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Executives

Annie Leschin - IR

Ken Oshman - Chairman and CEO

Chris Stanfield - EVP and CFO

Analysts

Dale Pfau - Cantor Fitzgerald

Carter Shoop - Deutsche Bank

Elaine Kwei - Piper Jaffray

Justin Cable - Global Hunter Securities

Ben Schuman - Pacific Crest Securities

Joe Maxa - Dougherty & Company

Sean Hannan - Needham & Company

Echelon Corp. (ELON) Q2 2009 Earnings Call July 30, 2009 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen, and welcome to the Echelon Corporation's second quarter 2009 earnings call.

I would now like to turn the call over to Annie Leschin, Investor Relations. Ms. Leschin, you may proceed.

Annie Leschin

Hello everyone and thank you for joining us this afternoon for our second quarter 2009 Earnings Call. With me on today's call are Ken Oshman, Chairman and Chief Executive Officer, and Chris Stanfield, Executive Vice President and CFO, both of whom will present prepared remarks.

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

Before we begin, I would like to let everyone know that in the third quarter, Echelon will be participating in the Pacific Crest Conference on August 9th in Vale, Colorado, the Cowen Conference on September 10th in New York, and the ThinkEquity Conference on September 15th in San Francisco. As additional events are scheduled in the quarter, we will make additional announcements.

I would like to remind everyone that during the course of this call, we may make statements related to our business outlook, future financial and operating results, accounting matters, and overall future prospects.

These forward-looking statements are based on certain assumptions, and are subject to a number of risks and uncertainties. We encourage you to read the risks described in our press release, as well as in our SEC reports, including our 2009 report on form 10-K for a more complete disclosure of the risks and uncertainties related to our business.

The financial information presented on this call reflects estimates based on information that is available to us at this time. Actual results could differ materially. Echelon undertakes no obligation to update or revise these forward-looking statements. Guidance will not be updated after today's call or until our next quarterly scheduled financial release.

I would now like to turn the call over to Ken Oshman.

Ken Oshman

Good afternoon and thank you for joining us. We began the second quarter with modest expectations after what we hoped was the low point earlier this year. While the tide is no longer receding in a few of our key markets, the question of when and how quickly it will return is yet unanswered. The economic slowdown and credit tightening remain the most determining factors to the growth of our various markets.

Capital spending in most of our markets, from utilities to building automation has slowed. Ironically, the slowdown seems to have been exacerbated recently by the promise of governmental aid, particularly from the US stimulus package. Large or small, the grants have yet to make their way into the economy and the complex application and reporting process has only just begun.

The good news is that revenues improved from the first quarter lows to $22.6 million, and gross margins stayed high at 43%, even as the revenue increase came from our normally lower margin NES revenues.

Operating expenses also came in better than expected due to the timing of expenses and our continued management of costs. This led to a net loss on a GAAP basis of $9.5 million or $0.23 per share, beating our forecast. Our cash position remain strong at $82.5 million in cash and marketable securities, and no borrowings.

First, LonWorks infrastructure. LonWorks infrastructure products had roughly a flat quarter, as some of our larger markets continued their slide, while the smaller, emerging markets made up for a bit of the shortfall, presenting very real opportunities for future growth.

The largest market for LonWorks products, building automation, remained at the first quarter's weak levels. Down approximately 20% year-over-year, this market shows very few signs of improving any time soon given its ties to the real estate market.

Another of our LonWorks markets, semiconductor manufacturing equipment, seems to have bottomed, though we expect it may take a little time to translate back into orders for Echelon. It remains unclear what shape the recovery will take in this industry.

Finally, LonWorks sales to other electricity meter manufacturing companies are down 70% from last year. Overall, customers are taking a wait-and-see approach, conserving cash, and lowering inventories until they gain greater visibility.

We were however encouraged by the strength of some of our emerging markets, all of which are centered on energy management and control. As the need for the smart grid and energy efficiency becomes an international focus, demand response is at the forefront, as it shaves peak usage by removing consumption from the grid.

One of our customers, Voltalis, has made a noteworthy impact in the French press with its residential demand response system, thus far deployed in about 10,000 homes. Their system can save about one to three kilowatts of energy per home during peak demand or 10% of a customer's typical energy usage.

Surprisingly, the French energy regulator said that Voltalis should have to pay the utility for lost revenue. As you can imagine, this has created a huge public outcry, and the regulator has now indicated that it will look at new rules by year end.

We remain excited about the demand response opportunity in France, and in all of Europe, and look forward to the regulatory barriers being removed quickly, so that this application can grow to its full potential.

In North America, we had our strongest quarter ever in commercial demand response revenues, at nearly 20% of LonWorks revenue. Several customers accelerated their installations in order to have them up and running before the summer, when energy use peaks.

Due to the seasonal nature of the installation portion of this business, we may see some falloff in the short-term, but continue to be very excited about the longer term potential of this market, and of Echelon's place in it.

Street lighting continues to gain focus in the United States. As cities face budget deficits and look for ways to save energy, the level of interest in street lighting systems has escalated, reflected in the doubling of inquiries we saw this quarter.

Our North American demonstrations expanded again, including a recent announcement from the City of Palo Alto, which aims to reduce energy and maintenance costs while improving lighting in its 6,300 street lights by 2015.

In addition, we just completed installation of our 118 light pilot project in San Jose, and the system is operating very well.

While cities are moving forward with pilots, questions still loom about availability of capital. Many cities such as San Jose are hoping to receive stimulus funding prior to moving ahead with full deployments.

Internationally smart lighting systems are farther along. Echelon's first installation in Winnipeg, Canada at the Kelly Western Services aircraft hangar uses dimmable lights to cut energy use by over 60% or 250,000 kilowatt hours a year.

Combined with the rebate incentives from the local utility, the Kelly Western installation expects a return on investment in just nine months. Even without the utility rebate, the payback time is still impressive at 14 months. In addition, our partners in China continue their trials and timing remains on track for installations by year end.

Two other important, if currently small markets, are enterprise branch energy management and alternative energy applications. In enterprise branch energy management, a key financial institution recently successfully deployed our LonWorks technology to manage its energy usage in hundreds of branches, with potential of over 10,000 locations over the next three years.

In a decidedly different segment of enterprise energy management, the shipment of kitchen equipment with Smart Transceivers to McDonald's continued to grow. As of the end of May, every piece of new Tier 1 equipment in McDonald's kitchens is now communicating and smart, with a Power Line Smart Transceiver built in, so that every store will become network ready with each purchase of new equipment.

These relationships are also leading to trials and pilots from various other restaurants and banking chains, which to-date are providing very strong results, with payback from energy savings in about 18 months.

Our partnership with SMA America, a key solar inverter supplier, is a way that our LonWorks products are addressing the alternative energy market. SMA is using our i.LON SmartServer in solar installations to monitor the health of the panels, and to measure the electricity generated by them.

This partnership shows how LonWorks products can take an energy saving device such as a solar inverter, and help it achieve its most efficient operation. Thus, it combines two energy saving systems into one.

With the installation of solar panels reaching all-time highs, and each installation requiring inverters to convert that energy into the grid, this could potentially be a strong market for LonWorks products.

Lastly, we have begun our first project through our partnership with Wonderware at an airport in Spain. We believe this installation lays the groundwork for the many other airports worldwide to utilize the application from Wonderware.

Moving on to NES. The global economic downturn was enough to slow the advanced metering industry. Utilities are being very cautious about capital spending. Some in the US are awaiting a boost from the stimulus package before committing to new projects.

All-in-all, the rate of awards of new, previously unfunded smart grid programs has slowed. On the other hand, there remains a good deal of activity in tests and trials. So we feel that the market will once again pick up when the economic and credit crises have passed.

We were encouraged by the growth of our NES sales in the second quarter. Most of this growth came from the deployment of meters already under contract, primarily in Denmark and other European countries.

Our NES system continues to perform at the highest levels, reflected by our follow-on orders. Though we had no new announced wins in NES this quarter, our partners in Europe are actively engaged with a number of potential contracts with utilities, and we continue to lead the transition to the smart grid in the international marketplace.

When it comes to the US, outside of Duke Energy, we have not done as good a job as we should have in penetrating the market. The smart grid is all about the communications network.

Echelon provides a robust future-proof, open solution for the smart grid, using our extraordinary Power Line technology.

Unfortunately, here in the US, as contrasted to the rest of the world, power line solutions have been identified with two prior power line technologies that are not really appropriate for the smart grid, and have created a bad name for power line. Their very low speed communication technology from companies like Hunt and Aclara and very high-speed broadband communication technologies over power line.

The low speed technology is too slow to meet the data demands of a smart grid, and broadband power line is both unreliable and expensive, and seems to have faded from the marketplace.

As a result, often without understanding the advantages of our technology, some believe that a power line network is inappropriate in the US, and that a wireless mesh radio network is required. This is simply not true. Utilities who have tried our technology tell us that our medium-speed power line network works more reliably than the wireless solutions they have tried.

Ironically, we believe that it generally provides more usable bandwidth per meter than wireless, and that it's less expensive to deploy. Maybe, most importantly, our technology provides unique information about the health and quality of the low-voltage power lines that is unavailable to RF systems, and that can help utilities lower the maintenance costs associated with the grid.

A second hurdle we must overcome is the belief that using the cellular network to provide an IP connection between the meter network and the central office will be expensive. This has been a legitimate concern in the US, because until recently, US cellular providers were disinclined to provide data services for metering on a different basis than they were providing cellular services to consumers.

Fortunately, our recently announced partnership with T-Mobile solves that problem, and we see other cellular carriers moving to provide data connectivity on the basis of time-of-use and amount of data carried. This has long been the case in Europe, and we believe it will become the standard in the US.

So, our focus today is on further educating the US market, increasing the understanding of our feature-rich, smarter grid solution versus the competition, which is often providing little more than automated meter reading, and selling the value and commonsense of using the existing electrical network as the communications network, rather than building a second network, a new proprietary mesh radio network that must be maintained and managed for the next 20 years.

We also need to get the word out about the costs of cellular communication. Ironically, even a mesh radio system generally uses a cellular network for the backhaul, and when based on the amount of data transferred, the operating costs of telephony should be the same for all systems that provide as much data as the NES system.

Though the education process is not going to be overnight, we are confident that we can win a large share of the US market. Already, we are expanding our presence in the US with a growing number of engagements with utilities at various stages of tests, trials, pilots and deployments.

Now, I'd like to turn to our outlook. The macroeconomic conditions remain challenging, at least for the near term with financing still a key issue for most of our customers and prospects.

To the disappointment of our team, this has pushed out profitability. While we could force the issue by instituting dramatic cost reductions, we've chosen instead to continue investing in our two product lines, which we see as critical to the formation of the smart grid, and at the forefront of energy management and control.

Combined with targeted investments in sales and marketing, we're using this period to focus our efforts, develop new products in technologies, establish and grow customer and partner relationships, and manage our cost structure to ensure that we are addressing our target markets in the most strategic way.

We're encouraged by our recent momentum in various emerging markets driven by the control and management of energy. The stimulus bill, combined with various regulations and policies, both domestically and internationally have only begun to highlight the significance of energy controls, conservation, and cost savings.

Nearly every indicator points to these markets flourishing over the next decade, even though the markets themselves have temporarily slowed. Echelon is uniquely positioned at the centers of these markets, as well as the emerging markets with a number of catalysts that should allow us to prosper once the markets recover.

We are making prudent investment decisions and managing our strong cash position to buffer the uncertainties of the future. I am confident, profitability will come as the markets return, opportunities expand, and our investments during this difficult period begin to pay off.

I would like to thank the entire Echelon team around the world for their dedication, creativity and hard work.

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

Chris Stanfield

Thanks, Ken. Now, I will review our financial performance for the second quarter and our outlook for the third quarter. Please note that all references to non-GAAP amounts excludes stock based compensation. For ease of reference, we have prepared a complete non-GAAP statement of operations for the three and six-month periods ended June 30, 2009, which can be found on the Investor Relations section of our website.

Revenues for the quarter were inline with expectations at $22.6 million, compared to $32.2 million for the same period in 2008. LonWorks infrastructure sales were $10.9 million, down from $13.9 million in the same period last year, and NES sales were $10 million versus $16.6 million a year ago. Revenue from our Enel project was $1.7 million, compared to $1.6 million in the same period last year.

Non-GAAP gross margin for the quarter was 44.9%, compared to 40.9% for the same period last year. This improvement was primarily driven by product mix and manufacturing variances.

Non-GAAP operating expenses were $14.7 million, compared to $16.9 million in the second quarter of last year. We were encouraged by the improvements in operating expenses across all areas, although the timing of certain expenditures created an artificially low baseline for this quarter.

Our structured salary reduction program, implemented during the second quarter, also had a positive effect with employees being even more conscientious about discretionary spending.

We continue to invest strategically in product development in order to well position Echelon in key markets. Interest and other income and expense was a net loss of $377,000 for the quarter, versus net income of $519,000 in the same period last year. This reversal was primarily due to currency translation losses we booked as a result of the weakening US dollar.

The GAAP net loss for the second quarter was $9.5 million or $0.23 per share. This compares to a net loss of $7.4 million or $0.18 per share for the same period in 2008. On a non-GAAP basis, the net loss for the quarter was $5.5 million or $0.13 per share, compared to a non-GAAP net loss of $3.6 million or $0.09 per share for the second quarter of 2008.

Moving to the balance sheet and related cash flow. We ended the second quarter with cash, cash equivalents and short-term investments of $82.5 million, a $5.2 million decrease from last quarter. This reduction was primarily driven by $5.1 million in cash, used in operating activities. Our inventories fell by roughly 5.6% during the quarter to $19.4 million.

Now, I will turn to guidance. Both our LonWorks and NES product lines have been impacted by the macroeconomic environment and the timing of the stimulus program.

We now expect total revenues for the third quarter of 2009 to be in the range of $21 million to $23 million, with LonWorks infrastructure accounting for approximately $11 million, NES about $10 million, and the remainder from Enel. We anticipate non-GAAP gross margin to be in the range of 43% to 45% for the quarter.

Finally, we estimate our GAAP loss per share will be between $0.24 and $0.26 and our non-GAAP loss per share will be between $0.15 and $0.17.

Now, I will turn the call back to the operator for questions.

Question-and-Answer-Session

Operator

(Operator instructions). Our first question comes from the line of Dale Pfau of Cantor Fitzgerald. Please proceed.

Dale Pfau - Cantor Fitzgerald

Great. Couple of questions here. The request for stimulus funding for the smart grid and so on are due here in August. Do you have any indication of how many potential customers out there are including your products in their bids for stimulus funding?

Ken Oshman

No, we really don't know how many. Most of our customers don't need to check in with us in order to file for stimulus grants. So, they don't check in with us. We are sure that there are a number of customers that are applying across all kinds of markets, everything from the smart grid market to schools to lighting to street lighting, so just across a number of different areas. Sorry that we don't have a real number there.

Dale Pfau - Cantor Fitzgerald

So, you haven't specifically given any recent quotations to support those bids?

Ken Oshman

No, no one much needs a quotation from us. We have some contracts and standard pricing with almost all of our customers. So there wouldn't be any special contracts probably needed for any of this.

Dale Pfau - Cantor Fitzgerald

Okay. You mentioned China for street lighting. We've seen a fair amount of activity there with China, various cities and so on placing street lighting contracts. Have you received any contracts yet? Have you received any large RFQs out of China for street lights?

Ken Oshman

Dale, we would not probably get any direct contracts with anyone in China. We have partners and customers in China who would get those contracts. I think there are five or six different companies building street lighting controls products on top of our technology and our product line.

There are a number of trials. I'm pretty sure there are four fairly large trials in four different cities in China right now with one of our suppliers, and they're doing very well. Street lighting in China is a very hot item, but the orders will come to us through our partners who will themselves sell directly to the cities in China. We won't be doing that.

Dale Pfau - Cantor Fitzgerald

One comment about NES in Europe. You mentioned this last quarter has been a little bit slow. Is this strictly an economic issue? Are there some regulatory issues going on over in various countries in Europe? Give us a little bit of a flavor there please.

Ken Oshman

Sure. I think it's a combination of a variety of things. First of all, if I had believed, if we all had believed an analyst's report written in late 2007, they predicted a lull in EU in terms of AMI deployments in 2009, and only if they weren't right.

So, really what has happened is that we sort of have gone through a transition of one set of countries. We sort of knocked the ball out of the park in Sweden, and we did a great job in Sweden, and Sweden is now very nearly completed. So, what was revenue to us last year in Sweden is now no longer contributing because we finished it. We did a great job and finished that. The same thing is happening in Denmark, and we see Finland and Norway as coming online later this year and next year.

So, we're in sort of a transitional lull. I use Scandinavia as an example because it's so easy to understand these four major countries, but the same has happened in a number of different places across Europe.

There are regulatory issues, however. I hope I'm not going on too long here, but there are regulatory issues. England is a very hot idea today, but a very difficult environment to get anything done, simply because the regulators are saying, we want to do something, but they haven't actually completed the job of getting regulations into a shape that actually incentivize progress.

Today in England, the ownership of the meter is just in the wrong hands, and there will be no smart grid as we know a smart grid. There will be no smart grid until the regulations get straightened out. However, that will happen. I think the English regulators are dedicated to doing that. So, while there's a lot of hype around England, for example, today, it is really not happening.

So, I can go on country by country if you'd like me to, but I think the two basic problems in Western Europe are, either, we're not to the point where regulation is highly supportive, but will be, and secondly, these capital markets are just slowing everybody down. If they're not getting a sort of tailwind from the regulators, they're not creating their own momentum.

Having said that, the rest of what we consider Europe, which is Eastern Europe and central Europe, is really on its tail right now. There is almost nothing going on in those countries, again, mainly not because of the desire to do AMI, but because of the lack of capital for those utilities.

Anyway, having said all of that, we think it's going to come back. I mean, these are great big opportunities. They're a long way from saturated. They're a long way from done. We have an outstanding reputation all over Europe. We're doing a great job in Europe. So, I'm unhappy that it's been quiet, but I'm not expecting that to last forever.

Operator

Your next question is from the line of Carter Shoop of Deutsche Bank. Please proceed.

Carter Shoop - Deutsche Bank

Good afternoon. I wanted to quickly ask about R&D. It looks like since 2004, it's up about 50%, while sales are down about 20%. First part of the question, can you help us understand where that increase in spending has come from?

Chris Stanfield

Carter, this is Chris. Are you looking at our GAAP or non-GAAP numbers?

Carter Shoop - Deutsche Bank

GAAP.

Chris Stanfield

Okay. You have to remember there was a transition in terms of how equity-based compensation was accounted for during that timeframe. The increase is not that rapid if you look at a common base that is just the real spending. I don't recall the number from memory, but its high single digits I think.

With respect to that, the increase has come, of course, in NES, principally, because there was no NES revenues in 2004, and we've had substantial investment in our smart metering, but we've also increased R&D investment in our LonWorks product line, particularly with respect to our i.LON SmartServer.

Carter Shoop - Deutsche Bank

Okay. Then sequentially, it looks like you guys made some pretty good progress trimming R&D back, particularly on a cash basis, excluding stock option compensation. I know you're not expecting much in the third quarter, but if some of these opportunities in the US and Europe continue to get pushed out, particularly in NES, is there opportunity to reduce that in 4Q in 2010?

Chris Stanfield

With respect to our spending, I made a point during my comments about the baseline. As you understand, there are portions of R&D spending and things like salaries and those just happen. Obviously, there was a slight reduction associated with our structured salary reduction. But the biggest effect were project related expenses, and frankly, those were low in Q2. So, that doesn't serve as a good baseline. But, yes, we're very pleased with the controls we've been able to put into discretionary spending.

Operator

Your next question comes from the line of Elaine Kwei of Piper Jaffray. Please proceed.

Elaine Kwei - Piper Jaffray

Thanks for taking my question. I was actually wondering if you could give us a little more color on your product development strategy or what areas of technology are you choosing to focus and emphasize your development in, and where do you see the technologies potentially having the most commercial possibilities?

Ken Oshman

That's something that we probably spend almost all of our effort to sure we're investing in the right place. So, that's a great big question for me. So, I'll try and simplify it by saying, what we think are some of the great investment areas for us today are continued investment in our NES product line, which we see as requiring additional investment as we provide new and increased functionality to our customers.

Let me stop there for a second and give you an example of what I mean. One of the things about our NES system is its long-term, future-proof nature. So, one way of thinking about what we do with NES is we provide dial tone to all of our customers.

Now, that we provided the dial tone, so now we can go back and show them caller ID next year if they want to know caller ID by downloading. I'm using the analogy to the telephone switch of course. If next year caller ID is a kind of feature that is important to the customer base, we just download that.

So, similarly, with our NES system, we put a very feature-rich system in place, but we are continuously adding functionality, new features, new functions, things that are tailored to the specific needs of the various markets where we operate. So, there's a continuing investment in that.

Let me give you an example. In our very first meters, we provided the ability to add-on the remote meter reading of gas and water meters in our European product line, in the very earliest product line, but we didn't. There were none and we didn't do that. Over time, we added that capability, and we've added it and we've changed it. We've added on and given people the ability to add more and more external products to the NES system.

So, the point is, we are continuously investing in the NES system itself. We, of course, have invested a lot of money and a lot of time and energy in cost reducing the NES system, in order to increase our gross margins, and that is beginning to have an effect on our gross margins, and it's a very good investment. It's also fairly straightforward and simple investment.

In our LonWorks infrastructure product line, the areas in which we're investing today or we are investing in street lighting, we're investing in our SmartServer product line. We are investing on refreshing, upgrading and developing our transceiver product line. We just announced a whole new generation of transceivers and a whole new generation of the LonWorks infrastructure product line itself, and that has been the result of continuing investment and continuing investment going forward.

So those are the kinds of things we're doing. We always seriously look at the payoff of the various investments. I hope that answers yours question. It was a very broad question, and I think I may have rambled a bit.

Elaine Kwei - Piper Jaffray

Sure, that was very helpful. I guess my next question is are you seeing any potential stimulus opportunities from energy efficiency funds that may have already been distribution either as part of block grants to states or through other programs moving along ahead of the smart grid funding awards?

Ken Oshman

You know we haven't seen a whole lot of that, but there has been some of it. It's been in the form of modernization of controlled and energy management for schools or hospitals if they're community-owned. There's some of that that's going on, and we've seen that in New York. We've seen that in Illinois.

However, it's not enough to make the big difference, but it has had minor effects. Cities I think are actually often using a lot of their block grants, their early block grants for infrastructure that is more fundamental like roads and sewers, and that sort of thing.

Elaine Kwei - Piper Jaffray

I see. Just lastly, if you were to look out three, five years from now, if you were to look at energy efficiency versus building automation versus lighting, I was just curious how sort of big you might see the lighting opportunity more specifically.

Ken Oshman

Let me just say, everything you said is about energy. Building automation is about energy. Lighting is about energy. It's all about energy. I think the lighting market is a very large increment to what we do because today, even though lights are all over buildings, they don't have modern controls in them.

So we see a big opportunity, and I do think there's a big opportunity in lighting, street lighting to begin with, high-bay warehouse lighting like we talked about with the aviation example that I talked about, street lighting.

Then we think there's going to be a big opportunity in controlling LEDs, not only for street lighting as is popular in the US, but also LED lighting for architectural building and a number of different LED lighting opportunities.

So lighting is I think is going to be a reasonably large opportunity for us. Again, it's an opportunity based on controlling things so that the energy consumption is minimized, and the controls themselves pay for themselves very quickly.

Operator

Your next question is from the line of Justin Cable of Global Hunter Securities. Please proceed.

Justin Cable - Global Hunter Securities

Thank you. The LonWorks division, it seems like the revenues for the last three quarters have sort of stabilized around this $11 million range, and I think the guidance assumes another $11 million quarter. Are we sort of at a baseline kind of real core stable business even in light of the current environment? Or how would you characterize the state of that business?

Chris Stanfield

I would go back to what Ken said. I think what you see first and foremost is that the building automation portion of the LonWorks product line remains the most important revenue stream, and while it varies by customer, it's down about 20%. It's been down at about that level for the time that you described.

In Europe, we have revenue that comes from other meter manufacturers that use our power line technology, and as Ken said, that's down 70%. So, as you would guess, the drop-off for that product line is much sharper in Europe. Offsetting the building automation drop off in North America is demand response.

As Ken described, demand response is doing very well in the United States. In Europe, there are some regulatory issues to be dealt with and the growth of demand response is sort of offsetting some of the decline with respect to what's going on in building automation. Does that help?

Justin Cable - Global Hunter Securities

Yes. I was really looking at the sequential trends in the last three quarters and in your guidance for the next quarter is pretty much in the same range, almost as if we are sort of at a nice baseline. If demand response activity continues to pick up, then maybe we might even see a little bit of a sequential uptick. However, we're still in a tough environment obviously.

Ken Oshman

Let me just say it's so hard for us in this environment to predict the bottom or anything, so we're doing our very best. So, that's why we're not talking really long term, but we are trying to do our best quarter-by-quarter. I can't tell you that we're at a bottom. However, it definitely feels as if we are at the bottom. We've been sort of here for a while, and it seems to have stabilized and it seems to be like a bottom.

However, look, let me just tell you something. If you'd have asked me last October what we're going to do this year, I would have told you we're going to grow dramatically and be profitable. I had lots of reasons to believe that was an absolute doable thing. Not only doable, it was where we were headed. Then along came December and all hell broke loose, and it just changed.

I wish I were better with a crystal ball. I wish I had a crystal ball, but I think we're at a bottom and I hope we're about to takeoff, but we really don't know that yet.

Justin Cable - Global Hunter Securities

Right. Okay. You mentioned earlier in the prepared comments about growing engagements with US utilities, and obviously they're facing funding issues in general. It sounds like activity may have actually picked up in terms of just discussions, and I don't know if they've moved to pilot projects, but can you give us a little more color as to what type of activity you have seen in the US?

Ken Oshman

I want to be careful about how I do this. I have no interest in sort of alerting our competition to what we're doing, because they don't help me that much either. We have a good deployment going on with Duke. I mean it's a very successful project. I think Duke is very happy with the results. I think we're doing everything we ever said we were going to do and more. I think that that is a project which has a good future. They've got approval for Ohio. They've settled with their regulators, with the interveners in Indiana. They're probably on the way toward getting PUC approval in Indiana.

So, that is an opportunity that remains out there for us, and we're optimistic about being able to capture some of or all of or more than all. So, that's one extreme. At the other extreme, we've got utilities who are just saying, we've got a situation here where we've not been able to make anything work. We've tried everything in this difficult area. We'd like to see if you can do this. You guys boasted you can do it, and we'd like to see if you can do it, and we just want to go do some tests, and we're going to do them in late August.

We know darn well we're going to do it. We know it's going to work. It's going to be great. So, that's the kind of thing that some people are coming back around, and saying, we've tried things and it's time to go try something we haven't tried before. Then there are other utilities that are beginning to want to go try and do something with us. I think we've had an aggressive sales program in place now for the last six months or so or nine months, and the results are beginning to show that we're beginning to educate people and explain what we've got, and the advantages of what we got, and they're beginning to listen.

Justin Cable - Global Hunter Securities

In this sort of trial process, are they testing a number of different venders, a number of different systems or is this more of a one-on-one engagement process with Echelon or your partners?

Ken Oshman

It spans the full spectrum. We have utilities who have never tried anything who are trying us. We have utilities who've tried everything and it's not worked who are trying us. We have utilities that are trying a few things and trying to figure out what they really want to do, and what their strategy's going to be. I think in all that spectrum, we really have something to show people, so I think we're quite optimistic. I want to remind you, utilities go through a very difficult, arduous process of making these decisions, which is further made difficult by the regulatory environments that they must live in. So, nothing happens overnight, but it's going to happen I think.

Justin Cable - Global Hunter Securities

Right. Right. The last question I have is, in expanding this education process, what do you plan to do different going forward versus what you've done historically in terms of educating your potential customer base?

Ken Oshman

I think the first thing that we're trying to do is to get the message right, and be sure that people understand what that message is. That's the first thing we've done. Second thing is we've tripled our sales force. The third thing is, we are continuing to look for partners, but we are also going direct to any utility that wants to talk with us, and believe that is a better model in the US. Actually, let me just call it, not better or worse, but it's just a more appropriate model in the US for most utilities right now.

This was the model in Europe when we got started. We went direct to the utilities, and over time the utilities decided that really what they wanted was a system integrator to take the responsibility for darn near everything. So, that was a change that happened in Europe. We haven't gotten there yet in North America. We may never get there, but today we are going more direct to the utilities themselves.

Operator

Your next question comes from the line of Ben Schuman of Pacific Crest Securities. Please proceed.

Ben Schuman - Pacific Crest Securities

Thanks for taking my call, guys. Most of my questions have been answered, but can you just take your best guess at what percentage of the LonWorks business is exposed to the uncertainty around stimulus and the weakness there?

Ken Oshman

Very little.

Ben Schuman - Pacific Crest Securities

Okay. So that's all NES related, essentially?

Ken Oshman

What we view as our business is really not exposed to stimulus money. We view the stimulus sort of like an upside if you will. There is no stimulus money that's helping us right now. There is no stimulus money that anyone is forecasting or any of our customers are telling us they've gotten. So, we just view it as a good upside across both of our product lines.

Ben Schuman - Pacific Crest Securities

Okay. Then to kind of dig into one of the last caller's questions. I think about 40 million or so AMI points have been awarded in North America, at least within some sort of framework contract, and then maybe another 30 million or 40 million at utilities that are sort of publicly considering AMI. Can you give us an idea of how many of those endpoints would fall within customers that you're engaged with at some level?

Ken Oshman

I think that it is fair to say that a utility that has issued a framework contract is not much of a prospect for a while. So, we're not spending a lot of cycles on those guys unless they run into some problems. We're very happy to help them and to work with them any time they get into some problems. There certainly have been, as you know, a number of utilities who have changed their mind in the US. So, we think some of that may happen.

However, for now, that's not our target. There are lots and lots and lots of, first of all, larger investor-owned utilities and then, of course, there are a number of very good size municipal and co-op utilities around the country. So, we have plenty of target prospects that we're working on without sort of attacking the 40 or so million that have sort of been awarded.

Operator

Your next question is from the line of Joe Maxa of Dougherty and Company. Please proceed.

Joe Maxa - Dougherty & Company

Thank you. Looking at your crystal ball, are you expecting any type of pickup in Q4 based on the customers you have now on the rollout plans?

Chris Stanfield

I'm sorry. We're not going to give any guidance, obviously. So I think Ken has talked to what's going on in the marketplace, and we'll sort of work at one quarter at a time.

Joe Maxa - Dougherty & Company

Okay. Chris, your gross margins were a bit higher than your guidance if I recall right from Q2. What drove the difference?

Chris Stanfield

As you know, we have both direct and indirect costs, and that applies to both product lines. With respect to the direct costs, we had very good product mix in both product lines. So, if you will, we hit on both cylinders, and that helped. Then our operations organization did an outstanding job of limiting our indirect costs, and that was the second part of it.

Ken Oshman

Joe, I will add a little bit more to what Chris said, and just remind you, our LonWorks infrastructure business is not highly lumpy. I don't think we're going to see 50% change quarter-to-quarter in that business in the fourth quarter or the first quarter. We haven't seen that kind of change quarter-to-quarter in the last five years, so I just don't think that's in the cards.

In our NES business, we have definitely seen that kind of lumpiness. It is a lumpy business. There's utilities and our partners want the product when they want the product, when they're ready for the product, the way they want it. It's can be a hurry up and wait kind of a business. So, I think it's just much harder to project the quarter-to-quarter changes in that business than LonWorks infrastructure.

Operator

(Operator instructions). Your next question is from the line of Sean Hannan of Needham and Company. Please proceed.

Sean Hannan - Needham & Company

Yes. Thank you. Just to follow up on some of the comments you had made a little bit earlier on activities within the US. I think that in previous discussions you mentioned that there were about 10 utilities that you were working with, and just wanted to circle back to see if that number remains the same in terms of discussion activity or if there has been any change?

Ken Oshman

There has been change. There are some new people we're working with, and July and August are not the greatest months for getting a lot done anywhere in the world. Nevertheless, we are seeing continual progress in the US. I expect to see that continue forever. I'm just very optimistic we'll find ways to engage with more and more utilities over time.

Sean Hannan - Needham & Company

Is that a handful of additions or has that number 10 effectively maybe even doubled in a quarter? Is there a way to get a sense of the magnitude?

Ken Oshman

It certainly hasn't doubled.

Sean Hannan - Needham & Company

Okay. That's helpful. So, demand response clearly was pretty significant within the quarter. Just the commercial side was probably about 10% of your overall business. As the momentum in this segment continues, is this a piece of your business that should be able to meaningfully represent about 20%, 30% of your LWI business kind of over the longer term or is that just a little bit too far stretched given where the dynamics are today?

Ken Oshman

Let me back off and not talk about demand response as a market segment, but rather talk about our product line, our SmartServer product line, because that is really the backbone, the core of our demand response business. That is also the core of our enterprise branch energy management business. That is the core of street lighting business.

So. these are all emerging businesses that are based on our SmartServer, which is the, very low-cost, highly reliable device that connects LonWorks networks, the everyday devices themselves, the things in someone's home to the internet, the street lights themselves to the internet, the energy using and conserving devices in a branch office to the internet, the kitchen equipment in a McDonald's to the internet.

So, this SmartServer is the piece that I think is more interesting to focus on than the market segment, although the market segments are all driven by energy and, therefore, as an aggregate are a great opportunity, whether it's demand response or branch energy management or street lighting energy management or lighting energy management and so on.

So, that is a business that we think will continue to grow as a percentage of our revenues over the next years. I mean it is a very, very important piece of what we do. However, don't misunderstand; we're very excited about demand response.

Sean Hannan - Needham & Company

Yes. If I were to, perhaps come at that from a slightly different angle, should the mix of your SmartServer line improve or increase as an overall portion of your business, do you expect a mix shift?

Ken Oshman

Yes, I do. Our revenues are pretty much dominated by our transceivers, which are fabulous technology with a lot of intellectual property and great performance, and price differentiation, and they are going to continue to grow. However, we think that the SmartServer part of the LonWorks infrastructure product line will grow more rapidly than the transceiver part, and become a bigger part of that.

Sean Hannan - Needham & Company

That's helpful. Thank you. On the NES side, since your T-Mobile announcement, is there a way if we can just touch base, what additional feedback have you received from either customers or partners on this relationship, and then also, as it relates to the level of willingness for utilities here in the USA to work with more of a rented network versus an owned?

Ken Oshman

Let me just tell you the best answer I can give to you about that is what Jim Andrus, our Vice President, North American NES, Sales said to me. He said, you know, the cost of the operation of the backhaul is a non-issue anymore, period, done, gone. With the utilities that he can talk to and explain this to them, it is no longer an issue. The cost of that is the same whether you're using your private mesh network or you're using our network with a power line based network. So that issue is absolutely gone to the extent that anyone understands that we have had a chance to explain that to someone. I think that's a major breakthrough because that used to be number one on the table.

Now, that is not the same thing as what exactly you said. I just want to say something about that. There are utilities who will want to buy, maintain, and build their own proprietary network, and maintain that for the next 15 to 20 years. We don't think that's a good idea. We don't think it's an idea with commonsense. But, if you want to add that network to everything else you're doing, we're not going to stop someone from doing that, and there are certain economic incentives in the regulatory process to doing that, even if it costs more.

However, we think at the end of the day, we've got a very compelling commonsense argument that building a second network is not nearly as good an idea as using someone else's, and using your existing network, which you must maintain anyway as your communications network.

Operator

That is all the time we have for questions. I would like to turn the call back over to Mr. Ken Oshman for closing remarks.

Ken Oshman

Thank you very much. Thanks everyone. Thanks for joining our call today. I'm sorry we were a few minutes late getting started because of a typo error in our press release on phone numbers. We did get it done and we thank you for joining the call. We'll be back next quarter for our third quarter earnings announcement. Thank you.

Operator

Thank you. Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect, and have a great day.

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Source: Echelon Corp. Q2 2009 Earnings Call Transcript
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