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Echelon (NASDAQ:ELON)

Q3 2011 Earnings Call

November 03, 2011 5:00 pm ET

Executives

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

Ronald A. Sege - Chairman, Chief Executive Officer, President and Member of Stock Option Committee

Annie Leschin - IR

Analysts

Benjamin Schuman - Pacific Crest Securities, Inc., Research Division

Craig E. Irwin - Wedbush Securities Inc., Research Division

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

Mark Sigal - Canaccord Genuity, Research Division

Dale Pfau - Cantor Fitzgerald & Co., Research Division

Patrick Sullivan

Joseph A. Maxa - Dougherty & Company LLC, Research Division

Colin W. Rusch - ThinkEquity LLC, Research Division

Elaine Kwei - Jefferies & Company, Inc., Research Division

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

Operator

Good afternoon, ladies and gentlemen, and welcome to the Echelon Third Quarter 2011 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. And I would now like to hand the call over to your host for today, Ms. Annie Leschin, Investor Relations. Please proceed.

Annie Leschin

Thank you, Operator. Hello, everyone, and thank you for joining us this afternoon for our third quarter 2011 earnings conference call. With me on today's call are Ron Sege, 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 a short time ago. If you would like a copy, please visit our website at www.echelon.com. Additionally, this quarter, we're going to refer to a set of 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'd like to let everyone know that in the quarter, Echelon will be participating in NASDAQ OMX and Tech America Conference on November 7 in San Diego, The Stephens Fall Investment Conference on November 15 in New York, The Raymond James Fall Investor Conference on November 17 in Boston, The Baird Clean Tech Conference on November 30 in San Francisco and the Goldman Sachs Clean Energy and Power Conference on December 8 and 9 in New York City. If additional events are scheduled, we'll make other announcements. Now, I'd 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 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 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. 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, Annie. Good afternoon and thank you for joining us for our third quarter conference call. First, I would like to take a moment to acknowledge, Ken Oshman, the longtime Chairman and CEO of Echelon. As you know, Ken passed away in early August. A sad time for all but especially for those of us who had known and worked with Ken for so long. He was a brilliant, well-respected man and a visionary leader. We all miss him dearly.

As you saw in our release earlier today, we announced an important development with our Edge Control Node project at Duke Energy. I will provide more detail on that later in my remarks, but first, I will go through the highlights of the quarter to provide some context. I'm pleased to report that we once again made progress towards our financial goals of growth and profitability this quarter. Strength in our utility markets grew 62% year-over-year growth in topline performance to $43.8 million and non-GAAP profitability of $0.04 per share. We were also cash flow positive for the quarter. We continue to ship products and volume to large utility customers, achieved a critical milestone in Brazil, built momentum with our partnership in China and achieved new wins in our street lighting vertical. Our recent European customer and partner event reinforced growing interest in our vision of a proven, open standard energy-control networking platform that runs metering and many other applications. It also reinforced our geographic targeting strategy, ranking attractiveness in terms of energy shortages, non-technical loss rates, political backing and distribution grid health.

Overall, we remained confident in our outlook for a strong 2011 with annual revenue growth at the high end of our previously guided range of 40% and our commitment to our goal of full year non-GAAP profitability for 2012.

Now let me turn to updates on our Utility business. Large scale deployments at Duke, Fortum, Landis and NRGi are ongoing. Our deployment with Fortum, Finland is exhilarating with Zigbee wireless and Echelon power line communication links, connecting the Fortum grid with home area networks to provide multi-application support. We are excited about our new power line connectivity option as we believe it will provide a highly reliable connection to customers' in-home displays and controllers. Our meters with home power line connections are currently shipping with hardware support to be followed early next year by the remotely upgradable enabling COS software. We have several other small wins this quarter including in Denmark, Russia and Switzerland. In general, political support for the Smart Grid remains strong in Europe where Smart Grid rollouts are deploying at a steady pace and pushing the envelope in terms of applications.

Another highlight of the quarter was Brazil, where our partner, ELO, received approval for its smart meters from the government regulator in Metro. This paves the way for ELO to begin selling Echelon powered meters to Brazil's 63 million meter market where smart meters are mandated by 2021. With the leading market share in Brazil, ELO has been priming the market and building a pipeline of targeted pilots. Brazil scores well in terms of our geographic attractiveness ranking as do other countries in Latin America and we believe ELO has a significant first mover advantage. This partnership demonstrates a success in benefits of our flexible sales strategy of selling systems, subsystems or components based on market needs. By using our proven, open standard energy control networking subsystems for its meter designs, ELO is capitalizing on Echelon's widely deployed technology, leveraging our R&D capabilities and accelerating ELO's time to market.

At the same time, Echelon is entering the Brazilian market more quickly, leveraging ELO's manufacturing and market-leading position. Our non-Brazilian customers also get another source of truly interoperable open smart grid protocol meters satisfying multi-source requirements. We seek good opportunities to employ our subsystem sales strategy for similar partnerships throughout the world, especially in Asia.

Our component strategy is also progressing through our partnership with Holley Metering in China. Holley completed its initial prototypes of meters with Echelon power line communications technology this quarter and we expect pilots in the first half of 2012. Given the national goal of replacing China's 300 million meters over 5 years, we are excited to be among the first Western companies to enter this market with such a strong partner using our technology. Our strategy of targeting attractive geographies and providing multi-application solutions was reconfirmed this quarter at industry events we participated in. Metering in Europe was very well attended, with utilities from around the world, especially Asia and Latin America, reinforcing the momentum we see outside the U.S.

While markets such as France and Germany have not ramped as quickly as forecasted, strong interest in the smart grid in this region continues as the 2020 mandate looms. During this event, we announced that Oracle has integrated its suite of smart grid applications, building operational support systems and meter data management with our COS framework. The resulting joint solutions will allow utilities to quickly and reliably manage their assets, saving them as much as 50% of their deployment cost through pre-integration. We are excited to begin selling this offering with Oracle to prospects worldwide.

Another recent event reflecting industry momentum was our annual smart grid conference in Prague. With key solution and application development partners, utility and industry analysts. Partners remain of paramount importance to us and are a key part of our strategy to build out the smart grid. We are fortunate to be one of the few players with such strong and broad relationships. Partners like Eltel and Telvent and utilities CEZ, NRGi and Vattenfall joined us to share their success stories and learnings. Our development partners demonstrated their latest innovation, highlighting the value of our open standard, multi- application platform to their customers. Two such partners were Greentech -- GreenWave Reality and System Level Solutions. GreenWave is marrying the power of smart meters with advanced home services in many Scandinavian utilities and will leverage power line and Zigbee connections to our meters. SLS demonstrated a unique energy management console, currently piloting at Fortum, that allows bi-directional information between the utility and the end-user over Echelon's proven power line technology. This gives utilities and service providers near real-time visibility to energy usage to better serve their customers. Together these solutions represent some of the best applications of the smart grid, offering additional value to our customers worldwide and demonstrating the power of Echelon's commitment to open standards. I found these 2 events very energizing. Applications that are only being talked about in the rest of the world are being deployed today in Europe.

Turning to our Commercial markets. Our OEM building automation components business drove the majority of activity this quarter as growth rates returned to more normalized level with a tentative recovery in real estate. Now in pre-emerging verticals, street lighting had the most activity, as many of the same dynamics driving demand for the smart grid applied. During the quarter, Oslo awarded a contract to the French company, CITELUM, the world's largest street lighting management firm, with over 2.4 million lights to deploy an Echelon and Streetlight.Vision based infrastructure to control the city streetlights. The solution places Echelon's COS powered streetlight controllers with application software from Streetlight.Vision in the 750 cabinets controlling Oslo's 65,000 streetlights. The project is expected to begin this quarter.

In Asia, the Japanese government selected ITOCHU, an Echelon distributor and one of the largest Japanese corporations engaged in smart grid and smart city projects, to deliver an intelligent streetlight pilot system to the city of Tsukuba. The first system of its kind in Japan, the Echelon energy control networking solution will help reduce power consumption, increase safety and security and save cost. Tsukuba is a key site for government and industry collaborations. While a small pilot, this could lead to a broader nationwide rollout to Japan's 10 million streetlights.

Finally, I want to update you on 2 important developments that occurred subsequent to the end of Q3. As announced in our press release today, unfortunately Duke has canceled the $14.5 million order for Edge Control Nodes that we announced in September 2010. Overall, our relationship with Duke remains strong. We continue to ship smart meters, data concentrators and enterprise software to Duke for its Ohio deployment. Our metering system, as performing very well as confirmed by the recent Ohio PUC report I discussed on our last call. Given the very recent regulatory decision that further delayed Duke's smart grid deployments outside of Ohio, it made sense for both companies to defer additional investment in a Duke-focused ECN until we have more visibility. Therefore, Echelon will ship our R&D investment to ECN and COS features for Europe and Latin American regions where we see more solid demands. We are of course, offering the ECN to other prospects in the United States where we especially see interest in its distribution automation applications. This re-prioritization also ensures that we free up R&D capacity to invest in projects targeting cost reductions and enhanced software differentiation as we drive to achieve our long-term financial margin levels. We believe Duke remains enthusiastic about the Echelon COS and ECN offerings and we plan to revisit our priorities when Duke jurisdictions become more promising.

Lastly, just announced yesterday, Bill Slakey will be joining our team as CFO and Executive Vice President. Bill has a strong experience as a public company CFO with Extreme Networks, Handspring and WJ Communications. I can't thank Chris Stanfield enough for his tremendous contribution, dedication and service to Echelon over the years. He has been a great partner to me and we all wish him the best in his well-deserved retirement. Bill will be joining us November 7 and Chris will stay on for several months to assist in the transition.

In summary, Echelon's continued success across several markets was again clear this quarter. While we are very disappointed that Duke did not receive the necessary regulatory approvals to move forward outside of Ohio at this time, we are optimistic about the many opportunities unfolding elsewhere in the world for our energy control networking solutions. Our approach of targeting countries with immediate critical needs is being emulated around the globe. Our flexible sales strategy of offering systems, subsystems and components continues to give us maximum exposure to global market opportunities that allows us to differentiate and bring benefits to our partners and customers most effectively. While some are concerned that the smart grid market is slowing in certain geographies, we witnessed firsthand this quarter the ongoing enthusiasm in this market. Finally, I want to thank all of the employees of Echelon around the world for their hard work and the good overall progress we are making with our business plan.

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

Oliver R. Stanfield

Thanks, Ron. Good afternoon, everyone, and thank you for joining us on our third 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 September 30, 2011, which can be found on the Investor Relations section of our website.

Turning to Slide 8. Revenues of $43.8 million increased 62% from $27.1 million in the third quarter of 2010. On Slide 9, our strong utility performance of $29.2 million drove the majority of growth this quarter, up from $13 million a year ago. Commercial revenues also improved slightly over the last year to $12.7 million, up from $12.5 million. Revenue from Enel in the third quarter was $2 million compared to $1.5 million in the same period of last year.

Moving on to Slide 10. Third quarter non-GAAP gross margin was 41.4%, below last year's third quarter non-GAAP gross margin of 47.3%. Our lower gross margin was due to the mix of business with a larger portion of our revenue coming from the lower margin Utility business. Also pressuring gross margins this quarter were the impacts of increased manufacturing cost that we have talked about on our last call. The impact of these cost increases began to phase in during the third quarter and is now fully effective in Q4. Our margins were also affected this quarter by initial shipments of meters that include the CNX 3000 module. This is the integrated power line communications module that Ron spoke about. We will provide Fortum with the COS software update next year that will enable full functionality of the module. GAAP requires that we expense the cost now and defer the module revenue until we deliver the software. While this had a minor negative impact on gross margins during the third quarter of 2011, we expect that we'll have a more significant impact from gross margins in Q4, reducing them by roughly 2.5 percentage points from where would they have otherwise been.

Non-GAAP operating expenses for the third quarter was $16.2 million, down from $16.4 million in the same period a year ago. Non-GAAP product development costs declined by $818,000 or 11.2% to $6.5 million. This reduction was primarily driven by reduced compensation expense attributable to the restructuring program we instituted earlier this year. Non-GAAP sales and marketing expenses increased by $217,000 or 4% to $5.6 million in keeping with our strategy of continuing to invest in sales and marketing. Non-GAAP general and administrative expenses increased by $398,000 or 10.6% to $4.2 million driven primarily by costs associated with accruals for our performance-based 2011 management bonus. Interest and other income was $390,000 in the third quarter, up from interest and other expense of $559,000 in the same period of last year. The reduction was driven by foreign currency translation gains during the third quarter of 2011 compared to translation losses we recorded on these balances during the same period in 2010. Non-GAAP net income for the quarter was $1.8 million or $0.04 per share, compared to a non-GAAP net loss of $4.7 million or $0.11 per share in the third quarter of 2010.

Moving to the balance sheet on Slide 11. We continue to carefully manage our working capital, ending the third quarter with cash, cash equivalents and short-term investments of $60.7 million, a $4.4 million increase from last quarter.

With that, I would like to turn to our guidance for the fourth quarter and full year of 2011 on Slide 13. We expect total revenue for the fourth quarter of 2011 to be in the range of $39 million to $41 million, with Utility revenues accounting for about 62% of the total, Commercial revenues 33% and the remainder from Enel. We anticipate non-GAAP gross margins to be approximately 40% for the fourth quarter, which includes the impact I mentioned above related to the CNX 3000 module. We continue to work diligently on our cost reduction activities along with value engineering of our products, which we believe will allow us to return our margins to more healthy levels over the next several quarters.

Finally, we estimate our GAAP loss per share will be between $0.12 and $0.14 and our non-GAAP loss per share will be between $0.04 and $0.07. The sequential decline in our non-GAAP earnings per share is driven primarily by the following: lower forecast revenues, no product development offsetting Q4, increased volumes in CNX 3000 modules. For the full year of 2011, we believe that revenue will be at the upper hand for our previous guidance at $156 million, plus or minus $1 million. We continue to drive for its full year profitability for 2012, as we focus our efforts on revenue growth while tightly controlling operating expenses. While we are forecasting revenue growth for 2011 of roughly 41% over 2010, we expect our full year non-GAAP operating expenses will increase by about 7%. This contrasts to 2010 where revenue and expense growth were both roughly comparable. Looking forward to 2012, while we are obviously disappointed that Duke canceled their $14.5 million ECN order, we continue to be confident that we will be profitable on a non-GAAP basis for the full year. We completed a detailed pipeline review and a broad set of global -- and we have a broad set of global revenue opportunities in front of us, including Europe, North America, Brazil and China.

Now before I turn the call over to the operator for questions, I'd like to say thank you to my team in finance and administration for their support during my 22 years at Echelon. They have always worked hard and I'm sure that Bill Slakey will enjoy working with them as much as I have. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Elaine Kwei with Jefferies.

Elaine Kwei - Jefferies & Company, Inc., Research Division

On the Duke control node, did you ever get to the point that you've actually piloting with it -- piloting with Duke and getting any performance -- product performance feedback there or was that already -- did it not even get to that stage before the regulatory decision?

Ronald A. Sege

Elaine, this is Ron. So as previously discussed, we were in field trial with Duke and we did get performance feedback and we were satisfied with the results of the field trial, we believe Duke was as well. So we have gotten feedback and it certainly will help us as we start to aggressively market this product in other parts of the world.

Elaine Kwei - Jefferies & Company, Inc., Research Division

Yes, okay. And I guess just a quick follow-up, based on, I guess, this is a little more of a question for I guess both of you and Chris, but based on the guidance, I mean it does look like we will see OpEx going back to closer to first half levels. So in terms of OpEx controls, are we just expecting a slower rate of growth and revenue growth, is that the goal?

Ronald A. Sege

Elaine, what happens with OpEx, as you know, is you have this effect of the offset that I have described previously, where we received amounts that we were able to offset against product development, that is highly nonlinear and so in the third quarter, the amount of offset was $1.2 million. The corresponding amount of offset for Q4 will be 0 and so if you subtract that from the spending growth, you'll see the overall spending growth is quite modest and is highly concentrated as sales and marketing. For the year, we expect OpEx on a non-GAAP basis to grow by 7%, which is well below our revenue growth rates.

Oliver R. Stanfield

To say more generally, Elaine, yes, we are very committed to discipline spending control and ensuring that revenue grows a lot faster than spending as we move forward.

Operator

And your next question comes from the line of Joe Maxa with Dougherty & Company.

Joseph A. Maxa - Dougherty & Company LLC, Research Division

Question on the Duke, Ohio rollout. How far are you through that rollout? And when do you need or when would you expect to have rollouts to other states in order to continue with shipping to Duke?

Oliver R. Stanfield

So we expect to ship to Duke through all of 2012. They're probably halfway through their rollout. As we mentioned in the prepared remarks, we don't currently have regulatory approval, they don't have regulatory approval to proceed in other states and we can't predict as to when they will have regulatory approval, but of course, we got other customers that we're shipping to around the world, hence our confidence in the guidance we gave for 2011 as well as the commitment to profitability in 2012.

Joseph A. Maxa - Dougherty & Company LLC, Research Division

So does the Ohio rollout, would you figure that would end by the end of 2012?

Ronald A. Sege

I don't think we know with precision, Joe, but I would remind you that what happens is that typically the meters and data concentrators are obviously purchased in advance of installation. And so, I mean, this same thing happened with our first utility project at Enel and the amount of that offset varies by project, but we believe we will have very strong revenue from Duke with respect to Ohio. And at this time, we can't project elsewhere because in order to have revenue elsewhere, there would have to be regulatory approval.

Operator

And your next question comes from the line of John Quealy with Canaccord Genuity.

Mark Sigal - Canaccord Genuity, Research Division

It's Mark Sigal for John. Just curious if you could quantify or at least give us a sense of the $14.5 million on the ECN line. About how much do you think was suppose to hit in '12? Would say half, a quarter, just a sense of the magnitude there.

Ronald A. Sege

We don't disclose that. I'd say you can assume it's less than the $14.5 million. So you can do the math and put it in the context of what our revenue run rate is. So it's -- it certainly always painful when a customer cancels an order. Obviously this was largely out of everybody's control because of the regulatory slowdowns. But it's not a major factor for us for next year. We've got lots of pipeline, as you know, in the last year. We've been very focused on sales discipline, building pipeline in general and building pipeline in particular for ECN outside of the U.S. And as I mentioned in our prepared remarks, I'm very enthusiastic about the interest in ECN in Europe and elsewhere. Of course, we've been prioritizing R&D for kind of the Duke specific feature set or the Duke priority feature set. And now with this cancellation, we'll be able to re-prioritize feature requirements for our customers in Europe, which I'm actually very excited about.

Mark Sigal - Canaccord Genuity, Research Division

Okay. And then today and in the past, we've talked about several different key geographies moving forward on the smart metering side, Brazil and also Germany. Given the regulatory approval in Brazil, can you talk about your timing expectations for Commercial shipments in '12 and then also how the German market is coming and when you might expect to start to respond to some RFPs?

Ronald A. Sege

Sure. So in Brazil, regulatory approval means that we announced our pilots. As I mentioned in the prepared remarks, our partner, ELO, has already been teeing those up. So 2012 will largely be a year of pilots and then moving into deployments, assuming we win those pilots, starting in 2013. As a reminder, it's a 60 plus million meter market and there is a mandate to move those meters to smart meters by 2021. So there'll be revenue starting to come in, in next year but we would expect it to be quite significant the year after. Germany is a bit of a mixed bag. We continue to be engaged in pilots there and therefore, we're responding to RFPs, however, as you may know, the regulators are still in the process of putting together a final -- particularly security requirements that will govern smart meter deployments and there's currently a pretty raging debate as to what the right approach to ensuring the appropriate security levels in Germany. And that hasn't been settled yet, which means that market is going a little bit more slowly than all of us would like. But we will continue to engage in pilots there and be aggressive. It's just we don't expect the significant rollouts to begin until after 2012.

Mark Sigal - Canaccord Genuity, Research Division

Okay, great. And then just lastly, I think on the last call, given all the success that you guys have had in the street lighting market, you talked about I think pilots in the order of magnitude of over 400 globally right now. I'm just curious if you might be able to bucketize that and of that call it 400 number, how many are nearing the decision phase given that pilot there can be over a year long?

I'd say that we're very excited about street lighting. We don't expect it to be a significant portion of our revenue in 2012. It's a long cycle market. We did pilots in Oslo, how many years ago, Chris?

Oliver R. Stanfield

Many years.

Ronald A. Sege

Yes. 3 or 4 years ago and as you saw, we've now won the city light deployment. My expectation is sales cycles will shorten as the market becomes educated on the strong ROI and as more participants come in to the market particularly on the energy services companies side. So I'd say it's still in kind of market priming stage. We're very early, therefore, very well positioned in that market and my expectation is it will be a big one but again not in 2012.

Oliver R. Stanfield

And I think one thing that's encouraging about street lighting is, a few years ago as you know, that market existed largely in Europe. And then the market developed in China because China has all the characteristics that Ron spoke about on his score card. And I think, what is interesting in Ron's remarks today, is you're seeing a pilot in Japan. Japan has a lot of lights and obviously, as a result of the tragedy there, their availability of electricity has changed and now they are a market for street lighting as well.

Ronald A. Sege

I also made a point in my prepared remarks that the same fundamental drivers for smart grid applications that I enumerated in the prepared remarks really drives street lighting as well. So that's why you're seeing the strong interest in Europe, the strong interest in China and now, the strong interest in Japan. So one might expect that, for example, Brazil will be an interesting market for street lighting as time goes on as well.

Operator

And your next question comes from the line of Dale Pfau of Cantor Fitzgerald.

Dale Pfau - Cantor Fitzgerald & Co., Research Division

Could we talk about the U.S.? I mean clearly, you're having strength internationally, which you've had in the past and outside of Duke. It's been a struggle and the U.S. looks to be little softer going forward. Have you given up? Are there still some possibilities here? What your thoughts on the U.S. Ron?

Ronald A. Sege

Dale, first of all, emphatically we have not given up. The U.S. is a huge market. The same fundamentals that I described in my prepared remarks will be at work in the United States in the future. It's just that they're not all at work today. So we will continue to invest in positioning ourselves here in the United States. We have a pipeline of opportunities for the ECN especially on the low voltage distribution automation side of things. So application for both bar control and so on. And the decision we've now made to prioritize development in Europe, Latin America and other regions is simply a question of sequencing and return on investment. As we look at our pipeline, we have lots of interest in the ECN in Europe and in other parts of the world and it just makes sense for us to put our investments, limited by our commitment to our long-term financial model, into prioritizing those features first. But as we see opportunities in pipeline building in the U.S., the same drivers that -- and ROI considerations will be at work and we'll start redirecting our R&D back to the United States. And of course, as Duke gets more regulatory clarity and starts to reengage in planning for smart grid rollout in their other territories, we certainly expect to be alongside with them.

Dale Pfau - Cantor Fitzgerald & Co., Research Division

Second question. Your Commercial looks it like it's picking up. Is this -- do you expect this general trend to continue? Do you believe this is just an indication of an improvement in the overall economy, or is it traction with your product specifically?

Ronald A. Sege

I think, Dale, there's 2 things driving that. Frankly, the overwhelming one is we are seeing a modest recovery in the real estate market. Particularly, we're tied to occupancy rates and tenant improvements and as the economy globally slowly gets better, our business starts to grow as well. So your guess is as good as mine as to what happens to the trajectory of the macro-economy. I guess every day, there's something new in Greece. We are selling more effectively, we're very focused on that, but our Commercial business is largely driven by design in cycles which are 12 to 18 months. So the benefits of that better selling discipline really have yet to be seen. But hopefully the market continues to recover and we can start growing faster than the market with improved selling discipline.

Oliver R. Stanfield

Dale I assume you were speaking with respect to Q4. And I think, when you look at the Commercial revenue, it's really comprised of the design in business in terms of selling components to folks who are using those in systems like building automation systems as well as project business. And part of the growth that we are anticipating in the fourth quarter would relate to that project business.

Operator

And your next question comes from the line of Sean Hannan with Needham and Company.

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

Just a follow-up on Duke. So they've canceled the order, they don't have the approval yet but you're saying that they like the product in terms of the field trials. But have they communicated to you explicitly or that they still explicitly intend to deploy the solutions when they do get approval, or what should we think there of kind of next steps?

Ronald A. Sege

I can't comment on what Duke -- what their plans are for the future. We worked very closely with them on this project. It reflects a fundamental architectural decision that we believe they're still committed to and they will continue to work with us in the development of the product going forward. Were still selling them meters, data concentrators, system-level software. The Ohio interim PUC report in terms of the quality of our metering products was superb. So overall, we're confident in the relationship but the rest really depends on how the regulatory approvals scenario rolls out in the future.

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

As a separate topic. Can you perhaps provide a little bit of color to us around how you view the importance of what you bring to ELO in terms of the R&D and the technical knowledge? Basically, your views on the utilities degree of reliance on the technical knowledge that you'll provide with the solution. And then, as part of that, your perspective on their ability or bandwidth to support multiple communication technologies as partners since -- and really since so many have questions whether some of your competition may come into the fray and the partnership with them as well.

Ronald A. Sege

A lot of questions, so let me start with what we bring to the party and I alluded to this in my prepared remarks. ELO is one of the largest -- is the market share leader from an electromechanical meter perspective, and by partnering with us, they leverage all our proven technology and our R&D, 20 years of energy control networking, 35 million meters and so on. Again, all of our R&D team, they get faster time to market and this isn't just a matter of months. It takes years to develop a smart metering system and go through all the testing to build something that's as bulletproof as ours is. So we think this gives them a tremendous time to market advantage, and there's a reason we were first in getting regulatory approval. It's because we were able to springboard them in that marketplace. We believe our relationship is very strategic and we're betting on them and they're betting on us. So we think this gives us a tremendous entrée and a unique entrée into the Brazilian market. So I don't know whether I answered your question but if there's other parts you want to follow on go ahead.

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

I guess the last piece of it is really, what's your view on ELO's bandwidth? Their internal ability to support working with multiple vendors? Given their infrastructure today or their core team, is there really an ability for them to go and start working with other competitors, or are they really constrained and right now, they're pretty wedded to working with you folks as they look at smart meter technologies?

Ronald A. Sege

Look, Sean, all I can say is, I've been down there several times. Our teams are -- they're working side-by-side with their engineers and their -- in their factories. We had a ribbon-cutting ceremony in the factory a little while ago. They definitely have enough bandwidth to work with us and our relationship is very strategic and we're going to go conquer the market together. So -- and as you say piloting, winning, deploying and being successful with the smart metering system requires a very strong close partnership, tight cooperation and we view this as very strategic and we believe they do as well.

Operator

And your next question comes from the line of Patrick Sullivan from Credit Suisse.

Patrick Sullivan

I was hoping you could just touch on maybe the 2012 outlook, not necessarily with numbers but just qualitatively. Which markets, which of your segments are growing more and if anything has changed maybe over the last quarter as you kind of put together your view for 2012?

Ronald A. Sege

I'll let Chris comment on the specifics to the degree he wants to but I think we've been pretty transparent about where we see the action from a market perspective and I don't believe there'll be any discontinuity 2012 relative to 2011. We're going to continue to rollout at Duke, obviously. We're going to continue to rollout of Fortum. We've made a couple of announcements relative to new wins in Europe. I noted my enthusiasm for overall European smart grid and smart meter market and we will expect good percentage of our revenue to come from there. But we will start ramping up in Brazil, Latin America and to a certain degree, China. So I would say, if you go back to the factors that I enumerated in terms of our geographic stack ranking, that's where we believe the action will be in 2012. And as I mentioned before, our Commercial business is largely going to be driven by the trajectory of the macro-economy. And then we hope over time, of course, that we can go faster than the market as we accelerate our rate of design wins because of our more effective go-to-market and selling discipline approaches.

Oliver R. Stanfield

What I would add is, in addition to the Latin America, obviously, and in addition to China, I think what Ron has said before is that the markets are moving east. And I think we're very excited about the opportunities we see in Eastern Europe. And so, we have a process that we go through on which we validate our pipeline and I think what is most interesting about that pipeline to me is its diversity. The fact that there are so many transactions, and that's always good news.

Ronald A. Sege

And just to, I guess, reiterate the geographic stack ranking kind of algorithm we used. It really is driven by fundamentals. Is there more demand for electricity than supply? Are the test levels high? Is there's strong political will? What's the condition of the distribution grid? And then, what's the availability of consumer credit i.e. is prepaid metering a big deal? So if you just rank the various regions around the world in those dimensions, you can really get our overall go-to-market playbook. So obviously, China ranks very high on every one of those dimensions and that's why we are so bullish about it and so does Brazil, Europe, in many dimensions, Russia and so on. I would just consider those factors as you think about where we believe the smart grid market will go particularly in the next year to 18 months.

Patrick Sullivan

The CNX 3000, how long do you expect that to be a drag on margins or when do we see that somewhat completing?

Oliver R. Stanfield

We expect -- just go ahead and provide the COS software next year. I don't want to get into specific timing but it was important to get the hardware included in the meters before they were installed and so we made a conscious decision to take the hit to provide the best possible solution to our customer.

Operator

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

Benjamin Schuman - Pacific Crest Securities, Inc., Research Division

So how did Bill get to a 48% gross margin in the long term model given a mix shift to the utility segment which has a lower gross margin than the Commercial segment historically? Is it all manufacturing efficiencies, software kind of all of the above? How did we get to 48%? That seems pretty far from where we are now.

Oliver R. Stanfield

I don't think Bill's going to do it by himself. But I think the way that Echelon is going to do it, is that if you look back at our results back in the early 2000s, we had utility, we didn't call it that then we called it, Enel. And we had Commercial, we called it something else. And overall, our gross margins were much higher than 48%. That's because we were pursuing a component strategy and we are also providing a lot of software, albeit embedded, in some purpose built hardware we called a data concentrator. And so I think our view is that as we execute against the strategy that Ron has described in terms of providing systems where systems need to be provided, providing components where that's the right solution and then providing subsystems where time-to-market is key, we think we can achieve a mix of gross margins consistent with that. And one last point, we've been very clear that software is a big part of our future. That is a -- I think Ron has made a statement before that one of the happy surprises to him when he arrived here was to find out how many software engineers we have and we're ensuring that we can get paid for that.

Ronald A. Sege

From my perspective, mixing more subsystems and components back into the Utility business helps our gross margin because we're focusing on the core of our value add. That's one piece of it. Value engineering, there's a lot we can do to frankly just improve cost of goods sold and we now have the R&D envelope to do it and we're committed to spending R&D on cost reduction. And then as Chris said, a lot of what kind of makes our solution unique i.e. the applications enablement and a lot of what will make the smart grid successful, is about software. And we both need to invest in it and frankly, do a better job of collecting money for it. So those are the key elements and obviously just leveraging our OpEx more effectively going forward. So, those are the key elements of our strategy.

Benjamin Schuman - Pacific Crest Securities, Inc., Research Division

And just one more question. What are the main competing technologies in the streetlight business?

Ronald A. Sege

It really is a nascent market. We are very well-positioned and we really are among the first. So as is in most of our businesses, there are kind of RF communication based solutions. But so far, they have a very minority position in the marketplace. But most of the other solutions, I say, at a higher level of architecture really require back-calling all of the data about the streetlight to some data centers someplace, whereas, we use a distributed control model. So those are the competing architectures but I'd say, really frankly, the competition primarily comes from awareness, getting out there and just educating cities and partners on the powerful ROI and the fact that this solution exist. So that's where we're spending most of our time doing.

Oliver R. Stanfield

And I think one of the things to remember is that as Ron indicated earlier, the streetlights are very similar to other utility applications. The power line environment is challenging their instances in which lights might be on the same distribution transformer as other assets, et cetera. And that's really something that we pioneered in terms of our world-class power line solution and I would submit that's one of the reasons that we've been so successful whether it be in Europe or in China.

Operator

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

Colin W. Rusch - ThinkEquity LLC, Research Division

If you look at evolving the ECoS platform, can you talk about where you're making investments and how much you expect to spend over the next 12 to 24 months?

Ronald A. Sege

I'm sorry could you repeat the question?

Colin W. Rusch - ThinkEquity LLC, Research Division

If you look at evolving the ECoS platform like in the cost reduction, enhancing functionality. Can you talk about where you're really focused and how much you're expecting to spend to make those adjustments and changes in evolution?

Ronald A. Sege

Well, without getting into sort of specifics of percentages, I think I already said it, we are going to be focusing a reasonable amount of our investment on creating European, Latin American versions of the Edge Control Node and there is slightly different software feature sets that customers outside of the U.S. require or stated another way, there were certain specific features we were working on for Duke. So we'll be working on that. There are just some differences in terms of power supply and communication modules and homologation in Europe relative to the United States. So that's the primary investment we'll be making in the Edge Control Node and COS. And then, we'll be investing in cost reduction across the board so we can move back to our long-term financial model commitments and then we'll be investing in applications that position us better for street lighting, metering, low voltage distribution automation, and that specifically, end up being a better host to third parties like Oracle, Streetlight Vision and Telvent as they write application to run on top of our multi-application platform. So not sure if I answered the question but that's how we'll allocate R&D investment, and again, all within the constraints of making steady progress towards our long-term financial model commitments.

Colin W. Rusch - ThinkEquity LLC, Research Division

And then looking at the growth of commercial real estate, we're seeing estimates of 25% plus growth of global commercial real estate. And with the majority of that coming in developing countries, a couple of which, you are engaged in the utility level, notably China and Brazil. Can you talk about how you started addressing that opportunity, the sales channel, the partners that you think you need to develop to really address those opportunities?

Ronald A. Sege

Sure, so -- and part of our decision to engage in China a year was to chase after that buildings business. You know, the dominant share of our revenue in Commercial is and will continue to come from our large commercial partners, Honeywell, Siemens, et cetera. And so a lot of our sales engagement model and the focus that we've applied to that in the last year, frankly, is about being a better partner to them as they penetrate those markets. And I'm sure you follow those partners. They've made numerous announcements positioning themselves in those rapidly growing marketplaces. Now having said all that, 25% is a pretty aggressive number relative to my view. I'm not an economist but we're being a lot more conservative about how we see commercial real estate growing globally, even if we do turn a lot of our attention to these high-growth markets.

Oliver R. Stanfield

The other comment I would make is that, as we have added resources to sales and marketing, some of those resale sources have been in the sales force to deal with commercial products. And those people have been added in markets like you mentioned. Markets in which the growth rates are going to be greater than say, they might be in the United States or elsewhere. And so, we're consciously putting feet on the street where the market growth should be greatest.

Operator

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

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

Most of my questions have already been answered at this point so I guess I will just go with one kind of high-level one. With your partnerships with ELO and Holley in China and Brazil, what are you seeing in terms of the size, the potential deployments in both those countries, and how do they differ from maybe the deployments you've seen in the United States and you guys have done in Europe? I know it's kind of early days but just...

Ronald A. Sege

Yes. Well, let me start with China because that is the clearest market. So China, all the factors that I described earlier are at work. I was over there a month ago and touring the factory. The factory manager said, "Okay. We got to get out now because the powers being shut off at 1:00 in the afternoon." "Why is that?" "Rolling blackout." So they have to do demand management. They have to improve the efficiency of their distribution grid so when the government there says that they're going to roll out 300 million meters in the next 5 years, it's going to happen and it's probably going to happen in 3 years. So it is a well circumscribed market. On the other hand, we're not going to waltz in there and say "Hey, here's this American made metering system please approve it at the state grid and install it in all 300 million points". So we're going to market with Holley and therefore, we will get a smaller portion of the value chain, right? But we will be focused very much on our value add and so we believe we'll get a disproportionate share of the profit pool. So that if you think about the U.S. market relative to the Chinese market, the U.S. market, at the rate it's going is 1/5 the size of the Chinese one. So being well positioned in China is very important to us over the next few years. In Brazil, it's a 63 billion-meter market and it's a 2021 mandate. So it's a smaller market and it will take a little bit longer. But with our subsystem strategy with ELO, we will capture a larger share of the value and therefore, we believe, the profit pool. And to the earlier question, by working so strategically with ELO and helping them gain an unfair share of market if you will, we believe that makes us a unique strategic partner to them and frankly, we tie up a lot of their partnering capability.

One more question, operator.

Operator

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

Craig E. Irwin - Wedbush Securities Inc., Research Division

My question's about Duke. I know this one has been asked many times but frankly, I don't completely get the explanation. Duke, when they got the stimulus money, spent several hundred million dollars on synchrophasors which had a positive ROI and did not need to go to their commission for that. So when I look at the rollout in Ohio which is obviously, the place where you would have the easiest time testing system, there's already commission approval for the use of collection notes using Echelon technology. And your systems, the way you described them to us at the rollout meeting and your marketing people have described to perspective customers, will actually eliminate the need for certain other nodes that are used for RF collection and other type of backhaul communication for utilities. So the necessity of going to commission and actually getting commission approval is something that I'd really like to get a little bit more clarity on. So if you could maybe give us a little bit more color on precisely what was declined by the commission and why and how this is different than the prior solution that was being considered or I should say, the portfolio solutions that were being considered and why is the trial -- because $14 million is a relatively small trial, was declined?

Ronald A. Sege

So just to be clear, Ohio, we have approval to roll out metering systems including our Edge Control Node. It is the other jurisdictions at Duke that we do not have regulatory approval and where there have been additional delays announced as recently as a couple of weeks ago. So we have approval in Ohio. The issue, Craig, is we're just running out of runway to deploy Edge Control Nodes. We talked earlier about how much of Ohio is already deployed. And if you marry that with the fact that ECN is a new product that has to be ramped up, that Utilities typically procure at a faster rate than they may deploy, there's just not a lot of room left in Ohio to deploy the ECN. And without approval in Indiana, which is by the way bigger than Ohio, and without approval in Kentucky, and no specific plans for the Carolinas, we just -- we see better opportunities frankly for a return of investment of our R&D and manufacturing dollars in other parts of the world. And so it's a simple calculus of where we put our investments, our R&D dollars and our capital dollars to get what kind of a return. And we had always been counting on rollouts, particularly in Indiana but also, in Kentucky, to justify prior ties in Duke the way we did. And frankly, I think for Duke, prioritizing their projects with us.

Craig E. Irwin - Wedbush Securities Inc., Research Division

So then an implication of the change for -- sorry for Kentucky, Indiana, and the Carolinas suggest that maybe Duke was considering re-upping. Obviously, everybody knows about Indiana but would that be a logical thing that maybe now this is something that we should look for not as a 2012 even but as a 2013 event for Duke to potentially go back and come back with another geography for Echelon?

Ronald A. Sege

Craig, I can't speculate on behalf of Duke.

Thanks, Craig and thank you all very much. And Chris Stanfield, thank you for the last 22 years. It's been a pleasure and you can come join the call as an honorary member anytime.

Oliver R. Stanfield

Okay, thank you.

Ronald A. Sege

Thanks everybody. Bye-bye.

Operator

And ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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