Q3 2013 Earnings Call
November 07, 2013 5:00 pm ET
Anne M. Leschin
Ronald A. Sege - Chairman, Chief Executive Officer, President and Member of Stock Option Committee
William R. Slakey - Chief Financial Officer and Executive Vice President
Chip Moore - Canaccord Genuity, Research Division
Welcome to the Q3 2013 Echelon Corporation Earnings Conference Call. My name is Adrienne, and I'll be your operator for today's call. [Operator Instructions] Please note this conference is being recorded. I'll now turn the call over to Anne Leschin, Investor Relations. Anne Leschin, you may begin.
Anne M. Leschin
Hello, everyone, and thank you for joining us this afternoon for Echelon's Third Quarter 2013 Earnings Conference Call. With me on today's call are: Ron Sege, Chairman and Chief Executive Officer; and Bill Slakey, 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 a short time ago. If you would like a copy, please visit our website at www.echelon.com. Additionally, we will refer to a set of slides that we have posted on the IR section of our website to help walk through the quarter's results and outlook for our market.
At the start of the fourth quarter, Echelon will be participating at the 16th annual Needham Growth Conference in New York City, from January 14 to the 16. As other events become available, we will make additional announcements.
Now I'd like to remind everyone that during the course of this call, we may make statements related to our overall business outlook, future financial operating results, accounting matters and future prospects. These are forward-looking statements 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 Form 10-K and subsequent reports on Form 10-Q for a more complete disclosure of the risks and uncertainties related to our business.
The financial information presented in this call reflects estimates based on information that is available to us at this time. Actual results can differ materially. Echelon undertakes no obligation to update or revise these forward-looking statements, and guidance will not be updated after today's call until our next scheduled quarterly financial release.
And now, I'd like to turn the call over to Ron Sege. Ron?
Ronald A. Sege
Thank you, Anne. Good afternoon, and thank you, all, for joining us on our third quarter conference call.
During today's call, I will provide a high-level overview of the quarter's results, an update on our long-term growth strategy and our various initiatives to execute that strategy and an update on our grid modernization vertical.
Please turn to Slide 3. For the first time in several quarters, Q3 Commercial subsystems revenue of $9.6 million was up slightly from last year. This may reflect the customer visits we've been making to outline our commercial strategy and roadmap, as I will discuss shortly. Total grid or systems revenue were $7.3 million, compared with grid revenues of $17.8 million in Q3 of 2012. This was a result of deployment contracts at Fordham and Duke having rolled off with no awards yet to replace them.
Total revenue of $18 million was in line with our expectations. Non-GAAP gross margin was unusually high at 58.5%, despite the lower year-over-year revenue. This was primarily the result of the $2.3 million of revenue we recorded from our previously announced software agreement with Ericsson, and due to the ongoing benefits of our value engineering programs.
Beginning in Q4, we expect our gross margin to return to the levels we have experienced in the first half of the year.
Our non-GAAP loss of $0.06 per share was in line with our expected range despite lower revenues, as our expense management initiatives continue to yield positive results.
Please turn to Slide 4. Let me now remind you of our 3 strategic objectives, which we discussed on previous calls. First, we are leveraging the strength of our assets in our Commercial business to lead our customers through the migration from their legacy control networks into what is being called the Industrial Internet of Things. Second, we continue to focus on vertical solutions in select markets, where we can add differentiated value, such as grid modernization, lighting and building energy management solutions. And third, we are focused on maximizing our financial model, via strong cost controls and increases in efficiencies, as we position Echelon for growth in our target markets.
Please turn to Slide 5. In this context, let me discuss our plans related to the Internet of Things market. The Internet of Things means the network of devices connected directly, or most likely indirectly to the Internet. These devices often communicate with sensors and actuators to interact with their environment based on data they generate and receive. There are several IoT subsegments, including consumer grade and industrial grade. The most demanding uses of IoT technology will be in industrial applications, where reliability, security and scalability requirements are the greatest. We and others are calling this subsegment, the Industrial Internet of Things, or IIoT, and it includes such applications as commercial building automation, grid modernization, lighting control and transportation. While most of the recent market interest has been in the consumer segment, the IIoT has the potential to be a very large market. For example, by 2025 the research firm IHS believes that nearly half of the installed base of 50 billion connected devices will be in industrial applications.
Please turn to Slide 6. The end-to-end IIoT system is comprised of many types of technologies, from the applications that program the devices and analyze situational intelligence, to the traditional networking equipment that delivers data to and from the cloud to the devices themselves. The biggest difference between the traditional Internet and the IIoT, is that we are now dealing with devices or things that must automatically communicate over a network without human-to-human or human-to-computer interaction to share information and to take action. Because of the unforgiving environments in which these industrial devices exist, and the long-lived nature of the assets they exist in, IIoT solutions must meet the challenging requirements of industrial-strength reliability, autonomous real-time operation and backwards compatibility with large installations of legacy devices. It is in these things on the edge of the network that Echelon Technology resides. We provide the communications and control intelligence that enables devices that make up the IIoT to meet these demanding challenges. Just like in the enterprise world, the IIoT will require wireless as well as wired connectivity. In all cases and similar to the enterprise networking market in the 1980s, legacy operating protocols, such as BACnet and LonWorks, will need to coexist with emerging standards such as TCP/IP, so that older devices can interoperate seamlessly and reliably with new ones. It is in meeting these requirements that we see Echelon's opportunity in this exciting emerging market.
Please turn to Slide 7. We said last quarter, that the first phase of our IIoT strategy would be a software launch and the announcement of a significant partnership. We have achieved both objectives. Last week, we launched our IzoT software platform to enable the creation of highly reliable, secure and scalable communities of both legacy and emerging devices. IzoT supports legacy and emerging protocols, meaning customers will be able to support their existing assets without engaging in wholesale system upgrades. IzoT incorporates the LonWorks protocol, and is endorsed by LONMARK International, so it offers a seamless support and migration path for our large installed base of customers.
Data versions of our IzoT protocol stack are now available on the Raspberry Pi hardware platform, so that our customers can quickly prototype new applications. We also announced a strategic partnership with Marvell Technologies to provide Wi-Fi powered IzoT modules for industrial grade applications. Given the demand for reliability, industrial customers have historically been hesitant about whether wireless will meet the needs of their environments. The powerful combination of Marvell and Echelon will provide developers with a ubiquitous and robust software environment for both wired and wireless device development. IzoT software for Wi-Fi modules is slated for release in the first half of 2014.
In the second phase of our strategy, we plan to expand our IzoT platform with a range of additional chipsets and modules to broaden our target market with existing and new customers.
In Phase 3, we intend to migrate our industry-leading design, commissioning and management toolset to the cloud, thereby leading to the potential for recurring revenue and a more flexible business model.
Please turn to Slide 8. By adding protocol support for legacy and emerging devices via the IzoT platform, and wireless capabilities to our existing best of breed wired solutions, we are significantly expanding the addressable market for our products, and eliminating what has been a hurdle to standardizing on the Echelon platform in the past. More specifically, non-LonWorks protocols make up significantly more than 50% of the installed base of industrial control systems, and wireless solutions are expected to make up nearly half the IIoT connections by 2020. So we have expanded our TAMs significantly with these announcements. With our $100 million unit plus installed base of devices, our brand, our distribution channels and now our IzoT platform, we believe we are well-positioned to gain share in this exciting new market.
As has been consistent with our 25-year heritage, we see Echelon as a horizontal platform and solutions provider also offering more comprehensive solutions in certain emerging vertical markets. These markets include outdoor lighting, building energy management and grid modernization.
Please turn to Slide 9. Turning to our grid modernization market, we continue to see positive activities in a number of our targeted geographies as government mandates become more proximate and utilities are investing in pilots in preparation for larger rollouts. Despite this activity, we remain cautious as to the exact timing of awards and rollouts. We were encouraged by the somewhat improved tone at the recently completed European utility Week Show in Amsterdam, which, along with more market activity, suggest the market may start to return in 2014 with significant deployment starting in 2015.
At the show, our Grid division announced several new smart meter pilots in Austria with our partner Kapsch, which represent early traction and acceleration in this important market of about 5 million meters. The pilots together represent maximum potential future orders of $3.5 million networked energy services, or NES Smart meters and software licenses. This demand has been prompted by an energy mandate in Austria that currently requires utilities to achieve specific grid modernization goals by 2019.
During the week, we also met with most of the major utilities in Poland, and believe that pilots and awards will be made throughout 2014 for deployment in 2015 through 2018, in that market of about 16 million meters. Updates from Norway, where we have already won the first major project in this market of about 3 million meters with Fortum Norway suggest that awards and deployments also will start in late 2014 and 2015. We believe that our strong brand, established local partners, differentiated feature set and pilot performance position us well to win our fair share of these markets when they do start to move. We also believe that we remain well-positioned in several deals in the Middle East with the potential of about 1 million meters, with strong business cases driven by the desire to reduce both technical and non-technical losses and to shed peak loads. As you can imagine, given the volatility in this region, we are being very cautious as to the timing of these awards and rollouts as well. In addition, the Open Smart Grid Protocol or OSGP family of specifications published by the European Telecommunications Standards Institute took a significant step forward at European Utility Week. The OSGP alliance shows the only live interoperability demonstration with products, including smart meters, load control and home automation devices from multiple vendors operating on the same network. OSGP has gained significant momentum during the past year or more, and now includes supporters such as LG, Schneider, Kapsch, Smart Energy, Mitsubishi, EDMI, Ubitronix Solutions and Eltel Networks.
Please turn to Slide 10. Also at the show, we announced the new DCN 3000 distributed control node, which will be a major pillar in our NES solution. This platform is designed to help electric utilities around the world accelerate and simplify their grid modernization and optimization programs with a series of applications with compelling business cases. The DCN 3000 establishes a more intelligent communication infrastructure between grid devices and the utility head-in through a variety of wireless and fixed connectivity options. Importantly, it can improve the return on investment on grid modernization by enabling a number of applications on the same cost-effective platform.
Please turn to Slide 11. The final leg of our 3 part company strategy is to continue to focus on tight financial management and to protect the operating leverage improvements we have achieved in the last 3 years. Going forward, we are pursuing additional opportunities to conserve capital through cost controls, but of course, this must be balanced with the imperative to remain competitive in light of the longer-term opportunities in our markets.
Please turn to Slide 12. In summary, we are very excited about our plans to expand our first generation control platform by adding broader protocol support and wireless connectivity to our world-class LonWorks-based wired solutions. We believe the IzoT platform will be the easiest way to build highly reliable networks of legacy and modern industrial devices into the Industrial Internet of Things, which in turn, will provide the sensing, analytics and control required to make the compelling promise of the IIoT a reality. Companies like Marvell are endorsing our approach, and we will look for other partners to broaden the choices for our customers. In all, with this new strategy, we diversify our revenue opportunities beyond single protocol wired commercial chips and modules into multiprotocol, multimedia chips, modules, software and total solutions. As we said previously, we intend to pursue our vision of being the platform for the IIOT devices, both organically and inorganically. We are reviewing options that include horizontal additions to our platform, as well as building blocks for differentiating vertical offerings. While we pursue our IIoT strategy, we remain cautiously optimistic about the trajectory of grid market activity and we believe our investment there should show a good return if and when a few awards go our way. In the meantime, we plan to continue to exercise the fiscal prudence that you have come to see from us, while we work to maximize our position for an eventual market rebound. We look forward to reporting our progress to you in coming quarters, as we achieve several milestones in the pursuit of our vision. As always, I would like to thank our employees, shareholders, partners and customers for their ongoing belief in our company. And now I'll turn the call over to Bill Slakey, to review our financials. Bill?
William R. Slakey
All right, Thanks, Ron. Good afternoon, everyone, and thank you for joining us. Before I begin, please note, that all references to non-GAAP amounts exclude stock-based compensation. For ease of reference we have prepared a complete non-GAAP statement of operations for the quarter ended September 30, 2013, which can be found on the Investor Relations section of our website.
Let's start with revenues, beginning with Slides 15 and 16. Revenues for the third quarter were in line with our guidance at $18 million, down 38% from $29.1 million in the third quarter of 2012. Revenues declined primarily due to the completion of our large smart meter projects at Duke Energy and Fortum Finland. Given that, systems revenue totaled $7.8 million, compared to $17.8 million a year ago and $13.3 million in the second quarter of 2013. Subsystem sales for the third quarter were $10.3 million versus $11.3 million a year ago and $11.6 million in the second quarter of 2013. The lower subsystems revenue was due to lower Enel revenue, which can be lumpy from quarter-to-quarter. Excluding Enel, our subsystem sales were up slightly on both a sequential and a year-over-year basis. Revenues from Enel, in total, were $2.5 million in the third quarter. This included $499,000 of chipsets, which are recorded as subsystem sales, and $2 million of Data Concentrators which were recorded as part of our systems revenue for the quarter. Total sales to Enel a year ago were $1.8 million, consisting entirely of subsystem sales.
Looking at gross margins, turning to Slide 17. Non-GAAP gross margin for the third quarter was unusually strong at 58.5% of revenue, well above last quarter's 47.8% and 41.6% in the same period a year ago. Gross margin for the quarter benefited from a $2.4 million software sale to Ericsson as expected. In Q4, we expect gross margins will return to the levels seen in the first half of 2013.
Turning to operating expenses. We continue to focus on carefully managing our expenses. Non-GAAP operating expenses for the quarter were $12.3 million, down 12.6% from $14.1 million a year ago. On a non-GAAP basis, R&D expense for the quarter was $5 million; sales and marketing expense was $3.8 million; and general and administrative expenses were $3.5 million. We estimate our breakeven is approximately $110 million to $120 million in annualized revenue, depending on the mix of sales. The benefits of our cost reductions and our improvements in our financial model should become more evident as our targeted Smart Grid markets recover, and we gain traction from our investment in the Industrial Internet of Things applications. Interest and other expense totaled $911,000 this quarter, that's an expense, compared with $520,000 in expense in the third quarter of last year. The increase in expenses was driven primarily by the changes in exchange rates, the euro in particular, and their impact on valuations of our foreign currency intercompany balances. Our joint venture with Holley in China generated $77,000 in revenue and a small loss for the quarter. The JV's results are consolidated in our results, and Holley's share of this loss was $266,000, which is credited on our P&L. Income taxes were $113,000 versus $57,000 a year ago. This led to a non-GAAP net loss for the quarter of $2.6 million, or $0.06 per share compared to a non-GAAP net loss of $2.5 million or $0.06 per share, in the third quarter of 2012. On a GAAP basis, net loss after tax for the quarter was $3.5 million or $0.08 per share, compared to a GAAP loss of $4.3 million or $0.10 per share in the same quarter a year ago. On a year-over-year basis then, we did a relatively good job of managing expenses and improving gross margins so that we were able to absorb the drop in revenue, while not increasing our net loss.
Moving to the balance sheet, on Slide 18. We ended the quarter with $56.7 million in cash, cash equivalents and short-term investments. This is down approximately $3 million from last quarter. Going forward, we expect our cash usage to approximate our non-GAAP operating loss.
Let me turn now to guidance for the fourth quarter on Slide 19. We expect total revenue in the range of $16.5 million to $18.5 million. We anticipate approximately 70% of our revenue will come from sales of subsystem and approximately 30% from systems. We expect non-GAAP gross margins to return to a more normalized range of 47% to 49% of revenue. We anticipate fourth quarter non-GAAP operating expenses will be in line with spending in the third quarter at around $12 million to $12.5 million. We estimate our non-GAAP earnings per share for the fourth quarter, excluding stock compensation and other items, will be a net loss between $0.07 and $0.12 per share, including approximately $1 million or $0.02 a share in stock-based compensation expense. We expect our GAAP loss per share to be between $0.09 and $0.14 per share.
In summary, our diligent efforts to lower expenses and improve gross margins drove our financial results this quarter, while our revenues are lower than any of us would like at this point, we are encouraged by the achievement of our first milestones in our Industrial Internet of Things strategy. Based on our conversation with existing customers, we believe our investments in the IIoT market have the potential to lead to future revenue growth in our Commercial business. At the same time, we have a number of additional catalysts for revenue growth in our Grid business in the coming years. These include improving economies in Europe, looming government mandates and a large pipeline of potential grid projects, including tenders that are expected to be awarded in 2014.
Ultimately, we believe these dynamics can lead to a return to revenue growth for the company. And with that, I would now like to turn the call over to the operator for questions. Operator?
[Operator Instructions] And we have Chip Moore on line with a question.
Chip Moore - Canaccord Genuity, Research Division
This is Chip for John. Just wondered if you could expand upon some of the reception you've gotten from customers as you've gone around, and then talk a little bit more about the rollout of this new platform, I think you mentioned it's in beta, and you're looking for a launch in the back half of '14, and what kind of R&D expense do you think -- that needs to tick up a little bit, as you build this out?
Ronald A. Sege
Sure, so you're talking Chip, specifically about the IzoT platform?
Chip Moore - Canaccord Genuity, Research Division
Yes, yes, the new -- exactly, the new software platform.
Ronald A. Sege
Right, it's been getting great reviews. I think I've said on past calls that we had the goal of visiting our top 100 customers in the last couple of hundred days, and we were previewing this platform and they are generally quite enthusiastic. Now part of that is, as you know, we haven't invested heavily in our IoT platform in the last few years. So they were very happy to hear that we were now focused on it, and we were modernizing that platform. But also, as I described in my opening remarks, everybody's trying to figure out how do we migrate from these legacy protocols to the protocols that will drive the Internet of Things. And this platform is exactly tailor-made for that. So, we're quite enthusiastic about the reception we're getting now. As you noted that -- we're just in the first phase of a 3-phase strategy. So this is a software launch that allows our customers to prototype with the software on the Raspberry plot to Pi and other platforms. So they can build prototypes of their future applications, and then as we launch the software on our chips and Marvell launches the software on its chips, then they'll be able to build, starting in 2014, actual products. So they've got to go through a design cycle in '14, and then the revenue would start to hit in '15. So I think, did I answer all the questions?
Chip Moore - Canaccord Genuity, Research Division
Yes, no that's perfect, that's helpful. And on the Smart Grid side, it sounds like your tone is a little more positive, coming out of Utility Week in Europe, are there any opportunities that stand out as particularly encouraging right now?
Ronald A. Sege
I'd say again, the ones that we mentioned in the prepared remarks, Poland and Norway and the Middle East opportunities are the ones that we're the most enthusiastic about. Again, they're driven by, in the case of Norway and Poland and Austria, they're driven by mandates that we believe are solid. But as we know from Brazil, for example, they're always subject to change. And then in the Middle East, there are real compelling problems to be solved that have high return on investments, but it's a politically volatile area. So, we have learned to be cautious in the last few years, but I would say that the show, from my perspective, there was a lot more activity than there was the year before.
[Operator Instructions] We have no further questions at this time.
Ronald A. Sege
Okay. Well, if others can't get in for technical reasons, you know where to reach us. But thank you, all, for joining us today. As you can tell, we're quite excited about the potential for Echelon as we position ourselves in this emerging Internet of Things market, where we think we've got great assets, a plan to expand our TAM, at the same time, being very focused on keeping our powder dry and our finances strong. So when the grid market returns, we're ready to play in it. So thank you, all, very much and we'll be talking soon. Bye-bye.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.
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