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Executives

Ronald Sege - Chief Executive Officer, President, Director and Member of Stock Option Committee

Oliver Stanfield - Chief Financial Officer, Principal Accounting Officer and Executive Vice President of Finance

Annie Leschin - IR

Analysts

Michael Cox - Piper Jaffray Companies

Carter Shoop - KeyBanc Capital Markets Inc.

Benjamin Schuman - Pacific Crest Securities, Inc.

Benjamin Kallo - Robert W. Baird & Co. Incorporated

Craig Irwin - Wedbush Securities Inc.

Elaine Kwei - Jefferies & Company, Inc.

Colin Rusch - ThinkEquity LLC

Patrick Sullivan

Sean Hannan - Needham & Company, LLC

Dale Pfau - Cantor Fitzgerald & Co.

John Quealy - Canaccord Genuity

Unknown Analyst -

Echelon (ELON) Q2 2011 Earnings Call August 4, 2011 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to Echelon's Second Quarter 2011 Earnings Conference Call. [Operator Instructions] I would now like to turn the presentation over to your host for today's call, Ms. Annie Leschin. Please proceed.

Annie Leschin

Hello, everyone, and thank you for joining us this afternoon for our Second Quarter 2011 Earnings Conference Call. With me on today's call are Ron Sege, President 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 we issued a short time ago. If you would like a copy, please visit our website at www.echelon.com. Additionally, this quarter, we are going to refer to a set of earnings slides that we have posted on the IR section of our website to help walk through the quarterly results and outlook for our markets.

Before we begin, I would like to let everyone know that in the third quarter, Echelon will be participating in Canaccord's Growth Conference on August 9 in Boston; ThinkEquity's Growth Stock Conference on September 13 in New York; Wedbush's Clean Tech Conference on September 15 in San Francisco; and Credit Suisse's Future of Energy Conference on September 27 in New York. As additional events are scheduled in the quarter, we will make other announcements.

Now I'd like to remind everyone that during the course of this call, we may make statements relating to our business outlook, future financial and operating results, accounting matters and overall future prospects. These forward-looking statements are based on certain assumptions and are subject to a number of risks and uncertainties. We encourage you to read the risks described in our press release as well as those in our SEC reports, including our report on 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 the estimates based on information that is available to us at this time. Actual results could differ materially. Echelon undertakes no obligation to update or otherwise revise these forward-looking statements. Guidance will not be updated after today's call until our next scheduled quarterly financial release.

I'd now like to turn the call over to Ron Sege. Ron?

Ronald Sege

Thank you, Annie, and good afternoon to everyone. I'm pleased to report that we continue to make progress on the goals we have laid out for the company at the start of this year, including higher growth and sustained profitability. Strong execution in our utility markets this quarter grow strong top line revenue of $43.8 million, an increase of 54% versus the first quarter and 62% year-over-year, well ahead of what we believe to be current market growth rates. We also delivered non-GAAP profitability of $0.05 per share this quarter.

Given our momentum in the first half of this year, we are confident in our outlook for a strong growth in 2011 and are raising our guidance for year-over-year revenue growth to 35% to 40%. Though an increase in contract manufacturing cost for our Utility products will limit our ability to maintain profitability for the remainder of 2011, our outlook for full year profitability in 2012 is intact as we implement plans to reduce product cost through design refinements and other activities.

Although early days, our go-to-market strategy of focusing on vertical segments and geographies with the right fundamentals for growth, is starting to show results. We are increasingly active in areas of the world where energy supply cannot meet demand, government mandates are strong and fast and lack of consumer limit utility operations. Our strong market position in northern Europe, bolstered by new wins this quarter, provides a great foundation for focusing eastward. And our performance and experience with customers there will be invaluable as we move into Latin America and Asia.

I'm very excited about our new partnership with Holley Metering to introduce Echelon's smart grid communications and control technology to the Chinese market. China fits all our criteria for a hot [ph] market, and Holley is a clear leader that expects to ship 10 million meters this year alone. The proven reliability of our power line components and the unique capabilities of our Echelon Control Nodes and Control Operating System, COS, will further differentiate Holley's offerings and accelerate its penetration of the market.

Now let's turn to our market updates. We had a number of new wins in our utility markets, and I'd like to highlight 3 of them. These wins illustrate the power of our multipronged sales strategy of offering system solutions, subsystems and components and leveraging partners based on the needs of the market.

The first project I will highlight is our resent NES win in Norway. Through our partner Telvent, Echelon was awarded a contract with Fortum Norway for 100,000 meters, with volume deployments beginning in August of 2013. Fortum has the option to expand the Echelon system with our recently announced power line interface to in-building devices. Powered by our COS software, this interface allows utilities to easily and reliably connect to devices such as in-home displays and load controllers.

This announcement represents the first significant smart meter award in Norway, which is a $2.6 million meter market. Similar to much of Europe, Norway recently issued a mandate requiring utilities to begin deploying smart metering systems. The mandates sets a high bar for minimum system functionality, enabling a feature-rich system such as ours to shine.

We also had a small but important win in Denmark this quarter with the potential to reach a much broader utility audience. Though I can't share all of the details with you at this time, what is particularly compelling is that our partner will host our system software using their IT infrastructure and operate it as a cloud service to other utilities. About 1 million of Denmark's 3.3 million meters are spread out over 105 utilities. These smaller utilities will benefit from the leverage of a cloud-based solution.

While we see great potential in Denmark, we also believe this new offering has significant potential for other markets. For example, of the 876 utilities in Germany, 800 serve less than 100,000 customers each. The challenges facing these smaller utilities are similar to those in Denmark. Now we have a new and innovative way to reach them.

With over 43 million meters nationwide, Germany is a very large market. While it has been one of the slower moving territories in Europe to adopt a national smart grid mandate, the planned shutdown of several nuclear plants should accelerate the market. Recent reports indicate the government will issue new energy requirements by the fall, including a timeline for wide-scale deployment of smart grid.

A few German utilities have decided to roll out smart meters ahead of a clear mandate. One example is Numbrecht, which recently chose Echelon system solution for its 6,000-meter citywide deployment beginning next year. This win came after successful pilots by our partner, EVB Solutions Energy of the Diehl Gruppe. EVB offers a pilot-in-a-box solution that includes cloud-based access to EVB smart meter software to enable a utility to quickly see business benefits from its deployments.

These are just a few of the many European pilots and deployments that demonstrate the growing pervasiveness of Echelon's technology. We are very pleased that in recognition of our accomplishments, Echelon was recently presented Frost & Sullivan's 2011 European Market Share Leadership Award in the smart meter market, highlighting our 81% market share in 2010 with about 35 million installed meters powered by Echelon. Frost & Sullivan also distinguished our NES system as the most proven, reliable and scalable of any smart grid solution available today.

Also this quarter, we reached an important milestone in extending our technology leadership with the granting of our 100th U.S. patent. I'm pleased that the vast majority of our patent portfolio is enabling companies to build highly reliable and scalable control networking devices and systems. We are seeing more proof of this differentiation as customers share their performance reports and as they benefit from utilizing our expanded functionality.

Two such reports came from Duke Energy and an independent auditor to the Ohio PUC. We were very pleased with the findings in both, which confirm the benefits enabled by our system, in particular, the high level of accuracy and extended functionality of our meters. The auditors also found no data integrity issues or errors in calculating customers' bills in their sampling and highlighted a number of our features that directly increase customer satisfaction. Additionally, we shipped our Edge Control Node to Duke on schedule at the end of June for extended field trials and look forward to production shipments beginning late this year.

Let's move on to China. With the total market size of approximately 300 million meters over the next 5 years and broad government-mandated energy efficiency goals, China is poised to be an important source of growth for Echelon. This market meets most of the key criteria we have established for our target markets: demand outstripping supply, renewables integration and strong state mandates. Chinese authorities have established their own smart grid standards, and power line communication is preferred. We are confident that Echelon's power line solution is far more robust than indigenous options, leading to a significant opportunity for us. In our experience, the only way -- the only successfully way to capture this market is to work with local manufacturers, integrating our subsystems into their solutions.

For nearly 40 years, our new partner, Holley Metering, has been shipping electricity and gas meters into State Grid Corporation of China, which represents 88% of the national territory and serves a population of over 1 billion; and China's Southern Power Grid, which covers a population of 230 million. Under new agreement, we will be adapting our power line communication, control nodes and COS software to the Chinese standard, and Holley Metering will be promoting our technology as part of their smart metering systems.

In some ways, our agreement with Holley Metering parallels Echelon's original component arrangement within Enel in Italy. The 30-million-meter Enel system using Echelon's components and technologies is still the largest and most successful smart grid deployment in the world.

Now a word on cost and our utility markets. In the next several quarters, we expect to have increases in our manufacturing cost that are in excess of our ability to recover in the same timeframe through value engineering. Plus, we took on a bit more operating expense in conjunction with our Holley agreement. As Chris will discuss, we are confident that we can recover from these increases and maintain intact our commitment to 2012 profitability.

Now let me turn to our commercial markets. Building automation components remain the majority of our Commercial business. For the most part, we are seeing this market resume its prerecession growth rates, recovering along with the real estate markets. Having introduced the FT 5000 Smart Transceiver, Echelon's next-generation chip for smart grid control networks and a key product in the LonWorks 2.0 platform last year, we are beginning to see our customers launch new products based on this technology, reflecting their continued satisfaction with our offerings.

In our 3 targeted emerging vertical markets of street lighting, renewables and building energy management systems, we are seeing the most progress with street lighting. The payback for these investments is fairly quick and the sales targets and process, relatively clear. Many of the same dynamics driving demand for the smart grid will also drive street lighting control system demand, including electricity supply shortages and political mandates.

We currently have 450 cities conducting street lighting pilots and initial deployments with our technology. This quarter, we began to partner with LED lighting companies that are entering this market. We're also starting to see an increasing number of projects coming up for bid in Europe and are actively bidding on some large contracts in Asia. In China, one of our largest regions in street lighting, we had several wins this quarter, reflecting the success of the ESCO model and the strong growth in that region.

In building energy management, our software partnerships are producing activity. However, sales cycles are long and sales, fragmented. We have several pilots underway in the U.S. with various companies and one significant win this quarter with a 2,400-location retail store chain.

Before I close, I would like to welcome Livio Gallo of Enel to our Board of Directors. As a top operating officer in one of the world's largest utilities, with vision and execution capability to build Enel's extremely successful smart grid system, we hope to learn much from Livio.

In summary, we made good progress in a number of key areas in Q2. Our discipline at focusing on markets that meet our criteria is starting to pay off. Our flexible systems, subsystems and components approach to the market is opening up new partnerships and opportunities. And the reliability, survivability and performance of our systems are being confirmed by our customers via new wins and industry analyst awards. Our vertical market focus in the Commercial business is showing promise, although there is more work to be done there. And most importantly, we are tracking to our commitments for growth and sustained profitability.

Finally, I want to thank all of the employees of Echelon around the world for their hard work and good progress we are making with our business plan.

Now let me turn the call over to Chris. Chris?

Oliver Stanfield

Thanks, Ron. Good afternoon, everyone, and thank you for joining us on our second quarter earnings call. 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 June 30, 2011, which can be found on the Investor Relations section of our website

Turning to Slide 8. Revenues of $43.7 million increased 62% from $27 million in the second quarter of 2010. On Slide 9, our strong Utility performance of $29.3 million in the quarter drove the majority of the growth, up from $13.5 million a year ago. Commercial revenue has also improved over last year to $12.7 million, up from $11.9 million. Revenue from Enel in the second quarter was $1.8 million compared to $1.6 million in the same period of last year.

Moving to Slide 10. Second quarter non-GAAP gross margin was 46.5%, slightly above our guidance and above last year's non-GAAP gross margin of 42.2%. Part of the year-over-year increase was due to improved margins on our Utility products and overall higher revenue levels, while the remainder was attributable to a stronger service revenues from Enel and customers in our Utility business.

Non-GAAP operating expenses for the second quarter were $17.4 million, up from $15.2 million in the same period a year ago. Non-GAAP product development expense drove the majority of this interest, up $1.2 million to $8.1 million this quarter. This increase was primarily due to the timing of customer funding for some of our product development expense.

As you may remember from our earnings call in February, approximately $4.5 million of our full year 2010 product development expense were offset by customer deposit payments we received. Of this $4.5 million, approximately $1.4 million was used to offset product development expenses in the second quarter of 2010, whereas the offset in the second quarter of this year was only $300,000.

Excluding the impact of these offsets, our non-GAAP product development expenses remained relatively flat year-over-year. Non-GAAP sales and marketing expenses increased $467,000 over last year to $5.7 million in keeping with our strategy of focusing more on sales and marketing.

Non-GAAP general and administrative expenses increased $572,000 over the last year to $3.7 million, primarily driven by cost associated with accruals for our performance-based 2011 management bonus plan as well as expenses we incurred in connection with the negotiation of our newly announced agreement with Holley Metering that Ron spoke about earlier in his remarks.

Interest and other expense was $153,000 in the second quarter, down from interest and other income of $504,000 that's been incurred in the last year. The reduction was driven by foreign currency translation losses during the second quarter of 2011 compared to translation gains on these balances in the same period of last year.

Our GAAP net loss for the quarter -- for the second quarter of 2011 was $141,000 or $0.00 per share. This compares to a GAAP net loss of $6.9 million or $0.17 per share in the same period a year ago. Our non-GAAP net income for the quarter was $2.2 million or $0.05 per share compared to non-GAAP net loss of $3.9 million or $0.09 per share in the second quarter of 2010.

Moving to the balance sheet on Slide 11, we ended the second quarter with cash, cash equivalents and short-term investments of $56.2 million, a $4.7 million decrease from last quarter.

Before I provide an update on guidance, I want to discuss some of the cost increases that will impact our gross margins in the near term. As you know, commodity prices have increased substantially and somewhat surprisingly fast over the past few quarters. Labor rates in China have also been on the rise. We anticipated some level of increase for these costs earlier in the year and had modified our financial forecast to accommodate them while at the same time focusing our resources to mitigate the impact of these underlying trends.

However, as of July 1, our contract to manufacturer, Jabil, further increased their pricing for the manufacturing of our Utility products to an extent that we cannot offset in the near term. These cost increases will phase in over the third quarter and will become fully effective at the beginning of the fourth quarter of 2011. Consequently, we expect our gross margins in the second half of 2011 will be negatively impacted by about 2 percentage points. Given the totality of these cost increases, our operations team has developed specific, high-priority plans through design and manufacturing cost reductions to offset the impact of the cost and return our gross margins historical levels as soon as possible.

With that said, I would like to turn to guidance for the third quarter and full year of 2011 on Slide 12. We expect total revenue for the third quarter of 2011 to be in the range of $42.5 million to $44.5 million, with Utility revenue accounting for about 66% of the total, commercial revenues, 30% and the remainder from Enel.

Given the cost increases we have outlined, we anticipate non-GAAP gross margin to be in the range of 40.7% to 41.3% for the third quarter. While we are disappointed in our margin values, we believe the heightened cost-reduction activities we are undertaking, along with our continuous process of valuing in our products to provide superior functionality to lowest cost will return -- will allow us to return our margins to levels recently seen over the next several quarters.

Finally, we estimate our GAAP loss per share will be between $0.05 and $0.08, and our non-GAAP loss per share will be between $0.00 to $0.03. Including our -- included in our estimates are additional customer payments from our product development activities that are tied to attainment of certain milestones, which are often hard to predict and subject to change.

For the full year of 2011, we have raised our expectations for revenue growth to 35% to 40% over 2010. We expect this strong performance to be driven by 60% to 70% growth in our Utility business, 5% to 10% growth in Commercial and 50% growth in the revenue from Enel.

Previously, we had said that we expect our full year non-GAAP operating expenses to increase in the high single-digit range over 2010. Now we expect operating expenses to increase 10% due to the additional cost that we will incur as a result of establishing our new arrangement with Holley Metering.

Looking forward to 2012, we have reviewed our forecast. And in spite of the impact of higher pricing from Jabil and the additional cost we will incur associated with the Holley Metering partnership, we continue to be confident that we will be profitable on a non-GAAP basis for the full year.

Now I'd like to turn the call back over to the operator for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Sean Hannan with Needham & Company.

Sean Hannan - Needham & Company, LLC

So I was looking to see if I could get a little bit of a feedback form you folks around how we should expect the continuation of the ramp as we go into 2012. Obviously, if you have some thoughts around the continued profitability, at this point, should we be expecting, at least from a pattern standpoint as we move through the year, something a little bit similar?

Ronald Sege

I'm sorry. Similar to what?

Sean Hannan - Needham & Company, LLC

To the current year.

Ronald Sege

Well, let me start. I'll turn it over to Chris. So we're not giving 2012 quarterly guidance, but we are reaffirming what we previously said is we expect to be profitable for the 2012 year. So we're not wavering from that commitment. And that's not GAAP, of course, Sean.

Oliver Stanfield

From a -- I think you're probably addressing the issue of Utility revenue. And from a Utility perspective, as you appreciate, the driver in terms of our growth issue has been that we've had full year deployment at both Duke and with Fortum. And we, of course, after our initial call, we're fortunate enough to win a new opportunity, an important new win in NRGi. As you look into next year, we expect all of those deployments to continue. We expect that we're going to see significant revenue contribution from our ECN product. We expect a contribution -- significant contribution from Brazil, and we expect to see contributions from the other markets that Ron outlined. And as you've picked up from Ron's presentation, we were very pleased, obviously, with Norway. You're very familiar with the pattern that occurred there with respect to our first win and everything that followed. And hopefully, Norway is for us as Denmark was for us.

Ronald Sege

Did we answer your question, Sean?

Sean Hannan - Needham & Company, LLC

Yes. That -- well, that's helpful. So you folks had mentioned that you were able to provide some product to Duke related to be ECN ECoS platform. How much of that product was actually delivered? How much is actually in the field with Duke at this point?

Ronald Sege

It's still, Sean, field trial quantities. So if you remember, previously, we said that we were shipping field trial units in June, which we did. And we're now going through the acceptance test process, and we continue to expect to ship production units by the end of this year. But volumes will only occur next year, and that's all consistent with what we previously guided to.

Sean Hannan - Needham & Company, LLC

Okay. And then lastly, in terms of the margins in the quarter -- sorry if I had missed part of this in the beginning of the call. It looks like there -- given the strength within the Utility group from a revenue standpoint, you must have had some fairly substantial margins there, at least on a relative basis versus prior quarters, in order to get to that 46.2%. Just looking to see if we can get a little color around what may have occurred in the different pieces of your business for those margin contributions.

Oliver Stanfield

Well, the -- from -- first of all, if you look back at our guidance, what you'll notice then is that we came in a little bit above our guidance. And the reason for that was that we had stronger than expected service revenues. Those can vary, and it's stronger than we had in Q1. It's stronger than we expect in Q3. And that contributed the extent to which we exceeded our guidance. We had always anticipated that we would see some decline in our margins in Q3. Because as you know, any company like ourselves, there is this constant balance between the increases you're seeing for commodities, for labor, et cetera and the design efforts that you're making to drive cost out of the product. And so we had expected some decline there. The portion that was different than our expectation had to do with what I spoke about in my remarks in terms of Jabil in the sense that they announced to us or provided us with notice that they were increasing some prices, and that affected our expectation by about 2 percentage points in terms of margin. But this is very much a tactical issue, and we believe, as I said in my prepared remarks, that we're going to be back to our historical margins in the next several quarters.

Operator

Our next question comes from the line Elaine Kwei with Jefferies.

Elaine Kwei - Jefferies & Company, Inc.

So based on your revenue guidance, it appears fiscal '11 is heavily weighted in 2Q and 3Q, and I was wondering if you could remind us which projects we could attribute this to. And then also, on the lower gross margin in 3Q, are you seeing any pressure in the pricing side? Or is it all from the cost side? And then would it be fair to assume that a good portion of that is commodities if Jabil was about 2%?

Ronald Sege

Yes. So, Elaine, Duke and Fortum, as we said previously, are the bulk of the drivers of our revenue in terms of -- and then on the pricing front, we're not seeing any appreciable pressure on pricing out in the marketplace, but obviously, we are seeing significant pressure on costs. And while we had expected cost increases and had built it into our internal modeling, they came faster and harder than we had expected. And while we have ongoing cost reduction, product cost reductions in place, unfortunately, those can't make up for -- we can't get them to market fast enough to make up for the speed and severity of the cost increases. But I've now told the team to prioritize cost reduction higher, because it will have a higher return on investment to us so we can get back on track to the guidance that we previously provided, and we feel very confident we can do that.

Oliver Stanfield

Elaine, one thing I would do is -- to answer the first portion of your question, if you look at Slide 14 and the slide deck that's available on our website, what we've done again this quarter is we've provided you with a summary of revenue for key customers. And what you'll see is very much what Ron was speaking about. As you know, Duke is obviously the Ohio project. Eltel would be the Danish projects. And Telvent is, of course, Fortum. So we give you that break out there, and we expect those same companies to be significant sources of revenue in Q3. As it relates to the difference between Q3 and Q4, that's entirely driven by the installation schedules of these customers. As you and I have discussed many times, installations are not done in a linear fashion, and that's just how these projects are installed this year.

Elaine Kwei - Jefferies & Company, Inc.

Okay, great. And just could you actually give us some additional color perhaps on how the partnership with Holley evolved specifically, what factors that led to Holley choosing Echelon over other competitors and then how you would you expect this to potentially translate to other markets that have different standards and requirements?

Ronald Sege

Okay. So the first question was, how did this come about? So as we talked for several quarters now, we're very focused on markets where the fundamentals for smart grid adoption are strong, so demand exceeding supply, government mandates, electric vehicles, sort of opaques, et cetera, et cetera. And China, clearly, is among the top of our hit parade for hot markets. So we set an objective for ourselves soon after I got here to get into the China market. And I've been over there a number of times, and we've been talking to most of the major metering players and developed the strongest relationship with the Holley and believe that they are the best partner for us. They're big. They're well positioned with State Grid and South Grid. They see the value in having a technology edge and in power line technology in particular, and they really wanted to work with a U.S. partner. So all those things, in my experience, lead to a great potential partnership. So that's how the relationship came about. As we announced, we entered into agreement, where we will be customizing our subsystems and components, our power line components, our mapping systems, our data concentrator and our COS software to the standards in China, and we will be selling those through Holley. So it will -- we will look like a local supplier in the Chinese marketplace, which is incredibly important, but we will provide Holley with significant differentiation. And in many respects, Elaine, this is very much like our relationship with Enel. And it really, in my judgment, in our judgment, is the only way to be successful in the Chinese marketplace. And obviously, I'm borrowing a little bit from my experience with Huawei 3Com. So does that help?

Elaine Kwei - Jefferies & Company, Inc.

It does.

Operator

Our next question comes from the line of Dale Pfau with Cantor Fitzgerald.

Dale Pfau - Cantor Fitzgerald & Co.

I’m going to get back again on Holley, and can you remind us again what are the major differences between the Chinese power line standards and what you've developed? How much work is that involved in there? What is the cost you expect to incur over what period of time? And when might we see revenues from Holley? And then of course, I've got a follow-up.

Ronald Sege

Okay. So first of all, China has mandated many things about smart grid, smart metering solutions. And effectively, the standards between the meter, the data concentrator and the head-in software are all tightly circumscribed. The one thing that they haven't defined is the lower layers of the communication protocol across the power line. So the good news is that our power line chips, our power line solution, can go in unchanged. So we -- what we really have to do is map our high-level protocols into the State Grid and South Grid standards. And that is not a super large development effort, so it won't cost us an enormous amount of money, and it won't take very long. So we expect to get into pilots in 2012.

Dale Pfau - Cantor Fitzgerald & Co.

Okay. Fabulous. Can we draw an analog between this and your relationship down in Brazil? Which one is stronger? And...

Ronald Sege

Well, they're both strong. They're both large markets. They both fit the criteria for being hot markets from our perspective. China's bigger, 300 million meters, so that's 10 Enels. The majority of our power line, that's at least 5 Enels. Brazil is a 65-million-meter market. So still very big and sort of approaching the size of the U.S., but not as big as China. In China, we are pursuing something closer to a component strategy. If you remember, we now have a system, subsystem and component strategy for getting the market. Sell the NES system wherever you can. But if you can't sell that, sell a subsystem in partnership with a local supplier like ELO. And then if not that, then sell components or lower-level subsystems, which is what we're doing with Holley. So Holley is more of a component strategy, and ELO is more of a subsystem strategy.

Dale Pfau - Cantor Fitzgerald & Co.

Great. That's very helpful. And one final question. We've been hearing that some utilities in the U.S. are examining their strategy and looking at just trying to use RF mesh work, but there are certain places that doesn't work and looking at maybe using power line or cellular for certain other pockets. Could you talk to us about have you received inquiries? Are there any pilots like that? And just a little bit of a thought about the development of the U.S. market.

Ronald Sege

We have had some of those discussions with utilities. And I would characterize there being some interest in that space, but I wouldn't characterize it as being overwhelming. As you know, the first reaction of the utility is to allow for opt out and to charge the customer extra to have the meter read manually. And so far, from what we can see, the PUCs are allowing that even though it -- we believe there's a better way, i.e. use power line, but I wouldn't say that there's a sea change. I will say that the U.S. market -- the interest in the U.S. market is moving significantly towards distribution automation and in particular, low-voltage distribution automation. So we believe that it makes it a right candidate for our Edge Control Node. And while in the near term, we're totally focused on our deliverables to Duke, we have started having discussions with other utilities. And in fact, I was on a sales call last week with the architect for distribution automation of a very large utility in the U.S. We went through the ECN, and he was very excited about it and wanted to know when he could get one in the lab and proceeded to say, "Hey, we've been looking for a model where intelligence and control is distributed out to the edge of the network so decisions could be made locally. And so far, all that we've seen are centralized control systems." So if you remember, the big differentiator for ECN, Edge Control Node, is the fact that those decisions are made at the edge in an open standard fashion. So I was very encouraged by a, the interest; b, the fact that this guy, who's probably seen all the solutions in the marketplace, would say that our solution is unique and very much consistent with his own view of the architecture. So we're quite optimistic about the prospects for ECN in the U.S. longer term.

Operator

Our next question comes from the line of Patrick Sullivan with Credit Suisse.

Patrick Sullivan

I hate to dwell on this. I just want to check the box here. So for the Holley Metering contract or agreement that's in place, I guess, should investors expect a similar margin profile than what we've seen with Enel? Or is there anything specific for what you're providing to Holley that might differentiate this contract a little bit? Anything we should be aware of?

Ronald Sege

Some -- I -- you should think of it as a -- as if having a component-like profile in terms of selling prices and margins. And yes, it does, we believe. It differentiates itself quite strongly from indigenous solutions. However, the pricing environment in China is pretty intense. So we just have to see how those things play against one another.

Patrick Sullivan

Okay. Then just 2 quick follow-up questions. First, in 2012, you mentioned you were expecting some pilots in China. What level of revenue are you expecting in your outlook from China and then also Brazil with the other arrangement?

Oliver Stanfield

We're not going to break that down at this time. I think we've -- we're very positive about the opportunities in China. Obviously, we're further along the path in Brazil in terms of having worked with ELO for a longer period of time. And my prediction would be that on these calls, at some future point, you're going to see those names listed on the exhibit that I just discussed with Elaine. But I don't want to get into the timing of that.

Ronald Sege

Yes. And the one thing I will say is, obviously, we started our partnership with ELO earlier, so we will get to revenue sooner than we will with Holley Metering in China.

Operator

The next question comes from the line of John Quealy with Canaccord.

John Quealy - Canaccord Genuity

First, just housekeeping again on the gross margins. Chris, when you're talking about 200 basis points of pressure from Jabil on the components, are you talking Q4 actual pro forma gross margin to what your guidance is for Q3? Or can you just clarify that, please?

Oliver Stanfield

What I'm saying is that away from that notice from Jabil, the guidance that I would have provided for Q3 would have been 2 full percentage points or 200 basis points higher than I provided.

John Quealy - Canaccord Genuity

Okay. And given the design cycle, we should expect that catch-up in cost to linger for a couple of quarters. Is that right, in 2012?

Oliver Stanfield

It'll linger for a little bit. But as Ron -- as I said earlier, there's nothing new about commodities going up. There's nothing new about labor. And as you know, what any manufacturer does is we work to drive down the cost of our products through design changes in which we reduce our exposure to some of those commodities. We take actions to reduce the amount of labor we're using through efficiency. And as Ron said, what has occurred as a result of these recent influx of cost pressures is those projects, which are on our road map, have moved up, and we expect that we will be able to rectify this and return to historical margins in several quarters.

Ronald Sege

I grew up in kind of the volume end of the networking world, where design for cost manufacturing and reliability were -- I mean, that's what you lived by. So this is a high priority for us, and there's lots of opportunity for cost improvement here.

John Quealy - Canaccord Genuity

And 2 final questions. First on Duke, can you tell us what percentage of that contract is completed for you guys? I know the ECNs might offer some other opportunity, but from an endpoint perspective, where are we?

Ronald Sege

They are -- as they are -- as reported, they're about halfway through their deployment. So that deployment will continue into 2012. And then we expect ECN volumes in 2012 as well.

John Quealy - Canaccord Genuity

And then lastly, Ron, for you. We've talked on a couple of calls and previously about your expectations of the sales force productivity and the cross-selling opportunity mostly on the Commercial side of the business. Can you give us an update on what you're seeing from the sales force on that side?

Ronald Sege

Sure. As I mentioned, we're making very good strides in street lighting. We're getting better and better visibility, and we're getting in more and more pilots. And we're understanding who to sell to, how to characterize the sale to them, who the competitors are and so on, and I'm quite happy and optimistic about that vertical. I also think that the solar opportunity for us from a components perspective remains strong, and we're having some very good discussions and building the pipeline there. The building energy management one, as I've said in my prepared remarks, still needs work. It's a longer, kind of more unpredictable sales cycle. Decision makers are very distributed, and the distribution channel is quite diverse. So that one I'd say we haven't quite cracked the code on. The other thing I would say, and I alluded to this in my prepared remarks, is the utility sales process and sales cycle is not unlike the street lighting one. And kind of the same factors are driving demand in both, which means that the geographic opportunity for smart meters and distribution automation is very similar to the one for street lighting, and I think we'll start seeing some synergies in our sales force as a result of that factor.

Operator

Our next question comes from the line of Carter Shoop with KeyBanc.

Carter Shoop - KeyBanc Capital Markets Inc.

I wanted to start off with a clarification on Duke. You said the volumes were halfway through. I assume you were talking about just for the Ohio deployment, not Indiana also.

Oliver Stanfield

Yes. So Duke issued a report recently, as you've probably seen, and they've done about half of their installations in that report.

Ronald Sege

In Ohio.

Carter Shoop - KeyBanc Capital Markets Inc.

Yes. And then can you help us to better understand the current RFP activity in Europe and specifically, if you were to win all of the RFPs that you're currently in -- out on negotiations with? Or what kind of revenue contribution could that be if you had 100% hit rate there?

Ronald Sege

Well, no, I can't. I can say that RFP activity and pipeline in Europe is strong, and it's generally been reported by -- in the industry, we think there will be accelerating demand in Europe, in Eastern Europe and in Russia in 2012. We believe we're very well positioned there. And again, we're not giving guidance for 2012, but we believe there's enough revenue there to deliver the profit commitment that we've -- that we have made to you guys. I guess the one change I would say again, which I discussed in the script, is we are more bullish and optimistic about Germany than we were last quarter because of the tragedy in Japan and therefore, their decision to decommission nuclear power plants. All of a sudden, they've become more of what we would characterize as a hot market, where demand -- supply no longer exceeds demand. And in fact, they're a net importer or will be a net importer of electricity from the rest of Europe. So we are seeing more interest in Germany. And as -- we've had some wins in Germany even in anticipation of the mandate which we expect in the fall. And we also, of course, talked in my prepared remarks about our cloud offering, which allows us to more effectively serve the fairly distributed market for the utilities in Germany.

Carter Shoop - KeyBanc Capital Markets Inc.

That's helpful. One more question if I may. Without giving guidance for 2012, can you help us better understand, which end market or which geography you're most excited about contributing on an incremental basis in 2012 versus 2011? Is it Eastern Europe, Brazil, potentially somewhere else?

Ronald Sege

Well, the bulk of our revenue will come from Europe and the tail end of Duke. But in terms of incremental contribution, it's the other geographies that we've talked about: Brazil, in particular and to a certain extent, Russia. And then we've got a more diversified footprint today than we've ever had in the past. So we also expect more kind of background or a run rate business coming from the increasingly broad geographic footprint that we have.

Oliver Stanfield

I think one way to think of it -- and because we've talked about Eastern Europe in the past and now we're starting to talk about Asia. One of the things we've talked about internally is the market is really moving to the East. And I'd like Ron to talk a little more about that.

Ronald Sege

Yes. I think, Carter, just in general, our hypothesis is if you look in the last couple of years, global demand for the smart grid has been -- there's been a background, obviously, in Europe, driven by Enel in the Northern European countries, which we participated strongly in. But then the bulk of the demand has been driven, 2009 and 2010 here in the United States, largely by government stimulus money. Our hypothesis is that growth and demand will now move to Europe starting in 2012 and then will move to Latin America and Asia in 2013 and beyond. So one of the reasons we're positioning ourselves the way we are is to be able to skate where the puck is going, specifically in Latin America and in Asia, while taking advantage of the large demand that remains in the U.S. and especially in Europe. Does that makes sense?

Carter Shoop - KeyBanc Capital Markets Inc.

Yes, that's very helpful.

Operator

Our next question comes from the line of Chris Kovacs with Robert Baird.

Benjamin Kallo - Robert W. Baird & Co. Incorporated

It's Ben Kallo from Baird. I just -- I want to go back to the street lighting deals. As you mentioned, the couple of hundred cities where you got pilots, could you just kind of walk us through that opportunity? There's full rollouts in the cities. Like how big is a deal? How long of a timeframe, that kind of thing.

Ronald Sege

Sure. So just in the macro sense, there's a couple hundred million street lights in the world. And typically, we believe that we can -- well, our customers are reporting to us that we can cut the consumption of energy of a street lighting system by mid-40s percent before we installed our system to after we've installed our system. And therefore, the payback is a matter of 2, 3, 4 years. So that makes it a very compelling solution for cities who have strong mandates, especially in places like China and Europe, where there's strong political mandates to save energy. As a mayor, you look at all the ways I'm spending energy in my city. It turns out street lighting is usually #1. So that's the -- kind of the macro characteristic. We have guided towards our revenue being $10 to $15 per street lamp or per pole, and that's a combination of our power line communication technology, our control node technology. And then in some cases, we participate in providing the head-in software, the control software that allows you to monitor and manage the streetlights. The deal typically starts with a pilot. And so a lot of the deals we've talked about when we refer to 450 deployments, they are mostly pilots. They run for some period of time and then turn into deployment. So that sale cycle may be 12 to 18 months and then the deployment may be 18 to 24 months.

Benjamin Kallo - Robert W. Baird & Co. Incorporated

So at this time, would you say that revenue for street lights is less than 1%, 2%? And then where would that be in 2012 and 2013?

Ronald Sege

Yes. It is -- it's not yet material to our business, but it will -- we believe it will be a rapidly growing portion of our revenue over the next several years.

Oliver Stanfield

And Ben, I would remind you of our strategy. And our strategy is that, obviously, we are heavily concentrated in building automation. That's a good place to be, because saving energy is key in those applications. But that business is not experiencing explosive growth. And so our focus has been to attach ourselves to markets that are small today. We're going to grow very rapidly, and one of those markets is street lighting.

Operator

Our next question comes from the line of Colin Rusch with ThinkEquity.

Colin Rusch - ThinkEquity LLC

Can you talk about the competitive environment in data aggregators and cloud-based solutions for Edge Control? Obviously, you're not the only vendor selling it to Duke in that space. And how do you see that space evolve over the next couple of years?

Ronald Sege

Well, this really gets to the fundamentals of our approach and our philosophy versus our competitors. So many of our competitors are what I would call routers. They just operate at the communication level, and they're -- we some time refer to them pejoratively as mules. So they collect data at the edge and send it back to the head end, where the data is collected, analyzed and decisions are made. We have -- in our -- my customer visit last week, reinforced the fact that everything he had seen so far presented by our competitors follows that architecture. We have a distributed control architecture, where we actually distribute from our head-end software the decision-making algorithms into our Edge Control Node via our Control Operating System so that telemetry can be collected locally, analyzed locally, decisions made and control actions or control commands issued. So the only thing that goes back to the head end are exceptions. So this allows a much more reliable system, a much more survivable one, because the data center can be down, the communication links can be down, and our system still operates in a much higher performance one, because decisions gets made with minimal latency, which is critical when you're controlling electricity. And that's something that customers are almost demanding, because they're drowning in data. And the cost of bringing it all back, mostly for no good reason, is getting quite significant. So we think it's unique. Our customers are telling us it's unique, and we just got to get it in deployment to Duke and then start fulfilling the rest of our pipeline.

Colin Rusch - ThinkEquity LLC

And changing gears just a little bit. You mentioned building automation is a bit of a murky sales cycle. You're saying you're getting used to it, but can you give us an update on what's happening in Fortum? It's obviously, I think, an interesting application of the technology to look at enterprise-wide command and control? How much work have you done with them? When -- and when can we expect to see to sales through that channel?

Ronald Sege

Sure. So just one clarification. So we distinguish business -- building automation from building energy management. So our building automation segment are the components that we sell typically through OEMs, Honeywell, Johnson Control and so on. And that is the bulk of our business, and that is not a murky sales cycle. It's a design-in business, so the sales cycles are long. But once we're in, it's a run rate business and very -- generally, very predictable and very clear. So that -- the business that I described as being a little more problematic is our building energy management business, where we approach, in partnership with guys like Infor, large end users, education facilities, quick-service restaurants and so on and sell them a complete turnkey system of our control nodes, sub-meters and then Infor's -- in this case, Infor's enterprise management system. So that -- the building energy management business, I did allude to a 2,400-store retail chain win that we had this quarter, and that would be an example of a building energy management win. So there is business out there. We've just got to find a way to get it more systematically and at a higher rate. So our relationship with Infor, they have an enterprise asset management system, and building energy management is one of the modules in that system. And what we agreed with them, that we announced several quarters ago, is that we would go to market together with a pre-integrated solution that includes their software and our control software and hardware. We are approaching the market together, and I would -- we're building a pipeline, but I'd say that it's early days, and I have no win to announce today.

Colin Rusch - ThinkEquity LLC

Great. And just one final quick question. When do you expect to -- that we'll see the volume products for intermittent renewable management in the marketplace using Echelon products? I understand that you've got few things that are going out, but when do you expect to see real material revenue from that segment?

Ronald Sege

My -- and I assume you're talking about our solar vertical, so integrating, for example, solar into control networks in the grid. Yes?

Colin Rusch - ThinkEquity LLC

Yes.

Ronald Sege

Okay. So first of all, our Edge Control Node fits right there. We will have revenue from that next year. We are in discussions with a number of solar panel and solar inverter and micro inverter customers. It's a design-in business, which means it's a 12- to 18-month design cycle. So maybe we'll get some revenue from that in 2012. But if we're successful there, that will be 2013 business.

Operator

Our next question comes from the line of Craig Irwin with Wedbush.

Craig Irwin - Wedbush Securities Inc.

First question I wanted to ask is really a clarification. On the last page of your slides that you provided, you give a long-term target model for percentage of revenue margin, R&D, SG&A, et cetera. Can you share with us what level of revenue this target model is based on for you to achieve those margins and overall cost burden assumptions?

Ronald Sege

Now that is Chris' line.

Oliver Stanfield

The -- that is a level that we will attain in a few years. We're not specific about that revenue level. I think, as you can observe, if we -- the way that I tell people to think about it, historically, before we had this tremendous opportunity come in China, if you can sort of for that, if you grow expenses at single digits and you grow revenues at double digits, you'll see you get -- you'll get to the approximate levels you achieve that at. And so it is not something that we think is in the far distant future. Clearly, we have to do some more work now in margin, because we were getting pretty close to that number. We'll recover that, as I said, in the next several quarters. And so we see it as a place that we will be in a time that's relevant to all of us, but it's not something I want to encourage you to think about in terms of next year.

Craig Irwin - Wedbush Securities Inc.

That's definitely understood. And then your comment about growing expenses at single digits and revenue in double digits is a nice segue into my next question. So first half over first half, you grew revenue 60%, but frictional cost excluding R&D were up 14%. And in the second quarter, your SG&A was below what I was expecting. Can you share us just some general color, how should we be looking at SG&A growth over the next several quarters? I'm not asking for guidance, but do you expect to maintain the same level of fiscal discipline that you have been delivering over the last few quarters. And 10%, is that a number?

Oliver Stanfield

No. I think -- and let me come at it a different way. I think, as we told you, we have a path here in terms of -- we started making our sales and marketing investments early in the year. Some of the savings that we're generating in other departments are pacing in over the year. We are going to get to Q4 to -- and exit rate in terms of spending, and we are going to manage that very carefully. We're going to limit the growth of that expense to the maximum extent possible. And I think the actions that we took last year -- and to be frank, in which we reduced spending in all of the aggregates other than sales and marketing -- were useful, because what it does is it gets us to a level that we can sort of grow those expenses at reasonably comparable rates and then grow into the spending levels that are shown on those charts that should show there. And so the message for the future is yes, we are going to maintain our spending discipline. Of course, when you have opportunities that you've become aware of like this tremendous opportunity in China, we're not going to be foolish and walk away from it, because it doesn't fit inside that model. But you should assume that operating expense growth will be modest. And that hopefully, revenue growth will be faster in it, and you understand the calculus just fine in terms of how that -- how we get to that model.

Ronald Sege

And, Craig, I'd say one other thing about this last slide. We think it's useful for you, but it's also very useful for us. So you can rest assured that every one of the executives that Echelon has these numbers tattooed on their forehead, and we are all driving relentlessly but prudently to this model.

Craig Irwin - Wedbush Securities Inc.

Great. Great. So my next question is about gross margins. You'd see that the top end of your guidance range for the quarter, basically 46.5% versus a top of 46%. Can you share with us what went better than expectations in the quarter? And the second part of the question is if we assume that your commercial products have held steady on gross margins, it looks like the Utility products continue to have fairly significant margin improvement. Completely understand the comments about what we're looking at for the back half of the year, but can you share with us where the margin improvement came from and what you think longer-term margin potential is for the Utilities side of business?

Oliver Stanfield

Certainly. With respect to Q2, the reason that -- in my opinion, that we exceeded guidance was because we exceeded guidance in terms of our services revenue, and that drove the modest amount by which we exceeded the guidance range that Ron and I provided in our last call. As it relates to what's going on in margins, you are correct. The improvements that we're making have been historically in Utility, and those come from the actions that we described earlier. We are constantly in the process of taking actions in terms of our product line in which we are trying to find ways to reduce the amount of metals that are subject to large price increases, the designing in for manufacturing, to improve the labor efficiency of our products, and those economies have been flowing through. To some extent, what they've done in previous quarters is offset the increases that have flowed through in terms of commodities. But overall, we've been making steady progress, and that's the path that we're going to continue on. And our goal is the goal that we've always had, and that is to continue to value engine our products, to provide superior functionality to our customers so each new version, you get more, and we do it for ourselves at a cost that's lower to us.

Craig Irwin - Wedbush Securities Inc.

So you don't -- just to be more direct there, do you want to share with us a number that you want to get to on the Utilities side?

Oliver Stanfield

No, I don't want to get into it, because it varies so much by -- as you would appreciate, by meter type, by configuration. The average stuff versus the problem of all average averages in the sense that there's too much standard deviation around it.

Craig Irwin - Wedbush Securities Inc.

Understood. And then my last question before I hop back in the queue. Your margin guidance for the third quarter, if we just take that compared to what you achieved in the second quarter, suggests maybe a $2.3 million headwind in margins now. You've shared a little bit about what's going on at Jabil, but can you give us a little bit of a breakdown on that incremental expense? Where the different pieces are coming from? And how much of that is really discreet in nature and will roll off relatively quickly versus something we should view as recurring.

Oliver Stanfield

Well, yes. And I think the most significantly effect is Jabil, as you would figure out, obviously, in terms of just looking at the number of basis points involved. The next most significant effect, if we're doing sort of a Q2 to Q3 roll forward, would be other cost increase in terms of products. We had been aware of the fact, obviously, that there had been other increases in commodities. We had built that into our models. And so we had expected our gross margins to come down a little bit just because of that. We are, unfortunately, going to not do as well in the third quarter in indirect cost of goods sold as we did in the second quarter. We manage those very carefully, as you know. We did an outstanding job in Q2. We're going to do a good job in Q3, but frankly, not as good. And then part of it is just what we talked about a moment ago. And that is we have more service revenue, and that probably contributed about 15% or 17% of the period-to-period change in gross margin points.

Operator

Our next question comes from the line of Ben Schuman with Pacific Crest Securities.

Benjamin Schuman - Pacific Crest Securities, Inc.

If I go back and look at it now, I get to about $10 per end point. I guess, a, is that correct? And b, is that a good kind of baseline to start with for Holley with the component relationship there?

Ronald Sege

I think that's approximately correct for what we guided to back then. So sort of directionally, with Holley, yes. I mean it's a different world. China is a more competitive place, and it's a slightly different composition than we're offering to Holley than Enel. But I would say you're in the ballpark.

Oliver Stanfield

So I think you're correct with Enel, but what I would also tell you is that with respect to -- if you look back at our building automation customers, they were paying more for transceivers 11 years ago than they pay today. And so as you know, one of the reasons that we have established the position we have is we constantly drive new versions of our products to provide more functionality to our customers at lower cost. And so many of those Enel meters were deployed with products that are actually backed 2 generations, if you will. And so you have to allow for the fact that if you made, as I said, the same test with Honeywell or to Johnson, you would see they're paying less today. At the -- these LonWorks 2.0 components are cheaper and faster than the products those same companies were using 10 years ago.

Ronald Sege

The other point I would make more generally is in some respects, Enel was really a beachhead for Echelon in the European marketplace and that we expanded our offering on the basis of that into other parts of Europe into a more turnkey solution. And we're hopeful that Holley presents us with the same kind of foundation or beachhead into the Chinese marketplace, and that over time, we can expand our [indiscernible] there into ECN, for example, and other parts of the food chain.

Benjamin Schuman - Pacific Crest Securities, Inc.

Okay. And then quickly, Norway, is that pretty much the same set of competitors as you guys say in Sweden and Denmark, essentially, Echelon and Landis? Or have more competitors kind of jumped into that Scandinavian market in the last few years?

Oliver Stanfield

I would say it's the same cast of characters. There are more competitors other than Landis, but you're correct. It's always Landis and Echelon and then there are any number of smaller companies.

Operator

Our next question comes from the line of Michael Cox of Piper.

Michael Cox - Piper Jaffray Companies

Two questions. One on how you're incorporating the Indiana component of the Duke project, I guess, if you will, into your planning.

Oliver Stanfield

Yes. We're assuming that there will be a pilot next year. We're assuming that -- that no decision will be made on that until all the matters are sorted out with regard to the cost, with regards to the power plant that's going to be some portion of what's just going into the rate base.

Michael Cox - Piper Jaffray Companies

Okay. Very good. And my second question. As you outlined throughout the call a lot of different geographic opportunities and product opportunities, but what's the risk of getting spread too thin across all of these different growth opportunities? And I guess, a different way to ask the same question is what's the risk that OpEx starts to ramp up faster as you try to attack all of them?

Ronald Sege

Well, as I said to the previous caller, we have this OpEx model emblazoned on our forehead. So we're living within a very strict selling cost envelope, and we're watching it very carefully. And the good news is that for the most part, geographic breadth is -- really, it tends to drive sales and marketing spending, which is tied to headcount, which we can control very tightly. So yes, we are casting our net more broadly, but we are casting it more and more with partners where they are doing the increasing percentage of the work. So we're leveraging ourselves that way in one dimension and then in the other dimension, we are very, very focused on this criteria, this hotness criteria, if you will, so we're only going after markets where we believe that their -- the fundamentals are right for near-term demand creation. So we expect our selling effectiveness to be higher and our R&D leverage to be higher.

Operator

Your last question comes from the line of Joe Maxa with Dougherty & Company.

Unknown Analyst -

This is Ash for Joe. I -- all my questions have been answered.

Ronald Sege

Well, thank you all very much for your interest in Echelon. And this concludes our Q2 call, and we'll talk to you next quarter. Bye-bye.

Operator

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

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