Orion Energy Systems, Inc. F3Q09 (Qtr End 12/31/08) Earnings Call Transcript

Feb. 3.09 | About: Orion Energy (OESX)

Orion Energy Systems, Inc. (NASDAQ:OESX)

F3Q09 Earnings Call

February 3, 2009 5:30 pm ET

Executives

Erik Birkerts – Chief Operating Officer

Neal Verfuerth – President and CEO

Scott Jensen – CFO and Treasurer

Analysts

Eric Prouty – Canaccord Adams

Eric Stine – Northland Securities

Jeff Osborne – Thomas Weisel Partners

Glenn Wortman – Sidoti & Company

Tom Spiro – Spiro Capital Management

Operator

Welcome to the Orion Energy Systems’ third quarter 2009 earnings conference call. (Operator Instructions). I will now turn the call over to Mr. Erik Birkerts, Chief Operating Officer.

Erik Birkerts

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

Before we begin, I will read the Safe Harbor Statement. Our remarks that follow, including answers to your questions, include statements that we believe to be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are generally identified as such because the context of such statements will include words such as “believe,” “anticipate,” “expect,” or words of similar import. Similarly, statements that describe future plans, objectives, or goals are also forward-looking statements.

These forward-looking statements are subject to risks that could cause actual results to be materially different. Those risks include, among others, matters that we have described in our press release issued this afternoon and furnished to the Securities and Exchange Commission on Form 8-K and Form 10-K filed with the SEC on June 27, 2008, and other filings we have made with the SEC. Except as described in these filings, we disclaim any obligation to update these forward-looking statements, which may not be updated until our next quarterly conference call, if at all.

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

Neal Verfuerth

I'd also like to welcome everyone to our Orion Energy Systems Fiscal 2009 Third Quarter Conference Call. After I make a few opening comments, I’ll ask Erik to provide some highlights from the quarter as well as describe progress within our business. Scott will then provide financial detail in the third quarter, and I will conclude with comments on Orion’s strategic direction and long-term vision.

We’re pleased with the results our business delivered in the third quarter despite navigating through the worst global recession seen in decades. These results demonstrate the strong fundamentals of our business, the value of our technology that we deliver to our customers, and most importantly the hard work and commitment of our people. Additionally our results during the quarter nearly reached the record levels we achieved in last year’s third quarter, a time when the economy was healthier and business confidence was high.

For the third quarter of fiscal 2009, we reported revenues of $22.4 million, net income of $1.2 million, and earnings per share of $0.04. During the third quarter we installed our high-performance energy-efficient lighting known as Phase 1 in over 344 facilities, an increase of over 300 facilities that we completed in the second quarter. Our installed base of our customer facilities in total now numbers 4387 facilities and represents over 725 million square feet of space retrofitted. Our projects have a positive impact on grid capacity and since late 2001, we’ve delivered permanent base load reduction of over 422 megawatts of base load. Furthermore, we’ve made significant progress in delivering new and innovative solutions to our customers with strong shipments and installations of our products, which include in addition to our Phase 1 offering a specialty freezer fixture and we continue to gain traction on our phase 2 and phase 3 deployment of the Apollo Solar Light Pipe and Wireless InteLite control systems.

Despite the economic headwinds, we continue to win new customers and roll out our solutions across our existing customer base. Even in the tough times, the economic savings and improved working conditions delivered by our technology are major contributors to our customers’ cost cutting and lean initiatives. However, this overall uncertainty in the market continues to present challenges to Orion’s sales engine. We now have to invest more time into developing new deals and reselling existing deal due to plant closures and key contacts and decision makers losing their jobs.

We are also investing time thawing Orion proposal from frozen CapEx budgets. We continue to be encouraged that our strong value proposition is shining through, but at this point, we are still maintaining a conservative outlook for the remainder of fiscal ’09. With that being said, we are reaffirming our guidance in the range of 0 to 9% with an earnings per share of $0.06 to $0.11.

We’re committed to ensuring that the company remains profitable without compromising our long-term enterprise value. We will continue to invest in our business with long-term view that will allow us to capture the sizeable opportunities that lie before us. I want to emphasize our financial strength and flexibility which will allow us to continue to be aggressive in the market.

We’re profitable and cash flow positive on an operating basis. We have $49 in cash and short-term investments and nominal debt on our balance sheet as of December 31. We maintain a bank revolving line of credit with approximately $20 million in availability. We are confident that we have the resources necessary to execute on our strategy. We also have about $7.5 million remaining on our $30 million share repurchase authorization from the board, and we have the ability to continue repurchasing shares in the market as opportunities present themselves.

While our current strategy remains unchanged, which is attacking the significant opportunities that exist within the $9 billion retrofit market, we are continually focused on providing our customers with a path to substantial energy savings in the future. The successes we have witnessed with our innovative new technologies have only begun to scratch the surface of the opportunity, and we are encouraged by Orion’s progress to date, and I will conclude the call with further comments on our long-term vision and strategy.

With that, let me turn the call over to Erik to take you through the progress we’ve made in our business.

Erik Birkerts

Before jumping some details around our sales organization, I’d like to take a quick moment to update on our new venture, the Orion Virtual Power Plant. We have seen positive traction since officially launching the Orion Virtual Power Plant in October 2008. It has allowed our salespeople to capture deals that would not otherwise have occurred due to capital constraints.

To remind everybody, the Orion Virtual Plant is an energy supply contract in which Orion commits to deliver a set amount of megawatts of essentially energy savings at a fixed rate lower than the customer’s rate to acquire power from the utility. As the Orion Virtual Power Plant is structured to qualify as an operating expense, customers benefit from cost savings, incremental cash flows, and Orion’s technology without having to make upfront investments or capital outlays.

As of December 31, 2008, we had twelve contracts to deliver over 27.5 million MW and we expect to continue to build further momentum with the Orion Virtual Power Plant in the future. As we discussed in our last call, we have the option of selling the recurring MW payments to a third party and recognizing the value of the deal upfront. The current present value of the 27.5 MW we have on our contracts is roughly $750,000. Alternatively, we may also elect to hold these contracts and recognize the recurring revenue on a monthly basis as we deliver across the MW delivery period. From an accounting and reporting standpoint, this option may lessen near-term revenue but may lead to more stable revenue streams over time.

Moving to our sales force, we finished Q3 with 62 people in our sales organization. We have resumed our recruitment efforts, and we are now looking to selectively hire the good talent that is increasingly available, and we expect to finish our fiscal year with about 70 people in our sales organization. As Neal mentioned, our sales team is performing well under difficult circumstances, and we are making progress on our core strategy of capturing the $9 billion plus retrofit opportunity.

Regarding new customers acquired during the quarter, we worked with 18 new national account customers retrofitting 20 locations in 11 states and one Canadian province. This compares favorable to the 11 new national account customers in 18 locations we retrofitted in the second quarter. We also secured a significant new customer rollout agreement. This agreement encompasses 15 facilities for a publicly traded multinational plastics manufacturer. At this point, our project management team is working with counterparts at this company to define the rollout schedule, the majority of which will take place in fiscal year 2010.

As we discussed in earlier calls, our third and fourth quarters historically have represented our most active months for national account projects. This year is no exception, as we’ve completed projects at 99 facilities for national account customers already doing business with Orion. These new locations cover 40 national account customers in 30 states and two Canadian provinces. The customers for whom we are most active completing multiple projects in the third quarter included Anheuser Busch, Coca-Cola, US Food Service, Kraft, Americo Logistics, and Sysco Foods.

I’d also like to provide some more detail on the success of our product development initiatives which provide valuable differentiated solutions for our customers. In the third quarter, we shipped over 8000 units of our specialty freezer fixture designed to operate at high performance in ambient temperatures as low as -20 degrees Fahrenheit. This product is a great application for the food service and cold storage industries. We also shipped over 3500 units of our wet-rated fixture which we launched in April. This specialty fixture is designed to operate optimally in wet and full wash down operating environments prevalent in the food and beverage sectors.

We deployed our Phase 2 proprietary Wireless InteLite control systems at 7 customer facilities in the third quarter, bringing to 25 the number of facilities with Orion Wireless InteLite controls installed. Although our wireless control systems have yet to contribute meaningful revenues, we believe this technology will be a game changer by virtue of adding intelligence to our fixtures, and we expect that it will soon be deployed in most new projects we undertake. We are also beginning dialogue with existing customers about wireless control upgrade, and as Neal will discuss a bit later, our wireless controls allow Orion to provide impactful demand response solutions.

Finally our Phase 3 Apollo solar light pipes also continue to gain market acceptance. In the third quarter, we shipped 284 units, and across the first nine months of fiscal 2009, we have shipped over 1100 units.

Let’s move on to our wholesale business. As we have discussed, we are making a strong push to strengthen our wholesale network of partners as this network will provide us with the geographic reach and market coverage necessary to capture the wealth of opportunities that exist at small and mid-size customers across the US. The top performers across this network will also serve as valuable installation and project management partners to help us deploy projects for our direct customers.

Within the quarter, our wholesale business contributed about 37% of revenues, whereas our direct sales efforts contributed about 63%. For the nine months ended December 31st, our wholesale business contributed about 43% of revenues. For this fiscal year, we expect the contribution of our wholesale business to be about 40% of revenue as the strength of our national account business in Q3 and Q4 outpaces our wholesale business on a relative basis.

In terms of growth, our VAR sales are up 47% versus prior year for the nine month period ended December 31st. We saw exceptional performance in growth from the VARs in the second quarter, whereas this quarter, while still strong, their sales were on par with what we witnessed last year in Q3. This served to pull down the year to date growth rate from the 83% we stated in our previous earnings call to the current 47%.

We also continue to expand our contractor network adding 51 new contractor partners in the third quarter. The network of contractors that have done business with Orion on a recurring basis now numbers over 370 companies as of December 31, 2008. In terms of sales, our contractor network is performing well. Sales to contractor partner for the nine months ended December 31st exceeded prior year sales for the same period by 75%.

Let me conclude by quickly reviewing what we expect to see in the fourth quarter. As Neal stated above, we forecast annual revenues this year in the range between $81 million and $88 million, although we will be closer to the lower end than the top end of this range. In fourth quarter, we currently expect that a little more than 40% of this target will come from national account rollouts that are scheduled for Q4. We currently expect that a little less than 40% will come from well qualified deals that are in the late stages of their sales cycles.

Our VAR partners are currently estimated to contribute about 20% of revenues in the fourth quarter. We also witnessed some quick hit and unexpected deals surface with frequency, yields on which we have no visibility but we are not including these in our forecast. Again at this juncture, we remain confident in our expectations for the remainder of our fiscal year, but we are cautious and proactively addressing any additional risks that may come from the uncertain times we now find ourselves in, which may include unanticipated plant closures or organizational upheavals at customers.

I’ll now turn the call over to Scott to take you through the financial results in more detail. Scott can also describe some of the discretionary spending reductions and efficiencies we pursued in the quarter.

Scott Jensen

Our reported revenues for the third quarter were $22.4 million, compared to revenues of $23.3 million in the same period of fiscal 2008. $20.7 million or approximately 92% of the quarter revenue was driven by product sales, while service revenue accounted for the remaining 8%. As Erik mentioned, our partner sales continued to remain strong which impacts our overall level of service revenue. We also had several projects still in process at year end for which we did not record the related service revenues.

Our gross margin for the quarter was 33.2% versus 35.4% in the comparable prior year. Gross profit dollars for the quarter were $7.4 million compared to $8.3 million in fiscal 2008. Product margins were negatively impacted by incremental manufacturing costs incurred as a result of increasing volumes of our enclosure, freezer, and recently launched wet-rated fixtures. These product lines are more complicated to manufacture and require more production time for both fabrication and assembly.

Due to customer project timelines, we incurred an additional $300,000 in added personal costs, overtime costs, and any efficiencies resulting in an overall margin impact of 1.3% for the quarter. Over the past several weeks, we’ve re-engineered our assembly process for enclosure fixtures, eliminated the additional staffing, and reduced material handling costs. We believe that we are now better positioned to improve our gross margin on these important product lines.

G&A expenses for our third quarter were $2.4 million or 10.9% of revenue versus the prior year of $3.3 million or 14.1% of revenues. Additionally, this was a $455,000 decrease versus our most recent quarter. For the quarter, we scaled back or eliminated areas of discretionary spending and implemented a corporate cost reduction program. For example, we eliminated our year-end employee and management bonuses. We also reduced travel, supply, and consulting expenses as appropriate.

For the quarter, we incurred $400,000 of public company costs that were not incurred during our prior year third quarter. These expenses are attributable to our Sarbanes-Oxley 404 compliance efforts and increased costs for legal, audit, insurance, and investor relations activities. Also it is important to note that in our prior year third quarter, we incurred $750,000 in IPO bonus costs that did not recur.

Sales and marketing expenses for the quarter ended December 31, 2008, were $2.7 million or 12.3% revenues compared to $2.3 million or 9.7% of revenues in the prior year. During the quarter, we did introduce some cost reduction initiatives along with some discretionary spending reductions in our sales and marketing areas. The increase in cost year over year was due to total higher sales headcounts, and direct mail campaigns targeting customer end channel, although we did scale back our marketing efforts from our most recent prior quarters.

R&D expenses for the third quarter were $347,000 or 1.6% of revenues, down from $454,000 or 1.9% of revenues in Q3 of fiscal 2008. R&D expenses have declined due to a decrease in material testing costs as our wireless technology moves into the production and go-to-market stages. We also witnessed a decrease in our product development consulting cost. We consider this reduction in R&D expenses to be temporary as our wireless technology moves into the market and as we initiate product development around new initiates. Moving forward, we expect roughly $400,000 per quarter spending in R&D.

Income from operations for the third quarter $1.9 million versus $2.3 million in the prior third quarter. Net interest expense for the quarter was $33,000 versus $648,000 in the same period of fiscal 2008. The decrease in interest expense was due to $500,000 of convertible debt interest cost that was recognized at the time of last year’s IPO.

Net income for the third quarter was $1.2 million or $0.04 per share on weighted average fully diluted shares outstanding of 26.4 million, compared to net income of $1.2 million or $0.05 per share for the same period in the prior year based on 22.8 million weighted average fully diluted shares outstanding.

Moving to our year to date numbers, our reported revenues for the nine months ended in December were $57.2 million compared to revenues of $58.4 million in the same period of fiscal 2008. The decrease can be primarily attributed to the softer sales that we experienced in the first half of this fiscal year and the difficult economic conditions in the market place.

Our gross margin for the first nine months of fiscal 2009 was 33.1% versus 34.5% in the comparable prior year. Our gross profit for the nine months was $19 million compared to $20.2 million in fiscal 2008. Gross margins were negatively impacted by under-absorbed factory costs resulting from new processes for manufacturing and coding introduced during the end of our prior fiscal year.

G&A expenses for the first nine months were $7.9 million or 13.9% of revenue, versus the prior year of $6.8 million or 11.6% of revenues. As I previously stated, we believe in our most recent quarter, we made some strides in addressing our cost structure and reducing discretionary spending. Year over year, our costs have increased approximately $1.5 million due to costs that we attribute as a public company operating cost including the defense cost for the class action litigation.

Sales and marketing expenses for the nine months ended December 31, 2008, were $8.2 million or 14.3% of revenues, compared to $6.3 million or 10.8% of revenues in the prior year. Our sales and marketing expense increased by $1.4 million for additional compensation costs due to increased headcount and $500,000 for increased marketing efforts. We believe the marketing channel spending was a good investment based upon the success we’ve experienced in our wholesale channel this year.

R&D expenses for the first nine months were $1.1 million or 2% of revenues, down from $1.3 million or 2.3% of revenues in fiscal 2008. Our operating income for the first nine months was $1.7 million versus income versus operations of $5.8 million in the same period in the prior year. Net interest expense for the first 9 months was $141,000 versus $1.3 million in the same period in fiscal 2008.

Net income for the first 9 months was $1.7 million or $0.06 per share on weighted average fully diluted shares outstanding of $28.7 million compared to net income of $3 million or $0.14 per share for the same period in the prior year based on $20.8 million weighted average fully diluted shares outstanding.

Turning to the balance sheet, as of December 31, 2008, we had a total of $24.2 million in cash and equivalents on hand compared to $78.3 million at the end of our fiscal year ended March 31, 2008. As a reminder, a significant portion of this decrease is due to a different classification for our $24.7 million invested short-term government agency bonds which carry improved yield versus our cash and money market investments. All of our agency bonds have continued to mature at par value. None of our cash is invested beyond one year, and 70% of our cash and investment portfolio is highly liquid with maturity dates of 120 days or less. The remaining balance in our changing cash from our prior fiscal year end is due to the $22.4 million in treasury share repurchases and the $10.6 million in capital spending invested in our technology center, ERP system, and operational cost reduction and integration measures.

In December, we did experience an increase in our accounts receivable. Nearly 20% of our year-end balance was paid within the first 7 business days of January. We are cognizant of the current liquidity and credit challenges in the economic environment and the high level of underwriting due diligence required as we review new customer opportunities. Overall, our receivables portfolio continues to be sound, primarily consisting of our national account customers and our wholesale partners.

We decreased our inventory levels by $300,000 from the prior quarter as we continue to focus on improving inventory turns. Additionally, we are carrying inventory of our wireless components which have longer production lead times than our traditional fixture inventory components. Our wireless component inventory also reflects our belief in the market success of our wireless technology and Phase 2 initiatives.

In the third quarter, we repurchased over 3.8 million shares of common stock at a cost of $14.3 million. For the year-to-date, we've generated $4.2 million in positive cash flow from operations before accounting for changes in the balance sheet.

With that, let me turn the call over to Neal to discuss Orion’s longer term strategy.

Neal Verfuerth

Although we are realistic about the challenges we face in the coming year, we are optimistic about our value proposition and competitive advantage in the market. In fact, we believe our strong financial position coupled with the power of the Orion Virtual Power Plant to get deals over the top in tough time would allow us to aggressively pursue the $9 billion retrofit opportunity at a time when many other companies may be retrenching, particularly those who have franchises built around the new construction market.

Keep in mind that we have a grater than 10-year record of successful execution in the retrofit market. The most recent evidence of our experience and success is the prestigious Facility Supplier of the Year Award we received from Sysco Corporation, a global leader in the food service industry. This is the second straight year we’ve received this award, and we were chosen by the popular vote of the Sysco broad line distribution companies in the US and Canada. We’ve retrofitted over 60 facilities, many years ago, and the fact that we still received the popular vote goes to show that the benefits of energy efficiency keep giving over time.

I would also like to highlight that we believe Orion’s integrated energy management system is a preeminent solution in the market place. In December, Orion received the coveted Platts Global Energy Award for sustainable technology innovation of the year. According to Platts, the award is given to the company that has made the single most innovative technology advance in the area of green technology. At the end of day, however, what really matters are results.

To this end, let me highlight what Coca-Cola Enterprises has achieved in California. Orion has retrofitted more than 4000 lights with our Phase 1 solution at 24 Coca-Cola Enterprises facilities throughout California with our HIF technology. This retrofit initiative will decrease CCE’s energy consumption by over $5.6 million KW hours each year, which is enough electricity to power 530 homes annually. Over the 20 year life of the system, energy consumption will be reduced by 113 million KW hours. From an environmental standpoint, CCE will prevent over 3700 tons of carbon from entering the atmosphere each year. We think that is impressive, and we commend Coca-Cola Enterprises on their commitment to state of the art business practices.

Although we remain focused on the $9 billion retrofit market, I’d like to highlight several initiatives that we believe will enhance Orion’s future growth. We’re very excited about the launch of our outdoor lighting product that will target parking lot and street lighting applications. By simply extending our existing technology with some minimal incremental R&D efforts, we have designed a product offering that outperforms high-pressure sodium and LED alternatives. Given that the US Department of Energy research indicates that there are more than 20 million parking lots in the US, not to mention millions upon millions of street lights, we see a tremendous opportunity to go after. Moreover, we can envision the day when the load reduced in the evenings and nighttime can be redeployed to power the electric vehicles of the future.

We also see tremendous opportunity working with utilities to reduce base load capacity constraints. We our first foray, we received approval in December from the New Jersey Board of Public Utilities to deploy Orion’s integrated lighting system as a capacity solution in the port region of New Jersey. The integrated solution will include all three phases of the Orion technology. Under the program which is a partnership between Orion, PSE&G, and General Electric, PSE&G will provide financial incentive to reduce the simple payback period for Orion’s integrated system which includes all three phases to two years. We are excited about this program, and we’re using it as a model we can deploy with other utilities in the future.

Our Wireless InteLite controls also position Orion to address peak load capacity issues. Not only do our wireless controls allow Orion to offer demand response solutions on the utility side of the meter, but they also offer demand control solutions to our customers on the customer side of the meter as well. It is important to realize that in a warehouse and in industrial settings, lighting load often exceeds HVAC and other loads in the facility. Out wireless controls hit this sweet spot. Moreover, our wireless controls are easily extended to control compressors, chillers, HVAC, and other load sources.

We also realize that our installed base of over 4300 facilities is a tremendous asset. As such, we are exploring additional partnership opportunities and acquisitions of other technologies that complement our existing suite of energy efficiency solutions. From a partnership standpoint, we are speaking to numerous solar players to create a PV offering for our customers.

In conclusion, we recognize that President Obama’s administration may bring unprecedented opportunities to companies such as Orion, which will provide workable solutions to the energy efficiency and sustainability challenges facing this country. It is still unclear how the president’s financial stimulus plan and broader energy and climate policies will ultimately take shape. However, the fact that energy is top agenda item for our president bodes for well for Orion as a pure play energy efficiency company.

Some things we are watching closely include funds targeted towards energy efficiency and weatherization upgrades for government and public buildings. This chunk of money when deployed may present immediate opportunities for Orion in school gymnasiums, government warehouse spaces, military facilities, and such. It also appears that significant funds may be sent to individual states to manage and disburse. Our people in Washington at the state level advise us that these funds will likely be directed into existing energy efficiency programs. Most such programs deploy funds through rebate incentives for energy efficiency projects, clearly a benefit to Orion.

We are closely monitoring how funds targeting the smart grid initiatives will be deployed as we see opportunities with our Wireless InteLite control systems and the associated demand response solutions. Beyond the fiscal stimulus plan, President Obama appears committed to new legislation around climate change. Whether this legislation takes the form of a carbon trade or carbon taxation remains to be seen. Orion stands to benefit under either scenario as our technology provides permanent base load capacity reductions that translate into CO2 reductions.

Let me leave you with a few facts to keep in mind as you think about Obama’s fiscal stimulus plan, climate change legislation, and energy policies. Orion’s solution offers customers a 50:50 value proposition. Our technology will reduce our customers’ lighting related expenses by 50% or more while providing our customers 50% more high-quality light. We call it energy savings without compromise. As it relates to the overall on a macro level, every 4200 fixtures Orion permanently deploys displaces one 400 watt legacy HIV and will result in one megawatt of base load capacity and the potential to expand an additional 40% peak load from the grid going forward, and from a carbon reduction, each 6-lamp Orion fixture will displace one ton of carbon annually.

Operator, at this time, we'd like to now open up the call for questions.

Question-and-Answer Session

Operator

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

Eric Prouty – Canaccord Adams

I was wondering if you could provide a little more detail about what you’re currently seeing out in the market now. If you could compare and contrast what your customers are doing or potential customers are doing and thinking now as compared to a year earlier.

Neal Verfuerth

The desire is still there. They are dealing with the same uncertainties we’re all dealing with in terms of what to expect in the overall economy. What we’re seeing is essentially a lengthening of the sales cycle, and that could consist of having to revisit the same deal as it’s going through the process additional times. In several locations, we’re actually having to go back and talk to a new group of individuals that have responsibility for the project, whether our initial sponsors were downsized out of organization or even in the case where our sponsors have additional workload because others of their team members were displaced. Lastly of course after we get through all of that gaunt, we have to get the capital freed up. If they don’t want to participate with our virtual power plant and they want to pay cash, many times it takes even CEO intervention to go in and pull the Orion deal out of the frozen CapEx budget because the fact of the matter is even when times are slow, the lights stay on and our value proposition is still compelling, even more compelling now than in the past.

Erik Birkerts

Eric, as we’ve talked about on earlier calls, about a year ago what we were seeing was we were able to really affect some quick hit deals where we would go in and just based on the payback period, we were able to get decisions from customers very quickly, and as we’ve talked about before, at the time we were seeing as much 40% of the deals closing within 60 days. That quick hit opportunity is not out there right now. That doesn’t mean that we don’t get the deals. It’s just taking a lot longer, and when we’re looking at our data, now we’re seeing maybe only 10% of the deals closing within 60 days. So customers are taking more time than they were in the past.

Eric Prouty – Canaccord Adams

What was the depreciation and amortization in the quarter?

Scott Jensen

Eric, in the quarter, the depreciation and amortization was $480,000.

Operator

We’ll take our next question from Eric Stine with Northland Securities.

Eric Stine – Northland Securities

I was wondering if you could break down the gross margin between product and service.

Scott Jensen

On the product side, gross margins were 34%, and as I mentioned there was some cost in the quarter that impacted that margins around some of our fixture lines that we feel we’ve addressed and very optimistic about our opportunities to grow gross margin on those product lines. Our service margins for the quarter were 23%, Eric, and a big reason for that decrease was that we had some legacy project costs recorded in this quarter based on some estimating issues, so that’s not something that I expect to recur. I view that more as an aberration.

Eric Stine – Northland Securities

So we should think about the service gross margin returning to somewhat of a more normal level?

Scott Jensen

Correct.

Eric Stine – Northland Securities

You guys did a good job last quarter when you talked about the remainder of the year and guidance. Could you break out this quarter what the revenue was between the national account base, the VAR channel, and also your pipeline?

Scott Jensen

National accounts were a little over $9 million. VARs were right around $4 million, and then pipeline conversion was $8.5 million.

Eric Stine – Northland Securities

Switch gears if you could and just talk a little bit, I know Neal did some, just on the competitive environment. I know over the last few weeks, and this has been going on for quarters that a number of your larger competitors have talked about weakness in the commercial construction market and for that reason, they are going after the retrofit market. Have you seen any difference in how they’ve acted or are there any pricing pressures as a result?

Neal Verfuerth

As I see it, nothing has changed. We continue to go head to head with the normal cast of characters out there, the large multibillion dollar players like the Hubbells, and we continue to win business, and if anything, we’re seeing some of the less established competitors out there being more challenged than they were in the past just due to what’s going on today in the marketplace and their access to capital and technology, so I think you’ll probably see a shaking out of some of the smaller ones on a go-forward basis. Lastly, I just want to comment, as it relates to comparing HIF technology to LED, we’re seeing a lot of change in overall sentiment in LED looking at lumens per watt and just overall performance. The HIF technology is proving itself to be far superior to the LED in so many ways.

Eric Stine – Northland Securities

The LED is being shown to more niche applications?

Neal Verfuerth

What’s interesting is you’re seeing a lot of press out there and industry magazines and white papers done that are talking about a drastic reduction in the overall longevity of the LED, and I saw them probably as recent as 18 months ago at 150,000 hours, went down to 100,000, and now they’re saying 50,000 hours. Conversely, the linear fluorescent guys are now north of 40,000 hours in life, and just on a lumens per watt basis, you can’t beat the high-frequency balance and triphosphor lamps on a lumens per watt basis. The meter exceeds the LED, so the LED, part of their story was historically longevity, now they’re getting down very close to what the fluorescent guys are at. The difference being there even if you assume all things are equal, they are five times the cost.

Erik Birkerts

As a foot note, Eric, they have an issue with lumen maintenance, so even across those 50,000 hours, they may not burnout per se, but lumen depreciation sets in. What we are talking about are white LEDs, not colored LEDs, and white LEDs are the technology that would be most suitable to general illumination.

Eric Stine – Northland Securities

Just on the cost side, if I recall correctly, you had your aluminum hedged through the end of ’08. Should we expect to start seeing some benefit from that now that prices have come down in you’re un-hedged?

Scott Jensen

Yes Eric. We did lock up new pricing for this year, had a nice benefit, so our anticipation is that that will flow through gross margin line.

Operator

The next question comes from Glenn Wortman with Sidoti & Company.

Glenn Wortman – Sidoti & Company

For the G&A expense, do you expect that lower level of about $2.5 million to repeat in the fourth quarter or should we expect that to move up a little bit?

Scott Jensen

I’d anticipate that that will move up a little bit in the fourth quarter. Some of our discretionary spending had to do with holiday functions, year-end bonuses. Obviously that won’t recur at the same level. Having said that though, we have implemented a corporate cost reduction program, and we’re very cognizant of our spending right now and driving profitability to the bottom line.

Glenn Wortman – Sidoti & Company

With respect to the sales and marketing, I know you said you were adding or looking to add eight new sales people, so I guess we should tick that up a little bit as well, right?

Scott Jensen

Yes.

Glenn Wortman – Sidoti & Company

As far as talking about the federal stimulus, do you know if any of your products are currently going to government facilities?

Neal Verfuerth

We have done projects with some military bases in the past, but by and large, we are focused on commercial and industrial in the private sector.

Glenn Wortman – Sidoti & Company

Just on the tax rate, that looks like that jumped up to about 47%. Just a little help on what maybe what we should be modeling there going forward.

Scott Jensen

It’s just a little over 46% right now. I would anticipate that that’s where that rate is going to end up at year end. We continue to be challenged with the non-deductible ISO stock option expense, and we do get a benefit when somebody might exercise and sell those on the same day, but it’s very difficult to forecast that. We had some higher exercise activity coming out of the lock-up period around those, and in the most recent quarter based on the share price, there was very minimal option exercise activity, so from a modeling standpoint what you see is what you are going to get right now for the balance of this year.

Operator

The next question comes from Tom Spiro with Spiro Capital Management.

Tom Spiro – Spiro Capital Management

You mentioned in your commentary that the sales cycle has lengthened, and you attributed that largely to the economic weakness the country is suffering these days. I was curious whether you think that another factor might be moderation in the price of electricity, in fact, perhaps it has even gone down in certain places?

Neal Verfuerth

I haven’t heard of any place where that has taken place. Natural gas of course has gone down. I see a $7 one-time credit or something for home owner for electricity, but on the C&I side, I haven’t seen any significant movement downward on the price of a KW hour especially the daytime.

Tom Spiro – Spiro Capital Management

On the utility side, are they now looking at reserve capacity that appears to be much more adequate than it appeared a year ago?

Neal Verfuerth

Absolutely. When we’re producing less goods, the overall demand is going to go down on a somewhat linear bases, but having said that, the base load requirements of the utilities are still something that they are short on and they need to shore up, so our solutions offer significant base load reduction, so they will continue to have value to utilities, and if anything, we gain more traction every passing month as utilities recognize that we are the least cost alternative, we’re clean, and we free up any issues that are plaguing their distribution infrastructure locally because we go right to the load center. It’s almost like distributed generation in many ways, but it’s load reduction.

Operator

The next question comes from Jeff Osborne with Thomas Weisel Partners.

Jeff Osborne – Thomas Weisel Partners

I was wondering if you could discuss what your outlook is over the next couple of quarters, not just next quarter or this current quarter, but the mix shift that you are seeing in terms of the VAR channel versus the direct channel and how you are realigning that.

Erik Birkerts

I am hesitant to front run our discussions on what fiscal year 2010 will look like, but in terms of the mix, we are investing in our partner network, and I think you are going to continually see that number in terms of percentage of revenue contributed from wholesale move upwards, and that really reflects the fact that we realize that our partners give us that geographic reach, cost-effective geographic reach, to start penetrating into those smaller and mid size customers that we just can’t cost effectively target and service with a direct sales force.

Jeff Osborne – Thomas Weisel Partners

I understand you don’t want to comment about the upcoming fiscal year, but just generically speaking, can you talk about what the margin impact is with that kind of secular shift in terms of gross margins? I understand OpEx would be a little bit lower as you referenced you’re more cost effective, but is it a lower gross margin business, perhaps a higher operating margin business versus your historical direct model? Can you just comment on that?

Erik Birkerts

Historically our gross margins with our whole business have actually been higher than our direct business.

Jeff Osborne – Thomas Weisel Partners

And what about on an operating basis, any type of commentary there?

Erik Birkerts

Very similar. Generally on an operating basis, you don’t have the direct cost either, Jeff.

Jeff Osborne – Thomas Weisel Partners

I understand that the megawatts rollout, and the strategy there, but can you just talk about more of the classic financing need that you are seeing from your customer, either existing installed base or new customers and their ability to get financing and move through with purchases.

Erik Birkerts

Is the question regarding whether they make a cash/CapEx purchase versus Orion Virtual Power Plant purchase?

Jeff Osborne – Thomas Weisel Partners

I think at the time of the IPO, you folks had partnered with a relatively small Minnesota bank for financing, and I was just curious if you have any new type of financing partners that you can detail.

Erik Birkerts

Well, we are still working with that bank that you referenced. We also recognize that at this point, in the grand scheme of things, the Orion Virtual Power Plant represents a small portion of our business, but looking forward, we realize it’s going to become a larger percentage of our business, so we are currently talking to other partners that will provide both capital and credit writing expertise so that we can offload some of that from our shoulders.

Operator

That does conclude our question and session. At this time I would like to turn the call back over to Mr. Neal Verfuerth for closing remarks.

Neal Verfuerth

I think we are through, and we thank everybody for joining us on this call, and have a good evening.

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