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Itron (NASDAQ:ITRI)

Q4 2012 Earnings Call

February 13, 2013 5:00 pm ET

Executives

Barbara J. Doyle - Vice President of Investor Relations

Steven M. Helmbrecht - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Philip C. Mezey - Chief Executive Officer, President and Director

Analysts

Zach Larkin - Stephens Inc., Research Division

John Quealy - Canaccord Genuity, Research Division

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Paul Coster - JP Morgan Chase & Co, Research Division

Sean K.F. Hannan - Needham & Company, LLC, Research Division

Susie Min - Deutsche Bank AG, Research Division

Amir Rozwadowski - Barclays Capital, Research Division

Christopher M. Kovacs - Robert W. Baird & Co. Incorporated, Research Division

Operator

Good day, everyone, and welcome to the Itron Q4 and Year End 2012 Earnings Conference Call. Just a reminder, today's call is being recorded. For opening remarks, I would like to turn the call over to Barbara Doyle. Please go ahead.

Barbara J. Doyle

Thank you, Justin, and good afternoon to everyone on the call. And welcome to Itron's Fourth Quarter Fiscal 2012 Earnings Call. On the call today, we have Philip Mezey, Itron President and Chief Executive Officer; Steve Helmbrecht, Itron Senior Vice President and Chief Financial Officer; and John Holleran, Itron Executive Vice President and Chief Operating Officer.

Steve will begin our call to cover the financial results and to discuss our financial guidance for 2013. Philip will then provide some additional color for 2013 and provide an update on key market opportunities, as well as his priorities as CEO. After our prepared remarks, Philip, Steve and John will take some questions.

We issued a press release earlier today announcing our results and 2013 guidance. The press release includes replay information about today's call. We have prepared slides to accompany our remarks, and these slides are available through the webcast and through our corporate website under the Investor Relations tab. Our earnings release and financial presentation include non-GAAP financial information that we believe enhances the overall understanding of our current and future performance. We have included reconciliations of differences between GAAP and non-GAAP financial measures in our earnings release and financial presentation.

I would also like to cover our Safe Harbor statement. We will be making statements during this call that are forward-looking. The statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially from these expectations because of factors discussed in today's earnings call and the comments made during this conference call and in the Risk Factors section of our Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not take undertake any duty to update any forward-looking statements.

Now please, let me turn the call over to Steve Helmbrecht.

Steven M. Helmbrecht

Thank you, Barbara, and good afternoon. Today, I will cover our Q4 financial results and discuss our financial guidance for 2013 before turning the call over to Philip.

First, I'll comment on our results as compared with the guidance we provided on the last earnings call. Full year revenue results exceeded our guidance range, and non-GAAP earnings per share were within our guidance range. Q4 revenues of $523 million were higher than we forecasted, with stronger book and ship revenues in both the Energy and Water segments. Q4 non-GAAP earnings per share of $0.58 came in at the low end of our expectations. Lower gross margin, higher selling expenses associated with the increased revenue and additional reserves offset some of the revenue upside in Q4.

Now I'll review the year-over-year results. Slide 4 shows a revenue bridge for Q4 compared with the prior year. Lower revenue from the top 5 North American OpenWay projects drove the decline as 4 of these projects are now substantially complete. Currency fluctuations were minimal for the quarter. The positive news is that revenues grew by $41 million, excluding these top 5 smart grid projects.

Other metrics for the quarter are on Slide 5. Bookings in the quarter of $467 million were down from $515 million in 2011 but increased approximately 2% sequentially from Q3 2012. Gross margin of 31.2% was up more than 120 basis points year-over-year. Drivers of improved gross margin include lower warranty expense, lower manufacturing costs from efficiencies related to our restructuring, and savings from our global procurement program. These actions more than offset the impact of lower volumes and higher professional services in the quarter.

Non-GAAP operating margin of 5.8% was down 4 percentage points year-over-year, driven by higher R&D and sales and marketing expenses. We continue to invest in product development and our sales force, as we position ourselves to capture new pilots and opportunities around the world.

Adjusted EBITDA margin of 8.4% was down 3.8 percentage points year-over-year on adjusted EBITDA of $44 million, reflecting lower operating income. GAAP diluted earnings per share were $0.40 for the quarter compared with a loss of $1.35 in 2011. The Q4 '11 loss was primarily driven by restructuring charges of $65 million and a $44 million impairment to goodwill.

Non-GAAP earnings per share, which exclude the impact of the goodwill impairment, restructuring charges, acquisition-related expenses and amortization of intangible assets and debt fees, was $0.58 per share for the quarter compared with $1.19 in 2011.

Slide 6 summarizes the year-over-year bridge for non-GAAP EPS. Gross profit dollars were down due to the decrease in revenue. However, our gross profit performance as a percent of revenue improved with gross margin up by 120 basis points year-over-year. Higher non-GAAP operating expenses had a negative impact year-over-year. Total non-GAAP operating expenses for the quarter increased 4%, driven by R&D and sales and marketing with lower G&A. Decreased other costs, a lower tax rate and a reduction in the number of shares from our stock repurchase activity resulted in $0.08 a share benefit compared to 2011.

We repurchased 158,000 shares in Q4 for $6.7 million. From inception of the program in October 2011 through today, we have repurchased more than 2 million shares at an average price of $37.96 for a total of $77 million of the $100 million authorized by the board. That represents a reduction of nearly 5% of our outstanding shares.

Now moving to Slide 7, I will review revenue by business line in more detail. Water segment revenues increased 12% year-over-year in constant currency. Our Water business grew across all regions, as we bring new and innovative products to market, such as solid-state heat meters and products that help our customers minimize water losses.

Gas revenues in Q4 were flat year-over-year in constant currency. Revenues were up in North America, driven by increased shipments of gas metering products, which more than offset the impact of lower shipments of communication modules and services due to project timing and schedules. Our customers' trend to smart metering and gas continued, with higher smart metering shipments and lower shipments of basic gas meters and services across the other regions.

The completion of our large OpenWay projects continue to impact our electricity year-over-year revenue comparisons. Non-top-5 OpenWay electric revenues were up 11% year-over-year, with growth in products and services in North America and EMEA. Our Cellular Solutions group that we acquired in May 2012 contributed approximately $10 million in revenue in Q4.

Water segment results are shown on Slide 8. Gross margin declined by 170 basis points. Benefits from favorable product mix and operational efficiencies were offset in the quarter by lower margin on professional services and incremental charges for the relocation of a small facility in France due to rezoning. Non-GAAP operating margin in Water was roughly flat compared to Q4 '11, with lower G&A expenses partially offsetting the gross margin impact.

Slide 9 summarizes our key financial metrics for the Energy segment. Energy gross margin increased by 190 basis points year-over-year, driven predominantly by reduced special warranty expenses and efficiency improvements in our factories. The operations team has done an excellent job managing cost in North America, given the large shift in production volumes that occurred in 2012. Our manufacturing team continues to implement quality initiatives and manage fluctuating volumes very effectively. Non-GAAP operating margin in Energy was 6.7%, down nearly 570 basis points compared with Q4 '11, driven primarily by higher sales expenses and increased G&A expenses related to certain assessments in the quarter for bad debt and legal contingencies.

Slide 10 summarizes key non-GAAP metrics at a consolidated level. Non-GAAP operating and net income both declined 53% year-over-year, reflecting the impact of the top 5 OpenWay projects and higher operating expenses. Q4 free cash flow of $52 million was down from $84 million in Q4 '11, due primarily to lower EBITDA. For the full year, we generated $155 million of free cash flow compared to $192 million in 2011.

Now I will move on to bookings and backlog using the next 3 slides, starting with Slide 11. Total backlog at year end was $1 billion and 12-month backlog was $568 million. Let's look at the main components of our backlog. The change in backlog compared to December 2011 was driven by the top 5 OpenWay projects as you can see on Slide 12. These projects have been highly successful, with more than 12 million units deployed, generating read rates above 99% and driving more than $1.5 billion in revenue since Q4 of 2009. 4 of these 5 contacts are substantially complete. And Detroit Edison, which is now approaching its 1 millionth smart meter, will continue its deployment into 2014 and beyond. Excluding these 5 large contracts, our backlog at year end was $760 million, up approximately 2% from December 2011.

Trended quarterly bookings are shown on Slide 13. Total bookings in Q4 grew sequentially by about 2%. Our largest booking in the quarter was for $33 million in the Energy segment for the NiSource contract. Total book-to-bill ratio in Q4 was 0.9:1. We had sequential upticks in our bookings in Q3 and Q4 of 2012, as our win rate on pilots and contract awards has increased throughout the year.

Now I'll turn to Slide 14 to discuss debt. Our total debt declined to $418 million during the year in which we drew on our credit facility to fund the SmartSynch acquisition and also repurchase stock. Interest expense in Q4 was $2.5 million. Assuming no major change in our debt structure or the LIBOR rate, we expect this quarterly interest expense to be a reasonable estimate for 2013.

Now I will cover our guidance for 2013, turning to Slide 15. We anticipate full year 2013 revenues to be in the range of $2 billion to $2.1 billion and a non-GAAP diluted EPS range of $3 to $3.25. This guidance includes the following assumptions: gross margin of approximately 33.5%, a non-GAAP effective tax rate of approximately 25%, and a euro-to-U.S. dollar exchange rate of $1.34 on average for the year, average shares outstanding of approximately 40 million.

I want to comment on a few key drivers underlying our guidance. Our full year guidance reflects growth across all businesses and regions except for electricity in North America. Electricity revenues in North America will decline year-over-year, given the nearly $200 million decline in 12-month backlog.

Moving to gross margin, we saw improvement in 2012 over 2011 despite decreased revenue due to lower special warranty charges, manufacturing efficiency efforts to offset lower volumes and the favorable impact of our restructuring activities. Our full year 2013 guidance reflects continued improvement in gross margin for those same reasons.

In operating expenses, we expect research and development to increase year-over-year by $10 million to $15 million. Half of this increase comes from the full year impact of R&D spending in Itron Cellular Solutions. The other half comes from increased R&D spending to expand our product portfolio to meet a wide range of functional and technical requirements around the world.

Sales and marketing grew the past couple of years, as we expanded and retooled our sales force globally. However, in 2013, we expect some decreases in both sales and marketing and general and administrative expenses, which will partially offset the higher R&D.

Our estimated annual effective tax rate is 25%, which factors in the recently signed tax legislation that reinstated the U.S. R&D credit for both 2012 and 2013. We expect to recognize a discrete tax benefit of approximately $4 million in Q1 for the 2012 R&D credit. This will reduce the Q1 effective tax rate to approximately 12% to 15%, with a planned 27% rate for the remainder of the year for an overall blended effective tax rate for the year of 25%. Our revenue and non-GAAP EPS guidance reflects an average euro-to-U.S. dollar rate of $1.34.

In terms of the shape of the year, we expect revenues to be back-half loaded, which will put pressure on earnings for the first half of the year. In addition, we believe Q1 will be the low point for the year.

In Q1, we anticipate revenues will be 10% to 15% lower than Q4 2012 due to expected timing of projects impacting margins and earnings in the quarter. Our guidance assumptions are subject to change as the year progresses and, as a reminder, we will update this 2013 guidance as part of our Q2 earnings release call later in the year.

With that, I will turn it over to Philip.

Philip C. Mezey

Thank you, Steve, and good afternoon to everyone on the call. I will use my time today to expand on 2013 and share with you what my priorities will be as CEO of Itron. After my first 45 days in the new role, I can tell you that I have never been more proud to be a part of Itron. While we are facing some headwinds in 2013, I want to underscore that Itron is a strong and successful company with substantial opportunities for growth and increased shareholder value.

Let me begin with my view of 2013. This year, we will be focused on building our core business and preparing for new, large projects that are developing around the world. Specifically, this means growing our revenues around the world, with the exception of electricity revenues in North America; further improving our gross margin; and a targeted increase in R&D spending for an expanding international market. Given the goals of increasing our backlog and growing market share, we must continue to build out our products and systems to pursue the most promising opportunities across the global gas, water and electric markets. We are strengthening our electric metering platforms for critical markets, including France, Spain, Japan, Hong Kong, the U.K., Brazil and Australia. We are pursuing solid-state metering in gas and water, gas telemetry and water loss management. And we'll launch a heat cost allocation solution in Europe in 2013 to open a new market for Itron.

In the U.S., we are also investing in a unified platform for Consumers Energy, Duke and the Los Angeles Department of Water and Power that allows for integrated cellular, mesh and RF systems. As we anticipated when we acquired SmartSynch last May, customer interest in cellular is increasing. Our recent announcement with Qualcomm keeps us at the forefront of cellular technology here in the U.S. It also broadens our portfolio for international bids, such as Tokyo Electric Power Company.

We will also continue to invest in our Itron Cisco platform in 2013, both in terms of technologies and geography. We are very happy with the success of our smart grid projects with Cisco, and we have additional very encouraging projects developing around the globe.

I am mindful that the level of R&D expense this year is higher than many of you may have modeled. Our increased product investments are targeted to specific requirements and markets with mandates and funding. In 2012 and 2013, we have significantly shifted our R&D focus from legacy products to forward-looking investments and from U.S. to rest of world opportunities, and that is where the bulk of our R&D is allocated.

With that, let me provide an update on key developing projects we are tracking. In Energy, we were delighted to see our field trial at National Grid expand to a full pilot and to be selected by NiSource for their Northern Indiana gas and electric project. We are also tracking forthcoming regulatory approvals, where we have been selected at Duquesne Light and FirstEnergy. We also have expansion opportunities at Con Edison of New York and CenterPoint, in addition to several other large electric and gas projects in North America. There are more projects coming up for bid internationally than are pending in North America. In France, the ERDF Linky mass rollout tender for 5 million to 7 million meters is anticipated by midyear with awards in December. We are fully engaged on this tender.

There's also a second project at ERDF this year. They're expecting to concurrently tender a small 4800-meter pilot to test interoperability for their second-generation meter referred to as G3. We have indicated to ERDF that we do not plan to bid for this pilot. While we have G3 power line carrier capability, supporting the pilot requires us to redirect skilled PLC resources that we think are better utilized at this time to deliver on the G1 mass rollout. Itron will bid for subsequent G3 mass rollout tenders. Spain's Iberdrola tender for 1.5 million PRIME PLC meters is expected in the March time frame. Itron's meter will be certified for this tender.

We are also working on smart meter opportunities that should come to market this year, and for which we believe we are well positioned, in Ireland, Hong Kong, Australia, Indonesia, Brazil and Ecuador. And we are working on multiple gas opportunities across Europe, India, and Asia. The other major opportunity is for 27 million meters at TEPCO. This opportunity is still in a multi-stage process, and Itron remains deeply engaged. The system integrator and participant selection is expected in the first half of this year. Delivery of the initial pilot volumes is planned for early 2014. The expectations are for 5 million meters to be deployed in the first 3 years of the project, starting in 2014.

In the Water segment, Marcel Regnier and his team are soundly executing our water strategy, driving growth in existing and new markets for Itron. There are significant opportunities for water and thermal solutions across all geographies. We are competing for 2013 deals in the U.S., France, Ireland, India and the Middle East. In addition, we have been awarded some key water contracts in the U.S., which we expect to announce shortly.

Before we take your questions, let me close with a few words about my priorities as Itron's CEO. I spent the first weeks in my new role working with my team to establish clear imperatives that will become the foundation for Itron's success. These imperatives are: commitment to quality, collaboration for innovation, investing for profitable growth. We are committed to improving the quality of all of the products and services that Itron delivers to our customers and continuously increasing the quality of all aspects of our business.

In 2012, we strengthened our internal and vendor quality programs to drive consistent, sustained progress and clearly measured improvement. We have already seen an impact in 2012 from improved quality, an impact that directly benefits our margin. Quality was critical for me as the head of our Energy segment, and it remains the top priority to me as CEO.

My focus on collaboration encompasses our internal Itron team and extends to our world-class technology partners. Collaboration speeds up the innovation cycle, and that is the core value of this effort. We are building collaborative teams focused on global platforms that will enable us to pursue more opportunities with greater efficiency. Our expanding work with Cisco and new relationships with Panasonic, Qualcomm and Deutsche Telekom are crucial in a world in which digital connected devices run on open standards. We are leaders in this industry transformation, and I believe that this type of collaboration drives innovation at a rate faster than any company can do alone.

My comments today should make clear my focus on investing for profitable growth. We are investing to speed innovation, to increase our share of demand and to expand our markets. Some of this investment is in-house R&D. In the case of cellular technology, the acquisition of SmartSynch made the most sense. We will also continue to invest in the partnerships that I just mentioned. My focus is squarely on profitable growth. While we are making targeted incremental R&D investments in 2013, I am firmly committed to ensuring that our operating expenses, over time, will decrease as a percentage of revenue. We will also continue the solid work we have begun on global efficiency in improving gross margin. This is of such high importance to me that one of my first moves after being appointed CEO was to ask John Holleran to take on the position of Global Chief Operating Officer. John will work to lead further actions to drive better performance and lower costs for Itron's operations around the world. And to help drive our growth strategy, I have appointed Russ Vanos to a new role at Itron to lead strategy and business development. Russ, an Itron veteran and industry expert, will build a clear roadmap for all of our growth initiatives moving forward.

Let me close by saying that Itron is the leader in our markets today by share of demand as well as innovation. As the industry continues to move to smart technologies, we see tremendous opportunity for Itron. It is our time to widen Itron's lead by aggressively pursuing new global business opportunities, where we can bring new, innovative solutions to market. As tenders for new projects around the world move forward in 2013, coupled with further efficiencies we are driving in operations and costs, we anticipate a return to top line growth and accelerated earnings generation by Q4 of this year and in 2014. I look forward to talking with you about our progress in our future calls.

With that, let's open up the call for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Zach Larkin with Stephens.

Zach Larkin - Stephens Inc., Research Division

First off, Steve, I wondered maybe could you give us a little bit more color on the sales and marketing and the G&A line? I thought the color on the product development was really great. But is there maybe a run rate we should think about, kind of plus or minus, from a quarterly perspective on the sales and marketing and G&A as we contemplate how to think about those 2 cost line items through the year?

Steven M. Helmbrecht

Yes. Zach, this is Steve. So in terms of the level of spending in those areas, we view that to be fairly consistent throughout the year. Sales can fluctuate a little bit with revenue. But generally, it's pretty consistent. And there is a bit of a down trend over time as some of those cost efficiencies are in. So we're looking at down a couple percentage -- a couple of percent on a year-over-year basis overall and, again, offsetting some, but not all, of that increase in the R&D expense on year -- year-over-year basis.

Zach Larkin - Stephens Inc., Research Division

And then maybe just one more, Philip. I -- you mentioned Brazil and some of these other areas of the world as being new opportunities. Could you talk through maybe how different some of the technology architectures are versus some of the other global markets that you focus on?

Philip C. Mezey

Oh, sure, great question. Brazil -- there are not only different meter technical requirements in those markets but also, in many cases, communication differences. Brazil would be a mixture of an RF mesh market with some cellular communications, most likely. Some of the other markets, our China Light and Power project is a power line carrier pilot. So there are -- and each of these communication technologies must be certified for the local market, as well as variations in the type of meter that is used in the local markets.

Operator

Next question comes from John Quealy with Canaccord Genuity.

John Quealy - Canaccord Genuity, Research Division

So just a couple of questions here. First, I'm sorry if I missed it, the sequential drop-off in margins in the Water business, I understand there's some relocation or some things going on but it was quite marked -- marketed. Could you talk about what was driving that quarter-to-quarter in Water?

Steven M. Helmbrecht

John, this is Steve. It was primarily onetime items that related, as mentioned, to a couple of activities in terms of the core direct margin. We're comfortable with actually what -- how we did over the course of the quarter, but there were a couple of items that came through, as I mentioned, that impacted the results for the quarter itself but we don't see as reflective of Water's margin capabilities going into '13.

John Quealy - Canaccord Genuity, Research Division

Steven, while I have you, free cash flow of $155 million last year, can you sensitize '13 for us about what we should we thinking about, given that some of the OpenWay stuff has been fully baked, excluding DTE at this point?

Steven M. Helmbrecht

Yes, John. Our 2012 free cash flow yield was about 7%. And as we look into '13, we see that in the 6% range, plus or minus. And drivers for that, a couple of things. We see our cash tax expense increasing a bit in '13 versus '12 as we continue to use up loss and other credit carryforwards quite well and those continue to be profitable. We think CapEx, it tends -- it will say at about 3% of revenue but, we think, year-over-year could increase a bit. As we invest in some additional equipment that will help drive some of the cost savings Philip talked about. And the rest would come from some of the change in the EBITDA, and there's some other movement. But I think a 6% number is appropriate, I think, at this point. And we're pleased with some of the working capital improvements in the fourth quarter, production inventory and all and so we'll be closely focused on driving and maximizing cash flow, given next year's outlook -- this year's outlook.

John Quealy - Canaccord Genuity, Research Division

And Philip, just 2 quick ones for you. First of all, can you expand a little bit on the international markets? I know you did a great job. But Turkey, I think, has been coming online, especially with some U.S. governmental help about trying to really deploy smart grid generation and meter-type technology. So if you could speak to that as a potential for us. And then lastly, I think this is the first I've ever seen smart cities mentioned in an Itron press release, and I wanted to talk about -- is that foreshadowing for acquisitions, Philip? Or am I reading too much into that?

Philip C. Mezey

Okay, John. Thank you. Two great questions. So international opportunities, specifically Turkey, of course, with the great announcement of Aksa Gas this year -- or last year, which will be rolling out this year and for the next several years. And then you commented on some U.S.-supported projects for conversion of the electric grid, which is a situation we're following closely. Turkey is a very promising market, across electricity, gas and water actually, for us. And the market development there is the privatization of a number of the cities in Turkey that will create some great smart metering opportunities for us. So we are following that very closely. The reference to smart cities is absolutely -- you will be hearing more from us about that. At DistribuTECH, we did talk about that. We see tremendous opportunities in the convergence of electricity, gas and water data with other sources on the smart grid. Part of the activity that you see, working with Cisco and Qualcomm, who are talking about the Internet of everything, is getting involved in larger networks that allow us to integrate information to generate new insights. And that, again, creates opportunities for us and further connected points in those extended grids and analytic and data collection opportunities for us as well.

Operator

And next question comes from Sanjay Shrestha with Lazard Capital Markets.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

A couple of questions. First, I just wanted to kind of talk about the guidance for '13 here a bit more. When you guys previously talked about '13 versus '12, it was kind of plus or minus 5%, and I understand R&D does impact that EPS number a bit more. So just wanted to understand, is there some conservatism there with this number here? Or was there anything got maybe changed a bit, that kind of got pushed to the right? And one final point of clarification on that, what are you guys expecting SmartSynch to contribute to the top line in 2013?

Steven M. Helmbrecht

Sanjay, I'll start. This is Steve, and Philip will add as well. In terms of SmartSynch, overall, let me start with that. We -- our guidance, it certainly includes the contribution of SmartSynch and we're -- in which, we now have folded into Itron Cellular Solutions or ICS. So as we look into '13, we do see improved revenue in '13, as we start to roll out certain projects. But as I mentioned in my earlier remarks, we also have included in our guidance increased R&D spending related to the next-generation products. We talked about that last earnings call, as well, the move to 3G. But that is included. In terms of growth in that piece of our business and ICS, which is now part of electricity, we really see that significantly changing in 2014 rather than '13 overall, so not contributing meaningfully to the earnings number in '13 overall. And in terms of the shape of guidance overall, as Philip mentioned as well, it's really the R&D investment. It is from a heightened level. We've looked closely at that, and have really buttoned down the priorities and the projects that are in place. As I mentioned, we see that up about $10 million to $15 million but, again, offset by reductions and savings elsewhere not completing offsetting. The real story is on the revenue line and it's that sequential decline in the 12-month backlog, which is predominantly due to the large OpenWay contracts rolling off. And the real issue in terms of the timing in the back-half shape is the timing of the tenders and when those are really going to come into place, and we see that in the second half of the year. But in terms of the timing of that, that's always -- there's some uncertainty associated with that. And I think, yes, that is certainly partially reflected in our guidance overall.

Philip C. Mezey

And Sanjay, I think that as we built this plan from the bottom up, we had provided -- we already provided an initial view. And as we have refined the business plan from the bottom up, I think we've gotten just a much clearer view of '13, which has led us to that top line guidance.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Okay, fair enough. Well, one quick follow-up, guys, if I may. So I think -- and I understand it's really not '13 earnings for you guys, it's really more around '14 and beyond. So that leads me to my next question which is, Philip, you talked about Iberdrola, Spain, and a lot of the European opportunities, TEPCO, and clearly R&D investment so the SG&A number probably directionally coming down. So how do we think about your margin going forward, as more of this international business starts to hit your P&L and sort of that '14 margin expansion, revenue expansion, earnings trajectory and beyond. How do we sort of think about that from a big picture?

Philip C. Mezey

Yes, great question. I mean, as -- so of course, we are projecting a nice improvement '12 to '13. And we have commented before that projects like Iberdrola and ERDF, which are highly competitive tenders, are challenges to us. But there are very attractive margin opportunities in other parts of the business. Steve mentioned the fact that 11 out of 12, that is across 4 geographies in 3 business lines, we have growth across gas and water in these geographies at more attractive margin profiles. And some of these large electric deals still are very promising. And our goal in investing in these systems, of course, is to maintain or improve the gross margin that we can achieve as opposed to just being relegated to being a meter provider. So there -- we have a very strong drive on the system side.

Operator

And our next question comes from Paul Coster with JPMorgan.

Paul Coster - JP Morgan Chase & Co, Research Division

I do appreciate that sales and marketing will be throttled back very slightly next year, but it's quite elevated as a percentage of revenue relative to where we were in '11 and even parts of 2012. Sales and marketing expense has gone up for a couple of years now despite the fact that revenue's come down. Most of us think of it as a somewhat variable expense. Can you tell us what's going on there? And it sounds like you're investing and maybe it's something to do with this international kind of reach that's forcing up[ph].

Philip C. Mezey

It absolutely is, Paul, thank you. I -- we have spoken about the fact that we are investing more in Latin America and Asia Pacific in order to expand our markets there. Our traditional strength, of course, has been in North America and Europe, Middle East and Africa. And we do see these expanding opportunities in these other markets, and so we've strengthened our sales and marketing presence in those markets. And we have also discussed that as we move beyond the meter to these more complex system sales that there is a somewhat different profile to the sales team that we are putting out in the field. And there are some costs to adding to our capabilities in that regard even in the European market.

Paul Coster - JP Morgan Chase & Co, Research Division

Got it. As you think about the strategy for the company, one of the things which is clear from DistribuTECH is that the application layer on top of the smart grid is actually growing, particularly customer engagement, software. Is that something you're interested in? Can you just talk about the long-term strategy? Are we locked into primarily a hardware business here or do you see yourself moving up the value chain?

Philip C. Mezey

Paul, we absolutely see ourselves moving up the value chain. We have the largest market share of the meter data management market on a global basis. And the reason that we focused on that layer of the system is because we feel that if we can collect, store and then start to analyze that information, it allows us to deliver more value to our customers. And so we are collecting and storing a massive amount of information across electricity and gas and water for our customers, which we think positions us very, very well for the developing applications and even, ultimately, a recurring service market in order to deliver analytics to our customers.

Paul Coster - JP Morgan Chase & Co, Research Division

Any sense of the time line there?

Philip C. Mezey

I mean, it's developing. We've announced several products on the analytic side, and I would expect the latter half of '13 into '14 that we're going to see more there. And the announcement of Russ Vanos to focus on the growth strategy, really, is around firming up our position in those markets.

Operator

And moving on, our next question comes from Sean Hannan with Needham & Company.

Sean K.F. Hannan - Needham & Company, LLC, Research Division

So actually, both questions I have are really cost focused here. I wanted to see if I could just bring up -- first, looking at the gross margins, I think year-over-year that change is pretty well understood and you partly addressed some of the onetime scenarios and touching on the dynamics that we saw in Water for the pressures going from the September to December quarter. But can we step back a little bit? Just give us a little bit better perspective on how we declined sequentially on better revenues and then how we have comfort on what drives your margin expectations in '13, particularly, how dominated that might be by the anticipated mix, et cetera.

Steven M. Helmbrecht

Sean, this is Steve. So we -- as I mentioned in the prepared remarks, we did, over the course of the year, see margin improvement over lower revenue. And that really came from seeing [ph] the results of the efforts that are under way to reduce procurement costs, to reflect the restructuring activities we announced a couple of years ago, and there is also the benefit of improved quality in the form of lower warranty expense. Those are the -- some of that key drivers. But there are additional efforts under way in terms of cost reduction. I think at a high level, I'd say that in terms of ASPs and there's always that type of pressure. But we really are making good progress on the cost side. And that's, as Philip mentioned, going to continue to be the main focus for John Holleran and his team. We went into the year, into 2012, with an expectation of 32%. That was a big improvement over the prior year. And over the course of the year, we saw better margins over time, such that, for the year, it's 32.8%. Yes, there was some impact in the fourth quarter. And there have been situations where we have some warranty or other charges, and that's reflected as well. So as we think into 2013 and we did the bottoms up and look at the mix of products and the continued improvements in cost, that is reflected in the 33.5% margin expectation for the year that's underlying the guidance. And we really don't see the fourth quarter as reflective of a new run rate. We see that as really reflective of some activity and some assessments in the fourth quarter.

Sean K.F. Hannan - Needham & Company, LLC, Research Division

Okay, that's helpful. And then a follow-up to that, getting now into the OpEx, and sorry for kind of beating a dead horse here. But I understand, I think we all do understand the need to spend here, particularly, as you're getting prepared for Europe and some of the other geographies. The question is obviously always around spending wisely. And just wanted to see if we could discuss a little bit more about how perhaps that step-up in R&D, as well as in considering where the elevated sales and marketing levels are. How that should be thought of as perhaps being sustained really going-forward years? Or is -- how much this is more specific to kind of '13 and early '14 due to a lot of that positioning for those ramps and other opportunities?

Philip C. Mezey

Sean, thanks. I am, as I said, absolutely committed to reducing the level of OpEx in relation to revenue over time, and I do see this as, and referred to it as, an elevated level of spending in '13 in order to qualify for this range of markets. The goal is to contain -- absolutely contain that level of R&D spending as revenues do increase. And as we talk about these slight offsetting reductions in sales and marketing and G&A, John Holleran's focus is to continue the trend on those reductions for us to continue to drive for greater efficiency. So I do not see a long-term trend here. I think this really is a standout investment year on the R&D side.

Operator

And the next question comes from Vishal Shah with Deutsche Bank.

Susie Min - Deutsche Bank AG, Research Division

This is Susie Min calling for Vishal Shah. Wondering if you could just dig a little bit deeper as it relates to SG [ph]. Steven kind of mentioned that going forward, you're working on improving your gross margin. So given that 2013 is kind of a transition year and the second half of this year will be back loaded, how should we think about gross margin in light of that, as well as the fact that you're working on cost reduction and lower warranty expenses, et cetera? So I guess, would it be, kind of evenly -- will you see the improvement through the second half of the year? Will it be kind of evenly dispersed? And how good should gross margin be?

Steven M. Helmbrecht

This is Steve. We see some commensurate with the shape of revenue over the course of the year that, that while the gross margin for the year will be 33.5%, will be improved in the second half with higher volumes and with a fuller reflection of some of the other cost savings initiatives reflecting more of an average of 33.5% in the course of the year.

Susie Min - Deutsche Bank AG, Research Division

Okay. And then, as it relates to the actual mix between Energy and Water, can you give any additional color on your expectations for the year?

Steven M. Helmbrecht

The relative ratio of Water will go up on a relative basis. Within Energy, you might see a little mix increase as well in terms of gas. And that, again, is a reflection of the decline in the North America electricity. So on a relative basis, and as Philip mentioned, the Water business grew nicely in 2012. And as Philip mentioned, we see growth in that area. So on a relative percentage, there would be a bit more weighting on both Water and -- relative to the Energy segment, and within Energy, a bit of a shift into gas but not material there. I view it more in terms of a little bit of mix increase in Water.

Operator

And our next question will come from Amir Rozwadowski with Barclays.

Amir Rozwadowski - Barclays Capital, Research Division

Just -- I know we touched on this sort of investment year thesis for a bit now. But if I may, just one more question along those lines. I mean, it does seem as though you're tracking a number of opportunities on a global basis. And I just want to understand, have you received specific specifications from these opportunities, whereby you're now investing in order to ensure that your product portfolio is well positioned to capitalize on these opportunities? Or is this sort of -- should we view this as sort of a -- some potential holes in your product portfolio that you're anticipating wins down the line or potential sort of standards down the line in order for you to meet those standards?

Philip C. Mezey

Amir, thanks. Yes, I commented on that, that we really are pursuing identified projects with specified requirements in markets that have mandates or identified funding. So there is very little speculative investment here in terms of build it and they will come. These really are -- these are focused -- very focused opportunities with known requirements.

Amir Rozwadowski - Barclays Capital, Research Division

And if I may, I know it's probably looking a little bit further out than the crystal ball allows at this point, but you did comment that you expect sort of accelerated revenue and earnings growth starting probably in the tail end of this year. Should we expect 2014 to be a bit more of a healthy growth environment from an overall installation perspective?

Philip C. Mezey

Yes. And that affirmative answer is based upon pilots that we have already won and are in the process of deploying that have ramping schedules, that begin to add up in the second half of the year, as well as the declared deployment intentions of our customers on a number of large tenders and other project opportunities. So yes, we expect 2014 to be a healthy year for growth.

Amir Rozwadowski - Barclays Capital, Research Division

And if I may just one last question, can you comment on sort of the pricing environment for some of these new projects that you see out there? I mean, is it increasingly competitive? Or do you see it sort of in line with historical trends? Any commentary along those lines will be very helpful.

Philip C. Mezey

First, I'd like to point out the strength of the Gas and the Water businesses and the strength of the gross margins in those markets. They -- we have done a really nice job of maintaining selling prices and strong gross margins across the Gas and the Water businesses, and we see that continuing. There are some specific electric opportunities that have very competitive bidding, but those are only a segment of the electric market. There are some very large projects in which we have the opportunity to provide meters, communications and services that give us a healthier margin profile, as well as, I would point out, significant opportunity in the small and medium end of the market in which, traditionally, margins remain healthier. So it is a diverse market. There are some very competitive markets, but we are actually doing quite well at maintaining selling price and overall gross margin.

Operator

And our next question comes from Chris Kovacs with Robert Baird.

Christopher M. Kovacs - Robert W. Baird & Co. Incorporated, Research Division

Do you think you've had a good amount of strength recently or a momentum, I guess, on the Gas side with a few multi-hundred thousand meter end point wins? What would you characterize as the biggest reason for this recent success? Is it new products you guys are introducing? Is it a new sales strategy? Have the competitive dynamics changed at all?

Philip C. Mezey

The competitive dynamics have changed, and I think these comments may refer -- a little bit more to North America, a couple of very large announcements there, in which we have seen an opportunity in the market and are pouncing on it to increase our market share. And it is based upon our very strong market position with our gas end points that we are using our sales force to bring along the meters as well in a very aggressive fashion. So U.S.-based market share has improved very, very nicely, which you see in those announcements.

Christopher M. Kovacs - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then not to harp on this too much but on the R&D side, it sounds like you have a few pretty large projects coming up for tenders on the international front maybe in the first half of the year. Should we think about R&D maybe being higher in the first half, as you qualify for some of these opportunities and now -- and then those projects start to maybe roll out in terms of being awarded in the second half of the year and that kind of slows a little bit?

Philip C. Mezey

Yes, would that it were so. No. I think the prudent thing to do is to think of it as being relatively flat. It is frustratingly difficult to complete projects in a 6-month period and/or to control headcount, to dial headcount up and down in that way. These are complex systems and so the prudent thing to do would be to model it as flat.

Operator

And that does conclude the question-and-answer session. I'll now turn the conference back over to you for any additional or closing remarks.

Philip C. Mezey

Thank you. I'd just like to make final comment here, which is, our revenue in 2013, this is our best view. It is what it is, and we are excited about the tender opportunities. We don't control the timing. We will provide you updates as we make progress on these. We do clearly believe there's a substantial opportunity. To the question of, are we being conservative? I really think that we are being prudent. Coming out of an interesting revenue year in 2012 and a decline in backlog, we really have studied this very closely and are giving you our best guidance. The gross margin, really, is a huge focus area. Again, where John Holleran will be targeted, where there is additional room for improvement you see from '12 to '13, we will control the OpEx and investment line very, very carefully and report back to you as we are qualifying products and making progress against these tenders. And I think that will give much clearer visibility into 2014. We are energized and excited about the year, and it's great to be on the call. I look forward to providing more updates to you on subsequent calls. Thank you.

Barbara J. Doyle

Thanks very much, everyone. Thank you, Justin. We'll end the call now.

Operator

And there will be an audio replay of today's conference available this afternoon. You can access the audio replay by dialing 1 (888) 203-1112 or 1 (719) 457-0820 with the passcode of 4441088 or go to the company's website at www.itron.com. Again, that does conclude today's conference. We do thank you for your participation today.

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