that fixed in the next year or two. Ireland is another market opportunity that’s happening right now.

Michael Carboy - Signal Hill Capital

How about France and Spain?

Ken Oshman

I was just going to -- I’m sort of working my way around the map. I’m boring every -- I’m probably boring everybody with this long thing. But France, we think is a wonderful opportunity. It is a very large opportunity -- sort of bifurcated into two piece. One piece is EDF, Electricité de France, which is the largest utility probably in Europe. Although, Enel is probably larger right now. But at any rate, EDF is sort of doing their own thing. They are designing their own meter. They are designing their own networks. They are doing everything themselves. We are not really in the business of designing a special-purpose meters even if for a large utility. So that is not an opportunity we have pursued in that format. But there are another 5 million meters that are to be deployed in the rest of France and that looks like a great opportunity.

And, in fact, I think we will have the largest market share of deployment in the next year or two as we get -- move along. And of course there is Denmark -- I mean, Norway -- help me, and there’s Holland. There is the Netherlands, where we’ve been working for a number of years and I think the regulatory environment is about to get sorted out, and over the next year, we’ll move ahead and we have or I would say 70% market share in the Netherlands. So I don’t know if that helps.

Michael Carboy - Signal Hill Capital

Yes, it does. And let me come back, Chris, we’ve talked about foreign exchange in the past, when the euro was running so strong against the dollar. It was really hurting you guys because a lot of your expense structure in Europe is actually denominated in euros, if I recall. Now that it’s going the other way, I’m hoping you might be able to quantify for us what portion of the favorable OpEx variance was foreign exchange related?

Chris Stanfield

My recollection is it was modest. It was probably maybe about 10% of the $1.3 million, about $125,000, but remember currencies really didn’t start moving until September when the crisis really took hold.

Michael Carboy - Signal Hill Capital

Okay. Are you planning perspectively -- are you planning on trying to put in place some hedges to better manage that?

Chris Stanfield

No. We’re not at this time. I mean I think as a practical matter, we think that as you know, we sell products in our own currency and it’s just -- I don’t see any great advantage of incurring costs to try to affect how those expenses flow through from a P&L perspective.

Ken Oshman

It’s a small part of our expenses, Michael. I am sure you realize that. It’s just our sales force, our support organization in Europe and a small product development activity we have in Germany that’s euro based.

Michael Carboy - Signal Hill Capital

And then last question, you touched on the issue of the Duke rate case in Ohio. Can you just let us know what the intervener issues were over? Were they related specifically to the cost of AMI infrastructure or were they other issues that they were wincing about?

Ken Oshman

Michael, I am going to tell you, I am so happy I don’t have to know the answer to that question. That’s a level of detail that our friends in these utilities have to deal with on a daily basis. And I just don’t know what the answer is.

Michael Carboy - Signal Hill Capital

Does it sound like it was related to the AMI cost issues?

Ken Oshman

I have no idea. I think there were a number of different parties and they all had different issues, and it was all -- appears to be all resolved. So that’s the most important thing to me.

Michael Carboy - Signal Hill Capital

All right, great. Thanks fellows.

Chris Stanfield

Sure.

Operator

For our next question, we’ll go to Ben Schuman with Pacific Crest Securities.

Ben Schuman - Pacific Crest Securities

Hi, guys. Thanks for taking my call.

Ken Oshman

Sure.

Ben Schuman - Pacific Crest Securities

I guess with Denmark driving your guidance reduction for the past couple of quarters, I was wondering if there’s something specific to that geography among multiple customers, that’s slowing things down there or just changes to customer specific time lines.

Ken Oshman

Chris, you may want to add to this, but Denmark really didn’t drive our guidance changes. Denmark is only one piece of a very large puzzle and what we’re really talking about are push-outs, delays in decisions, deployment delays. These are things that are happening and these are good -- they’re happening for good reasons. The utilities are doing -- making good -- trying to make good decisions. They’re trying to do great deployments, and all of these things just are happening. This is something we are learning. We have never figured it out perfectly and we are learning. I can tell you one of the things we do, however do, is we give you the very best information we have at the moment. So if it’s just in the last week’s things moved out from a variety of things. Denmark was a contributor but not the whole deal.

Chris Stanfield

Yes. This is Chris. I just wanted to add that as we have said, the total size of that opportunity has not changed. All that changed was the portion of that opportunity that’s going to become revenue in the fourth quarter. But that is the same story at many other utilities that we tracked and I think as we talked last time, what happens here is that we have excellent visibility as to the size of these projects. But sometimes the actual timing of the deployment is different than what we expect or frankly what our customers expect when we provide you our guidance.

Ben Schuman - Pacific Crest Securities

Okay. And last quarter, you guys provided some visibility metrics, I’m sorry if you’ve already given this. But can you tell us how much of the Q4 NES revenue that your forecasting has already been booked and maybe what your visibility looks like heading into the next couple of quarters?

Chris Stanfield

Chris, on NES, all of the guidance is in backlog.

Ben Schuman - Pacific Crest Securities

Okay.

Chris Stanfield

In terms of the next several quarters, as you know, we have not provided guidance. But I think we see the normal parallel there. We have projects. The example, I would use is Denmark, since we are speaking about it. We have excellent visibility of that project, as it goes out over the next year...

Ben Schuman - Pacific Crest Securities

Okay.

Chris Stanfield

...as the visibility in shorter.

Ben Schuman - Pacific Crest Securities

And any update on the second North American pilot that you guys announced last quarter as well?

Ken Oshman

No, new news.

Ben Schuman - Pacific Crest Securities

Okay. All right. Thank you very much.

Operator

For our next question, we’ll go to Bud Leedom with California Equity Research.

Bud Leedom - California Equity Research

Hi. Thanks for taking my question. Just a couple of things; one, related to Duke, you said shipments continued in the third quarter and you’ll see more in the fourth quarter. Is there any way to quantify that? Is that all part of the original pilot or has there been an extension of that?

Ken Oshman

The pilot has dramatically expanded. It’s not the original pilot. It’s much larger. I don’t like to get out in front of Duke in terms of what they have said publicly. And so, I won’t do that. But certainly in our revenue numbers for Q3 and Q4, is Duke revenue, both quarters. And we are well beyond the original 50,000 meter number that I think we started -- well, I think the first pilot was 7000 and then the next thing was around 50,000. So, we are well beyond that.

Bud Leedom - California Equity Research

Okay. So, it’s beyond that 50,000. Okay. And then just in terms of an update on your shift to tier 1 manufacturers, was that -- did that have any positive impact on your gross margins this quarter and where does that stand if you can maybe provide a little detail there?

Chris Stanfield

Well, we have now moved our manufacturing to the tier 1 manufacturers as you have stated. We did see an improvement in our NES margins as I’ve indicated. Frankly, I can’t tell you which portion of that is due to moving to the tier manufacturers and what portion of is due to our design. But yes, we have seen an improvement in our margins.

Ken Oshman

We also saw -- I mean to be totally complete, we also saw expenses associated with leaving our previous contract manufacturer in the third quarter.

Bud Leedom - California Equity Research

Okay.

Ken Oshman

Which are in the numbers.

Bud Leedom - California Equity Research

And I assume part of the gross margin improvement too was more of a mix issue with greater proportion of LWI revenue in the quarter I would imagine.

Chris Stanfield

Absolutely.

Bud Leedom - California Equity Research

Okay. Okay. And then just finally, obviously, October was kind of a freeze across many different industries. As you characterize your pipeline that’s out there as being very robust, could you maybe characterize some of the discussions? Were there some discussions that were put back or anything related to just this October freeze that we saw in the market?

Ken Oshman

I would tell you that the NES business, as best -- and I think you are asking about the NES business because...

Bud Leedom - California Equity Research

Right.

Ken Oshman

...I think we talked a little more about the -- and I talked a little more about LWI. As far as the NES business is concerned, it is driven primarily by other decisions. It’s driven by regulatory needs. It’s driven by needs to upgrade the grid. It’s driven by a number of things. Having said that, we have not -- none of the orders that we expected in the fourth quarter had any affect -- that have moved out, had any affect from the financial situation. But I would be very surprised if somewhere along the line, we don’t see some amount of credit crunch hitting utilities somewhere in the world. But of course, utilities have the strongest credit rating of about anybody in the world. So, if anyone’s going to get money, they are going to get it.

Bud Leedom - California Equity Research

Thank you.

Ken Oshman

Sure.

Operator

For our next question, we’ll go to Richard Verdi with Sturdivant & Co.

Richard Verdi - Sturdivant & Co.

Actually, my questions have already been answered. Thank you.

Ken Oshman

Thanks for being on the phone. Thanks.

Operator

Next we will go to Dougherty & Company’s Joe Maxa.

Joe Maxa - Dougherty & Company

Thank you. Chris, the gross margin guidance for Q4 being down sequentially, is that -- what are we seeing there? If I model NES and NL roughly similar, as in 60 and 50%, it looks like we’ll see NES drop a bit. Is that how we should be looking at it?

Chris Stanfield

No. I don’t think you should. I think what is happening is that -- well, first of all, I think as Bud had already mentioned, there is an affect on our margins based upon the relative proportion of NES in any period. And as you know, there is more of that. You’ve already built that into your model. But the other factor was that we had some favorable absorption variances that occurred in the third quarter that we don’t expect to happen -- to be repeated and we also had some very, very favorable product mix that we don’t think is going to be repeated.

Joe Maxa - Dougherty & Company

Is the product mix within the meters themselves?

Chris Stanfield

No. This is product mix within the products that we sell, principally.

Joe Maxa - Dougherty & Company

I see, okay. What do you expect your inventory level to be at year end? Do you expect it to be similar to Q3? Up, down, can you give us an idea?

Chris Stanfield

We expect the inventory level to steadily decline over time. I can’t tell you exactly where it’s going to be at the end of the quarter until we get some more detailed information. And part of -- I think you understand that in some instances when we’re shipping to customers under certain terms of sale, inventory remains in our books until it arrives at the location. But we’ve -- I think what I will talk about is the long-term trend, we see those inventories tracking down.

Joe Maxa - Dougherty & Company

Okay. And then the deferred revenue increased $3 million in the quarter. Can you give me a little color on that?

Chris Stanfield

Once again, that’s just a function of where we are in terms of the shipment cycle. As you know, that is driven across all of our businesses, we have deferred revenue, but the biggest factor in the variability would be NES and it just has to do with the stuff that was out there awaiting acceptance.

Joe Maxa - Dougherty & Company

So, that is short term and most of that -- would you expect to be recognized in Q4?

Chris Stanfield

Yes.

Joe Maxa - Dougherty & Company

Okay.

Chris Stanfield

That’s the NES portion. As you know, the portion associated with our LonWorks business tends to be a constant, because it relates principally to distributor inventories, which we defer.

Joe Maxa - Dougherty & Company

Yes.

Chris Stanfield

We account distributors on a sell-through basis.

Joe Maxa - Dougherty & Company

Right, absolutely. And then, are you still expecting your NES gross margins to get up into that 35% plus range?

Ken Oshman

We definitely -- we definitely do expect that to happen.

Joe Maxa - Dougherty & Company

And then when -- I mean can you give us a ballpark or may be a revenue ramp to actually hit those ranges?

Ken Oshman

I think that it is all related to revenues and that’s a good way of looking at it, and I think when we are at something like 50 or 100% of our current revenue run rates, we ought to be at those kinds of -- be able to start achieving those kinds of numbers.

Joe Maxa - Dougherty & Company

Okay. And then I’ll just ask one more on the income statement line. The interest and other income, Chris, the 1.14 million, doubled from last quarter. What are we looking at? I mean what was in that in the quarter, something one-time and what should we be looking at going forward?

Chris Stanfield

Well, when we put that forecast together, just as you do, is comprised of three things. Interest income, which we were pretty close on, the expense that gets booked under the way that we have to account for our building lease, which we hit that on, the thing that caused the improvement that you’re seeing has to do with translation gains on our inter-company balances. And this was associated once again with what happened to principally the euro and the pound sterling, as a result of the first portion of the financial crisis. As you know, both of those currencies fell very sharply against the dollar. It was a reversal of what we had seen actually in the previous quarter.

Joe Maxa - Dougherty & Company

Okay. And then, Ken, the discussion in Denmark, are you -- would we look at these projects to ship relatively consistently once we get into ‘09 and they start shipping, say, year-over-year over the next two to three years?

Ken Oshman

Sure.

Joe Maxa - Dougherty & Company

Okay.

Ken Oshman

We would definitely look at -- for that.

Joe Maxa - Dougherty & Company

And then the last thing, can you give us an update on Nuon? You had some discussion on that last quarter?

Chris Stanfield

I think the most important update on Nuon is that the Dutch market continues -- the Dutch legislative environment continues to chug along and we think that it will all be cleared up by the end of next year. So there is an interim now that -- an interim period where utilities have got to comply with some, as yet to be defined regulations, which makes it a little bit hard for them to do so. But they must, on the one hand, install new smart meters in every place they install a new meter, meaning growth or new building. And, so they’ve got to do that and at the same time, the exact definition of that new meters -- metering system is not totally complete. But we think it’s very close to complete. I think Nuon expects to issue a tender for -- we don’t know exactly how many, but may be in the range of somewhere between 400,000 and 800,000 -- who knows, meters, we think they expect to issue a tender for that sometime before the middle of next year.

Joe Maxa - Dougherty & Company

Okay. Thank you a lot. Thanks you a lot.

Operator

For our next question, we’ll go to Nollenberger Capital’s Bill Gibson.

Bill Gibson - Nollenberger Capital

Hi, Ken. And I’m going to ask sort of the same questions everybody else has in sort of a strange way. And that is --

Ken Oshman

Let’s see if I come up with the same answers, that will be interesting.

Bill Gibson - Nollenberger Capital

Well, let assume my competitors on Wall Street hadn’t burned down the financial markets with derivatives and we hadn’t had a financial crisis.

Ken Oshman

God, wouldn’t that be great?

Bill Gibson - Nollenberger Capital

Yes. But, would we still be looking at modest NES growth or that kind of guidance just because there is a lack of major projects coming in Europe? Or is there the potential for something larger to hit out of a country like France or Germany or even Holland?

Ken Oshman

Bill, what I think we are trying to tell you and what we’re trying to tell you and what we’re -- with forecast learn is how to forecast future business in the NES portion of our business. I think we’re getting better at it. I think our customers are -- the utility customers and our strategic partners are getting better at it. But we’re not perfect. And so we’re just trying to be as realistic as we can about the future at this moment. I don’t think modest, large, small, intermediate, any of those words at this point would mean -- I don’t think we can really say what we think next year is going to be kind of -- but I will say I don’t think it’s going to have a lot of financial market impact. I mean in other words, I don’t think the financial markets are going to be a major factor in any of that. I actually think in the U.S., the Obama administration will be a positive impact, whatever the financial markets are, in terms of encouraging development of the smart grid.

Bill Gibson - Nollenberger Capital

And I know in your opening comments since you were talking about what happened in Denmark, I assume that’s part of the plan in the U.S. that ultimately you’ve got a shot because of the superior performance and a better model for the grid.

Ken Oshman

Well, we basically have I think -- let me say, I think that what we have is a system, which is rock solid in terms of reliability based on our power line technology. There is -- we’ve got -- the system is running like 100% of the time the meters are in communication -- and we’re in communication with the meters. The only times that anything happens is when the cell tower goes out or something. So, it’s just a really rock solid open network. We believe that the openness at either end of this network is very vital. We think the fact that these -- that the network itself can be, if it’s appropriate, can be a public network, managed, maintained and so on, by a network provider who has got even more interests to keep it up and running than just these the smart grid. And the net -- at the bottom of it all is that it’s just a lot less expensive to deploy our kind of the network than some of this -- than some of the competition.

I view that we are definitely the leader in terms of power line technology, but let me also say, we have no religion around that. We’ll do whatever it is the most reliable, lowest cost way to network these -- the smart grid. And we just think we’re in a very good position right now. In North America, against Itron, in Europe against Landis and Gyr.

Bill Gibson - Nollenberger Capital

Thanks Ken.

Ken Oshman

Sure.

Operator

(Operator Instructions). We’ll now go to Justin Cable with Global Hunter Securities.

Justin Cable - Global Hunter Securities

Thank you. Just a couple of quick questions here.

Ken Oshman

Sure.

Justin Cable - Global Hunter Securities

In the quarter, again, how much of the revenues were from international and maybe if you could provide a breakdown?

Ken Oshman

Let me dig and see if we have that yet in terms of the actual split between international, and why don’t you go to your second question.

Justin Cable - Global Hunter Securities

Yes. A similar -- along similar lines, how much of the revenues were from indirect channels, versus direct, with your channel partners?

Chris Stanfield

I’m not going to have that at my finger tips right now. I think -- because, as you know, in the NES business, a large portion of that is indirect. But in terms of our LonWorks infrastructure revenue, about 5.5 million of it was in the Americas and the remainder was international. In terms of the utility space, about a third of it was domestic and about two thirds was international. And then obviously Enel was all international.

Justin Cable - Global Hunter Securities

Yes. So on the indirect business, have there been any new developments there with your channel partners? Any new partners that have emerged or any expansion of existing partnerships during the quarter?

Ken Oshman

When you say indirect, are you talking about our NES business or are you talking about our LonWorks infrastructure or what?

Justin Cable - Global Hunter Securities

Either or both, and just in terms of trying to gain market share overall, certainly the indirect channels --

Ken Oshman

So we are continuously working to develop our partner channels especially in our NES business where we identify specific partner opportunities and our sales force is very focused on trying to develop those. And we continue to add channel partners in the NES business. LonWorks infrastructure is more or less all indirect. It’s -- every customer is an indirect customer if you will, embedding our products in their products or distributing our products for the -- and integrating them with other things. So everything we do is about developing indirect contacts in our LonWorks infrastructure business. I hope that...

Justin Cable - Global Hunter Securities

Yes. I was just looking to see...

Ken Oshman

Sure.

Justin Cable - Global Hunter Securities

...if there was any new partners that have emerged over the last quarter or so. Obviously, it’s an ongoing program that you guys have?

Ken Oshman

It is an on going program and, well, I mean for example, I think we announced this French -- the French thing, where this is a new partner for us in France, and a very important and good partner to us.

Justin Cable - Global Hunter Securities

Last question is just on share repurchases, is that something that you will come back to?

Chris Stanfield

I’m not going to predict the exact time that we’re going to do anything. We had a goal for this year as I indicated in my prepared remarks and we were able to fulfill that. That’s been a continuing program. As you know, we’ve been doing that for a number of years. And so I -- to the extent that the past was a good guide, yes, I would think that we would -- be something, but in the near term obviously cash is king.

Justin Cable - Global Hunter Securities

Okay. Thank you.

Ken Oshman

And I would just add that at these prices, our money is burning a hole in my pocket. But cash is king right now. So we are not jumping around.

Justin Cable - Global Hunter Securities

Got it.

Operator

And Mr. Cable, is there any things further?

Justin Cable - Global Hunter Securities

That’s it. Thank you.

Operator

Thank you. That will conclude our question-and-answer session. I would now like to turn the call back over to Ms. Leschin for closing remarks.

Annie Leschin

Thank you, everyone, for joining us and we look forward to seeing you at our Stephens’ Conference and upcoming events.

Operator

Okay. And that does conclude today’s conference. Thank you again for your participation and have a wonderful day.

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