Itron's (ITRI) CEO Philip Mezey on Q4 2015 Results - Earnings Call Transcript

| About: Itron, Inc. (ITRI)

Itron, Inc. (NASDAQ:ITRI)

Q4 2016 Earnings Conference Call

February 17, 2016 5:00 PM ET

Executives

Barbara Doyle - VP, IR

Philip Mezey - President & CEO

Mark Schmitz - EVP & CFO

Analysts

Noah Kaye - Oppenheimer

Jennifer Ky - Credit Suisse

John Quealy - Canaccord Genuity

Sean Hannan - Needham & Company

Sven Eenmaa - Stifel Nicolaus

Dave Delahunt - Robert Baird

David Rose - Wedbush Securities

Jeff Osborne - Cowen & Company

Operator

Good day, everyone, and welcome to the Itron Incorporated Q4 2015 Earnings Conference Call. Today's call is being recorded. For opening remarks, I would like to turn the call over to Barbara Doyle. Please go ahead.

Barbara Doyle

Thank you, Melissa, and good afternoon to everyone. Welcome to Itron's fourth quarter 2015 earnings conference call.

We issued a press release earlier today announcing our results. The press release includes replay information about today's call that the operator will also repeat. We have also prepared a presentation to accompany our remarks on this call. The presentation is available through the webcast and through our corporate website under the Itron Investor Relations tab.

On the call today, we have Philip Mezey, Itron's President and Chief Executive Officer; and Mark Schmitz, Itron's Executive Vice President and Chief Financial Officer.

Following our prepared remarks, we will open up the call to take questions using the process the operator will describe. First, please let me remind you of our non-GAAP financial presentation and our Safe Harbor statement.

Our earnings release and financial presentation include non-GAAP financial information, that we believe, enhances the overall understanding of our current and future performance. Reconciliations of differences between GAAP and non-GAAP financial measures are available on our earnings release and on our Investor Relations website.

We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially from these expectations because of factors discussed in today's earnings release and the comments made during this conference call and in the Risk Factors section of our Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements.

Now I will turn the call over to our CEO, Philip Mezey.

Philip Mezey

Thank you, Barbara, and thank you to everyone on the webcast for joining us today. I will review some key highlights in the fourth quarter, and then turn the call over to Mark Schmitz, to cover our financial results and guidance for 2016.

Overall, Itron ended 2015 on strong footing. Q4 showed solid operational results with the highest revenues, margins, earnings and bookings in the year. As you can see on Slide 5, bookings were very strongly in the quarter with a 1.7 to 1 book to bill ratio, the highest book to bill ratio since 2007.

Bookings included a significant $250 million contract with Consumers Energy to help modernize the company's gas distribution system through their smart energy program. The contract expands upon our current work of upgrading their electric system with our OpenWay cellular communications. In total, the contract covers one million electricity endpoints and 630,000 gas endpoints. This is a great example of a customer growing their project with Itron and using even more of Itron’s solutions.

We had other notable bookings with Duke Energy in electricity, NiSource, Questar and CenterPoint Energy in Gas, and Water bookings with Veolia, France and the City of Grand Prairie, Texas.

Slide 6 and 7 review backlog trends. Total backlogs at year-end of $1.55 billion, increased 4% from year-end 2014, and 12-month backlog of $833 million, increased 11.5%. This gives us an improved visibility to revenue levels in 2016 and beyond. 2015 was the third consecutive year of backlog growth at Itron.

Our backlog has increased more than $500 million since 2012 at a compound annual growth rate of 14%. Our backlog performance points to two things; healthy level of utility and municipal spending on smart systems and analytics, and Itron’s strong share of the growing customer demand in all three end markets; Electricity, Gas and Water. And our selection as vendor for several upcoming projects helps increase our backlog visibility for 2016.

I'm also very encouraged by a healthy pipeline of opportunities and the competitive positioning of our next-generation OpenWay Riva platform in several active bids. OpenWay Riva provides a fully integrated electric, gas and water IoT solution for customers beyond anything else in the industry.

First, we built in better network performance with adaptive communications technology that dynamically integrates radiofrequency, powerline carrier and cellular communications. ACT assures connectivity through the most reliable and fastest communication path available for robust networks at lower total cost of ownership.

Then we added powerful distributed computing at the edge of the network with Itron Riva, delivering more IoT functionality. Our secure standard spaced approach at every level of the solution allows application processing, not just data collection at the device level, whether it be a smart meter, a solar inverter or a street light sensor. Working together, Itron’s ACT and Riva technologies improve integration and connectivity for active smart grids. These technologies enable secure and truly interoperable communications that can crossover between utility and city networks, creating synergies and new potential revenue opportunities for our customers.

Riva demos at DistribuTECH were sold out, as we spoke with customers about the potential to increase the value from their smart grid investments by deploying Itron’s new technologies.

Now let me turn the call over to Mark.

Mark Schmitz

Thank you, Philip. Itron posted solid results for quarter four, achieving constant currency revenue growth in the quarter of 4%, and non-GAAP EPS of $0.76. Highlights of the quarter were strong revenue growth in the water segment, improved gross margin in gas, strong bookings in backlog at both Electricity and Gas, and improved cash flow.

Earnings per share for the full-year was $1.01. Earnings for the year were negatively affected by the warranty charge taken in our water business in quarter two 2015, accounting for $0.42 per share. Partially offsetting the warranty impact, we also had lower incentive compensation expenses for the year, amounting to $23 million or $0.33 per share. This reflects earnings for the year which fell below the threshold at which we felt it appropriate to pay incentive compensation.

Slide10 summarizes consolidated company results for quarter fourth 2015 versus quarter four of last year. Total revenue was $490 million, down by $20 million or 4% from the year-ago period, but up by 4% in constant currency. On a full-year basis, revenue in constant currency was up by 5%. Gross margin for the quarter was at 31.7%, up 140 basis points from the year-ago period, helped by lower incentive compensation and by a significant improvement in the gas business segment.

Operating expenses were down year-over-year, reflecting currency and the reduction in incentive compensation expense. As a result, non-GAAP EBITDA showed a $14 million improvement to $53 million and a margin of 10.8%, up 310 basis points from the year earlier period. The year-over-year reduction in incentive compensation expense for quarter four amounted to $23.5 million. We also had roughly $20 million of other non-recurring items that reduced our non-GAAP EBITDA. So looking through the non-recurring items, we can see a non-GAAP EBITDA run rate of roughly $50 million for the quarter.

The effective tax rate for the quarter was 27%, well below last year's rate due to an improved mix of earnings by jurisdiction and favorable discrete tax items. Non-GAAP EPS was $0.76 versus $0.36 in the year-ago quarter. Free cash flow was $42.6 million, up from $4 million a year earlier, reflecting improved working capital metrics. Itron finished the year with $131 million in cash, and debt balances are down by $15 million from quarter three.

GAAP results are shown on Slide 11. The significant improvements seen in GAAP operating income reflects a $53 million restructuring charge recorded in quarter four of last year, as well as a $15 million acquisition-related legal settlement. GAAP EPS was $0.56, up from a loss of $1.25 per share a year earlier.

Turning to segment results, beginning with the Electricity segment on Slide 12. Electricity revenue in quarter four was flat in constant currency and up by 11% for the year as a whole. This reflects the traction gained in smart meter projects and managed services, particularly in North America, where full-year revenue grew by more than 20%. Electricity gross margin was up by 50 basis points in the quarter to 30%, while non-GAAP operating margin was up by 460 basis points to 10.5%, reflecting lower incentive compensation expense.

Electricity continues to enjoy a strong pipeline of new business witnessed by its exceptionally strong quarter for bookings. In addition while Electricity’s non-GAAP operating margin got a non-recurring boost from reduced incentive compensation, there were a number of other non-recurring items that reduced reported results. We can look behind these non-recurring items and see real improvement in Electricity’s run rate.

Gas segment revenues showed on Slide 13 was up 1.3% in constant currency on the strength of record North American revenues. Gross margin improved by 580 basis points year-over-year to 34.7%, further improving on the 33.6% gross margin recorded in quarter three. Gas gross margin benefited from favorable North American volume mix, as well as improved mix in EMEA. Our next-generation lower cost smart gas meters for selected EMEA markets will be launched in quarter two of this year.

Non-GAAP operating margin in the Gas segment improved year-over-year by 730 basis points to 16.4%, driven by the higher gross margin, as well as reductions in operating expenses. Reduced incentive compensation expense was an insignificant factor in these improvements.

Water segment revenue grew year-over-year by 13% in constant currency as shown on Slide 14. Gross margin declined by 210 basis points to 31.3% due to weak business conditions in Brazil and an adjustment to warranty costs, offsetting strong business in North America and EMEA, as well as improved services margins. Non-GAAP operating margin was down only 30 basis points year-over-year with the decline of gross margin offset by reduced incentive compensation expense and other discretionary expense reductions.

Finally, before turning back over to Philip, I'd like to discuss our guidance for 2016 as shown on Slide 15. We expect 2016 revenues of between $1.85 billion and $1.95 billion based on a Euro to US Dollar exchange rate of $1.10. This represents constant currency revenue growth of between 1% and 7%. We expect non-GAAP diluted earnings per share of between $1.95 and $2.25 based on 38 million shares outstanding and an effective tax rate of 37%.

While we are not providing specific guidance on gross margin, it's noted that the special warranty charge taken in our Water business in 2015, offset by higher incentive compensation expense of 2016, should provide a modest lift to gross margin. As in prior years, we should also note that quarter one would be the weakest quarter of the year, and that the second half will have stronger revenue and profit than the first half. Our guidance for 2016 excludes any costs and benefits related to any further structural and operational changes being planned.

As discussed in last quarter’s call, Philip has asked our COO, Tom Deitrich to lead a comprehensive review of supply chain and R&D improvements, in addition to important process changes. This review is likely to lead to manufacturing and R&D footprint changes and consolidations. We will have more to say on our quarter one earnings call in early May.

Now, I would like to turn it back over to Philip.

Philip Mezey

Thank you, Mark. As we progressed through 2015, we delivered operational improvements, gained share and delivered industry-leading innovation, and we are taking this momentum into 2016.

In Electricity, we saw benefits from our decisions to focus more of our investments on high-value smart grid technologies and reduce our business in certain non-strategic standard metering. Full-year Electricity revenues grew 11% at constant currency, driven by smart project revenues. Planned reductions in certain low margin electric business cost us about 2 percentage points of growth in 2015, while positively impacting Electricity segment EBITDA by approximately 70 basis points.

We will see an even greater margin and mix benefit in Electricity going forward, as we fully exit non-strategic business. Overall, we are well on our path to achieve sustainable high-single-digit EBITDA in Electricity by the end of 2016.

In Gas, our North American business continued to perform very well in revenues, margins and new bookings. Itron has a clear leadership position in the North American gas market. According to the Q3 2015 Scott Report, Itron’s share of AMR and AMI gas shipments in North America was 60%, up nearly 5 percentage points from 2014.

In addition, our European gas business results showed improvement in the second half of the year with savings following the closure of our Naples factory in the second half, and better product mix in EMEA volumes. Our focus in 2016 is to continue this progress, including delivery of our cost improved second-generations smart meters.

In Water, we grew revenues significantly driven by an exceptional growth of 19% in EMEA and 16% in North America. In North America, revenues increased while we also maintained an aggressive delivery schedule for the warranty replacement units. The replacement program was the right decision. We gained customer loyalty and led the competition with 30% share of shipments to North American water utilities.

Overall in a challenging macro environment, we continue to build market share and make progress on all three segments. Importantly, we continue to invest for the future as our customers look to further increase their operational efficiencies and customer service levels by embracing new technologies. Against this backdrop, we had an unacceptable level of unplanned costs and charges. Reducing the variability in our performance is a top priority for me and my leadership team. We are aggressively addressing this with several actions, including, strengthening our quality processes, additional project risk management controls, centralized global supplier and procurement management, more operational process rigor and intensive focus on working capital.

We also invested in our organizational capabilities in several key areas. In addition to bringing Tom Deitrich to Itron as our new COO, we made changes in our Gas business leadership. We added a new Head of Global Sales and Operations Planning under Tom to help drive aggressive operational process and performance improvements throughout the supply chain. We grew our Flextronics contract for more flexible manufacturing, design and procurement. We further augmented our software and services team and reorganized our cloud-based development and systems operations under Bruce Douglas, bringing additional resources and synergies to this critical growth area.

We doubled the size of our India Development Center in preparation for additional R&D efficiencies through new global centers of excellence. And we made substantial progress in global business shared services, which enables more G&A efficiencies in 2016 and ‘17. We also bolstered our financial team with a new Treasurer and a new Head of Financial Planning and Analysis to help our CFO, Mark Schmitz, drive business forecasting and planning process improvements.

We have more to do and we will make additional meaningful changes to our operational structure that will increase our agility in global markets and drive further margin improvements.

I'd also like to mention a recent Navigant Research report ranking Itron as the top leader in Meter Data Management Systems. The Q4 ‘15 report identified Itron as the company to beat in this highly competitive space. 73 energy companies used Itron’s software to manage data for more than 37 million meters across six continents.

Our MDM solution is highly scalable application pre-integrated with Itron analytics, and can be delivered off-the-shelf or through cloud-based services solutions. The top ranking of our MDM solution is a strong validation of Itron’s focus on delivering outcomes to our customers through software and services. And earlier this month, we announced the launch of Itron Idea Labs to focus on rapidly developing new solutions that exploit the power of Itron Riva technology. Itron’s Idea Labs run as an entrepreneurial development team within our CTO office.

The focus of the lab is to design and pilot new Itron solutions and continue to build the developers network to broaden the ecosystem for our Riva platform. The recognition of our industry-leading MDM software and our new Idea Labs showcase our software and services vision in action. I’m very excited about both of these announcements.

I'll wrap up our remarks by saying I'm upbeat about our position entering 2016. We've taken decisive actions on the operational front, increased our backlog and revenue visibility, and will deliver substantially higher earnings in 2016.

Operator, let's open up the call now to take some questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And we’ll pause for just a moment to allow everyone an opportunity to signal for questions. We'll take our first question from Noah Kaye with Oppenheimer.

Noah Kaye

Good afternoon. Thank you for taking the question. Philip, maybe we just start with your comments on a couple of related items. First, the software demos at DistribuTECH that were sold out and your comments around the growth of software and services. Could you maybe just give us an update on whether that part of the business stands in your 2016 guidance, how much is coming from software and services, what kind of growth does that represents and what's driving the growth? Thanks.

Philip Mezey

Sure. So Noah, we have not broken that number out. The references that this is an increasingly important portion of our revenue, not only as a stand-alone growth opportunity but with our Riva software, we are actually embedding analytics into the endpoints themselves and into the system, and this is giving us unparalleled insight of what's happening at the edge of the network that is on the side of the house.

And so we are both broadening our expertise in the center of the network at the Meter Data Management level and above an analytics but strengthening it throughout the network, and we’ve said that we consider this to be a strong growth opportunity as a separate business area, but also embedded and strengthening our Electric, Gas and Water offering.

Noah Kaye

Understand. You mentioned continuing to invest in technology, just noticing the decline sequential in R&D. Can you talk about how you expect that to trend in 2016, and kind of how you're managing the continued investment in technology versus spend levels there?

Mark Schmitz

Noah, this is Mark, and I'll give up the first answer on that and Philip may follow-up. First of all, yes, we do continue to invest in technology, no intention of stopping or trimming down or stopping that in any way. We expect R&D to be roughly flat in 2016 versus 2015, but bear in mind that our emphasis here is to become more productive and more efficient, and in some ways more targeted in our R&D spend, a much more disciplined approach with better productivity, getting more for less.

Noah Kaye

I would just like to follow-up with one last question, if I may, and that's on the market and the pipeline. I think in the last quarter or two, you’ve had some very positive views on RFP environment. What are you seeing now, and maybe if you could kind of give us a bit of color in terms of number of large RFPs that you're seeing increase, where those opportunities are coming from, and in particular, to what extend the complexity of those RFPs is increasing to reflect the development and improvements in the core networking technology that you’ve being able to achieve? Thanks.

Philip Mezey

Sure, Noah. So first of all pointing out strengthening RFPs activity, we saw that in the book to bill ratio of 1.7 and 1.05 for all of 2015, so increasing momentum in bookings at the end of the year. Starting out North America where we see some of these very large contracts develop, I talked before about a strengthening regulatory environment in the North East Pennsylvania, Massachusetts, New Jersey and New York, Ohio, but we've got a broadening of deals actually in opportunities that we see in the North West, and we are actually starting to see replacement activities and follow-on opportunities in some of the initial installs that went in, in North America smart metering.

Gas had a very, very strong bookings performance in the fourth quarter, and as we've commented, record performance in North America. We see strong opportunities for that to continue. As well, the Water business showed very strongly. Rest of world of course there are follow-on tender activities as we build momentum in these large European deals that we expect to see volumes starting to ramp up latter ‘16 and ‘17 that’s still ongoing.

Noah Kaye

Thank you very much for the color. I’ll turn back. Thank you.

Philip Mezey

Thanks Noah.

Operator

We'll take our next question from Patrick Jobin with Credit Suisse.

Jennifer Ky

Hey, this Jennifer Ky on the line for Patrick. Given the recent award with Con Ed to a competitor, do you think the competitive landscape has materially changed for Itron? Do you have any thoughts on why the markets shouldn’t view the loss as an indication of chances in future tenders?

Philip Mezey

So Electric revenues in North America were up 20% in 2015. So we see strong momentum in market share gains for Itron. The release of Riva, we think, puts us at the forefront of the marketplace, and based upon both RFP activity and selection activity for deals not yet announced, we see a robust and healthy competitive marketplace.

Jennifer Ky

Great. And how much of your business is services?

Philip Mezey

We've commented on the order of $100 million to $200 million.

Jennifer Ky

And how much do you have in your 2016 guidance?

Philip Mezey

We do not break that number out separately.

Jennifer Ky

Great, thanks.

Operator

We will take our next question from John Quealy with Canaccord Genuity.

John Quealy

Good afternoon folks. Do you hear me?

Philip Mezey

Yes, John. Thanks.

John Quealy

Hi Philip. So a couple of things. First, on the quarter and fiscal ‘15, just recap for us, what do we take for restructuring charges, what's left to be done in ‘16 and ‘17? Can you just give us a brief overview there?

Mark Schmitz

Yes, I can say that actually we are on track I think with what we've promised earlier that we'd be roughly 50% complete by the end of 2015, and that's about where we stand, 50% done. You should be seeing 50% of our, as we've indicated, $40 million run rate savings when the program is complete. You should see something close to that 50% in our 2016 numbers. And by the end of 2016, will be all but say 95% complete with that program.

John Quealy

Okay. And Mark, so does that translate into free cash or walk us through your free cash thoughts for ‘16 versus ‘15?

Mark Schmitz

Yes, well, it's a bigger subject than just restructuring of course. We will have something in the teens, I’d say in terms of restructuring cash outflow in 2016, but what we are seeing in 2016 is certainly a much greater contribution to cash flow from base profitability and the potential for some significant release of working capital. So we are really looking for a - I don't want to promise a number here but I think I feel quite sanguine about free cash flow in 2016.

John Quealy

And again, I would imagine that would align with your comments or Philip’s comments earlier about second half better than first half. Is that right?

Mark Schmitz

I would expect so, yes.

John Quealy

Okay. Then just a last couple. On the visibility, so good bookings performance and all that, underlying organic guide of 1% to 7%, that's a big sort of window. Can you talk about U.S. versus non-U.S. smart versus not smart, just the puts and takes on that? I imagine U.S. is okay with home starts, maybe solar not a huge business for you, but maybe flattish given what the solar installers have reported. Just help us dig down a little bit on your visibility in where it could - the variances are?

Mark Schmitz

Yes, well I think this is a question that almost every international company is struggling with right now, and we are being deliberately on the cautious side in revenue projections and guidance for 2016 with economies weakening in almost everywhere except North America and that perhaps extending to North America, we've got some reason to be a little bit cautious. But having said that, the North American pipeline is strong. We are not seeing any weakening of business conditions that affect our business in particular in North America. So if anything I would say, we are going to see robust growth in North America and we're a little more concerned about especially emerging markets, and we are concerned to some extent about EMEA. So that is why we have the wide range. The visibility is just quite limited right now with the turbulence going on in international markets.

John Quealy

Okay. And then, I'm sorry, lastly, so back to the competitive landscape, not necessarily on any one RFP, but with Sun Capital coming in GE and putting it into Aclara. Clearly I would imagine some of that have changed in maybe some alliances versus networking and metrology take off. So Philip so far what have you seen in that respect and what would you expect in the next year in terms of entrance or exits from your competitors? Thanks again.

Philip Mezey

John, I can speak for the data that we have seen without speculating about the competition in which there is third-party data available that indicates market share and has us gaining share in a healthy position, specifically in the North American market that I will say third-party data on a global basis, and that's even including the selectivity that we talked about in which we are taking a pass-on some lower margin business to focus on higher profitability market.

As to specifically the transaction that you talked about, it's a pretty lumpy - that's a pretty lumpy market. We are happy with, although we could always do a better job at just our basic electric meter market share, but we are very pleased with the performance of the Electric group again up 20% in ‘15 and in the strong bookings visibility in ‘16.

John Quealy

Great. Thanks. Nice job guys.

Philip Mezey

Thanks John.

Mark Schmitz

Thank you.

Operator

We'll take our next question from Sean Hannan with Needham & Company.

Sean Hannan

Yes, thanks folks. Can you hear me?

Philip Mezey

Yes, Sean.

Sean Hannan

Okay, great. First question here is from an application standpoint, when I look at Gas, some of the comments where you spoke that in slide deck, Europe picking up. So I'm trying to understand and see if I can get a little bit more color on what's the driver behind this? Is it just underlying markets getting generally healthier, is it the projects that perhaps you’ve won in the past starting to move, I think there has been a little bit more movement on the gas front, or is this uptake momentum really translates your revenue products. So if there is a way we can get some better color around just the improvements here are in EMEA?

Mark Schmitz

Sure, I'll take the first shot at the Sean. First of all, what we are seeing happen in the Gas business really it’s the North American mix and volume growth that overshadows other factors and has contributed to the improvement in Gas profit gross margin climbing by 580 basis points year-over-year.

But having said that, we've also seen a significant contribution to gross margin coming from improved mix in EMEA. It is true. And it's not so much volume-driven as it is a mix of business there where we are seeing more attractive margins, and especially - well it should improve further with the introduction of our next-generation smart meters in EMEA markets, which starts in quarter two of this year.

Philip Mezey

And I will say that we expect volume to build the back of ‘16 and into ‘17 as we see projects like GrDF in the Italy residential market increase. So as Mark said, we haven't quite seen the full volume effect there but improved mix and efficiency with the closure of our Naples facility and some cost optimization.

Sean Hannan

Okay, that's helpful. Now if I switch to software and services, and strictly as I think about software related to the Riva offering, now that’s an offering I think that you’re continuing to step-up here, and just trying to understand the recent project that you’ve won in North America, how much are you expecting there to be momentum with kind of the most upgraded platform where we are today and any more color around what we’re getting from customers on that front outside of the context of demonstrations and discrete effects [ph]?

Philip Mezey

So Sean, what I’d say is that - and you know this well, is that the standard business case that we've seen in the smart metering and smart grid space is really around largely operational efficiency with some customer service benefits. What Riva as a platform offers is the ability to optimize distribution and provide customers with much greater visibility, and you've seen industry quotes and competitive quotes about the opportunities expressed in dollars for endpoint per year of ranging in the several dollars up to higher numbers that are possible as that business case really broadens beyond the revenue cycle that we've traditionally gone after. So we certainly see that opportunity is starting to develop. So stronger business case that gives us an opportunity to sell this more advanced technology initially and then build on top of it over time with additional offerings that broaden out the business benefits that our customers see.

Sean Hannan

Okay. So in essence there is an opportunity to have the software and services outtake in terms of growth versus the rest of business? Now it comes from a small base, but there is - it sounds like there should be good momentum there, correct?

Philip Mezey

That it - yes, that is correct. And that software and services spans from the actual operation of the system to analytics that are running at the core of the system to analytics that are running across the system and actually at the end point.

Sean Hannan

Understood. And then, when I think about the offerings in software and services relative to past, is there also a migration for richer solution, improving the leverage and thing that general space for you ultimately and you get better margin profile from this revenue contribution as we move forward as well?

Philip Mezey

So, Sean, I want to make sure that yes - well, let me say this back to make sure I get it which is, we expect that this expanded value proposition that we can offer with our system both enhances our margin profile for our core Riva offering as well as offering a very attractive margin pure software stream. So there is an integrated effect here that both strengthens the core offering and adds additional capability.

Sean Hannan

Well, it sounds like it improves the multiple independently just at software and services and obviously as it lifts a broader platform than I think.

Philip Mezey

Yes, okay, there is another aspect you’ve raised which is a well-executed strategy in the space broadens beyond just the traditional smart grid connectivity that we are starting to see opportunities in smart cities and other areas to bring on additional endpoints that represent yet another additional stream for us.

Sean Hannan

Great. Thanks so much for the color folks.

Philip Mezey

Sure Sean. Thanks.

Operator

Thank you. And our next question comes from Sven Eenmaa with Stifel.

Sven Eenmaa

Yes, thanks for taking my questions. Just wanted to ask in terms of your gross margin guidance for the next year, you mentioned Water gross margin improvement potentially here, but could you also have comment on your expectations for Electric segment gross margins, relatively what you delivered in the fourth quarter, as well as in the Gas segments?

Mark Schmitz

Okay, I think your question is what are our expectations relative to Electric and the Gas segments.

Sven Eenmaa

Yes.

Mark Schmitz

We haven't provided the discrete guidance on segment margins to that degree in the past, but I think the flavor I'd be willing to give you on this is that Electricity is improving. Electricity, we see the continued march forward and improvement in Electricity as a result of the optimization plans that have been put in place, restructuring plans from 2014, the movement away from very low margin business, the concentration on opportunities where we can earn attractive margins. And bear in mind that also the strong pipeline we've got in Electricity business in North America that Philip commented on just a few moments ago.

North America we tend to enjoy pretty attractive margins in the Electricity segment. So all I'd like to spell out there is to say that there is a secular positive trend in Electricity gross margins. Bear in mind that we do expect to see some headwind from increased incentive compensation in Electricity, and then frankly in all segments in 2016. So will that I don't want to get any more specific than that.

In Gas. The Gas business, the improvement that we've seen in quarter three and now again in quarter four is encouraging. I think we said to you that we expect to see this improvement occur. We do expect to see further improvement but it’s not going to be on a straight line. That Gas business has some additional improvement ahead of it, but because mix is such significant impact on the business, there could be variations from quarter to quarter. I hope that probably gives you enough flavor.

Sven Eenmaa

That's helpful, yes. The second question I had, you mentioned also that in the month of April you will - I mean following the next earnings trend, you would provide an update on some of additional cost reduction initiatives you're working on. At this stage, could you just give us a framework in terms of how the part of your current cost base is affected by those initiatives?

Philip Mezey

So, Sven, first of all I want to be very clear about something that Tom is, from the day he showed up, he has already had a very positive impact on the overall operations of the business. You see this in our strong fourth quarter results. I've mentioned a number of initiatives already underway in supply chain optimization and planning, and steps that are under execution currently and underdevelopment that are contained within our current projections for the business.

The comments that Mark had made about additional optimization opportunity here is that we see the opportunity to continue to take a look at our overall manufacturing footprint at our supply chain and our R&D, and the work that Tom has done have identified some very helpful opportunities for us really to continue on the path that we started several years ago of asking some hard questions about the number of manufacturing facilities that we are operating, how much of that work that we are doing in-house versus on an outsourced basis and how it is that we can continue to simplify our business overall.

So I see - the messages here are - the work is already underway. We've made substantial and strong progress with the restructuring work that we began last time. We're making urgent operational improvements currently and throughout 2016, and that we see additional opportunities that we will share with you in more detail on the next call.

Mark Schmitz

And I'll just add to that, Sven, that you asked I believe how much of our cost base could be affected by these activities that are part of the studies and structural operational improvements that we’ll be making in. I mean it's almost all of it. It's our direct spend and indirect spend in the factories. It's our purchased raw materials and parts. It's our product development R&D spend. It's almost everything that's touched by us [ph].

Sven Eenmaa

Got it. Thanks so much.

Operator

We'll next go to Ben Kallo with Baird.

Dave Delahunt

Hi guys. This is Dave Delahunt on for Ben. Congrats on a good quarter. I know you touched on this earlier, but I was wondering if you could add a little more color on the improving the R&D optimization and what segments you're going to be focusing on and still more color about the change that we will be happening there?

Philip Mezey

Sure. So the first is - the first and most important point is that as we bring this Riva capability to market, this, we think, really changes the game in the market, broadens it and is an enabling platform for some very exciting opportunities in the growth of software and services and actually broadening beyond our traditional metering and utility marketplace. So we are clearly focusing on providing a unifying standards-based platform across Electricity, Gas and Water, adding other elements in ecosystem to that platform.

Mark made the comment that R&D will be held essentially flat in 2016, that indicates that we are taking a very hard look at a broad portfolio of legacy products that we have been supporting globally and making some very focused decisions similar to the ones that we made on in the electric business on lower margin metering opportunities, looking at our R&D portfolio and ensuring that we are focusing dollars on forward-looking high return projects that are going to really drive the vitality of our business and put us at the forefront of innovation and leadership.

So it is really a realignment and some very clear thinking about how it is that we are using that invested capital most productively.

Dave Delahunt

Great. Thank you.

Philip Mezey

Thank you.

Operator

We'll next go to David Rose with Wedbush Securities.

David Rose

Good afternoon. Thank you for taking my call.

Philip Mezey

Sure David.

David Rose

I just wanted to - I wanted to touch on a little bit on the leverage in what our expectations should be in the operating leverage that is and what can we assume in terms of the add back in comp expense for next year and what sort of hurdle rates on the top line or operating income do you need to hit as we add back that comp expense? And then maybe you can paint a little bit of a clear picture for us in terms of the puts and takes on the margins. What drives it a little bit higher? Is it material cost, is it labor, is it product mix, maybe you can kind of break it down for us in pockets?

Mark Schmitz

To start with on the - your question on operating leverage. You should think in terms of us adding back something in the order of $25 million in cost in 2016. Now bear in mind, as in any company, it depends very much on the curve and where you are in that curve. And so when you think about being at the middle of the range guidance we provided, we're probably talking about $25 million of additional operating leverage from incentive compensation expense.

David Rose

Okay.

Mark Schmitz

And then David, I'm going to have to ask you to repeat the second part of your question if you don't mind, I couldn't get it all.

David Rose

Sure. So the second part is, as you think about the offset to that $23 million increase for you to get to the guidance level, how do you break it down in terms of the cost savings between labor, material and product mix?

Mark Schmitz

Well, of course first of all you’ve got to flow-through from revenue growth that we do - although we've given up cautious guidance range, we do expect to see revenue growth. We do expect to see some accretion in gross margin. How does it come from material versus factory and labor productivity and so on? It would be difficult for me to spell that out here, but we do expect to see some accretion to gross margin. And then overall, we are looking the whole operating expenses roughly level year-over-year.

There were a lot of other moving factors here, David, and I mean I just spell out a couple of them that you might know about and picked up one course is the special warranty charge which we’re surely not going to repeat in 2016, that was $29 million.

David Rose

Sure. And then another housekeeping question is just on the tax rate. Is there some reason that it would be at the higher end of the range, given what we are seeing in terms of growth internationally? I would have expected a couple of points lower perhaps. Or is this just kind of a conservative view to start with and then work your way down, and then does that include the R&D tax credit?

Mark Schmitz

It does include the R&D tax credit since that was made permanent by Congress just at the end of last year. No, I would not characterize it as being conservative, no. We've been careful but not conservative in this. Our tax rate has been quite variable, partly as a result of having valuation allowances in place in three or four jurisdictions, one in Brazil just in quarter three of this year and that both existence of those value and sales allowances causes more variability that the existence of those valuation allowances causes more variability than we’d like see in our tax rate in the event of low profitability or negative profitability in the jurisdictions where those valuation allowances are in effect. I'd like to add to say that as we move forward, and I think we’ve said this in prior calls, we do have a plan in mind to begin to reduce that variability in the tax rate and expect to see some of that happen in 2016.

David Rose

Okay. That's helpful. And then, if I may, just one last one. And I know you don't like to talk about specific awards, but perhaps Philip you could put it in a context of competitiveness. How would you’ve been better positioned in the Con Edison contract both on the networking side the metering side with OpenWay Riva had that been a bigger part of the solution earlier on?

Philip Mezey

David, I'll say this way. Both, we and our competitors, have been involved in piloting our technology with various large customers. Some of those pilots have been in place for several years. And once in a pilot, if the supplier does a good job, the conversion rate is typically quite high. Had we had Riva in the marketplace several years ago when the pilot initiated, I think that would very likely had an impact upon the process and we are also have a high conversion rate in success where our technology has been piloted and been in place over several year period. We feel that OpenWay Riva will change the competitive landscape favorably for us, however we are growing very strongly and winning with current capability that we do have as well.

David Rose

Okay. Great. Thank you very much.

Philip Mezey

You're welcome.

Mark Schmitz

Thank you.

Operator

We'll go to Jeff Osborne with Cowen & Company.

Jeff Osborne

Great. Thanks for all the details so far. Just coming back to Tom Deitrich’s assessment that he is working on with you folks. Can you just frame Philip where we are at today with the manufacturing footprint, where we might have been two years ago before some of the French announcements? It would just be nice either if you have that information handy now or when you have the next call to set the framework of where you’ve been, where you are and where you're going. So I know there has been a lot of changes so far, but it's a bit unclear where you are actually at in terms of facility closures. So anything would be helpful on that front.

Philip Mezey

Yes, Jeff, let me - yes, let me answer the question this way rather than a quantitative answer which is that where we were was essentially a legacy environment based on an acquisition footprint. Where we got to was incremental improvement based upon that footprint, and the value of Tom and the work that he’s done is to define where an optimal footprint of where or not a quite optimal, but a footprint of the desired future state as opposed to getting the incrementally over time. So the value of bringing in a strong outside view is to shape your vision, not based upon where you’ve been but where you need to get to. And so he is really bringing a very strong perspective about what that desired future footprint is. That's directionally - we are consistent with the work that we've done, which is that we are evaluating the overall capacity and capability of our facilities looking at the rate of technology change and where we expect future volumes and desirable margins to be, but just driving that process further and faster than we have historically.

Jeff Osborne

Got it. That's helpful. And a lot of times in technology industries where the value has over time shifted from hardware to software and services, which I think if you look at your strategy, you would acknowledge that you are kind of repositioning that way, a lot of the industries have moved to contract manufacturing. Can you just touch on the delicate balance that you have as you would assess contract manufacturing use, and A, if you are allowed to with the customers that you have? Historically your industry has been less of a proponent of that, but I just wasn't sure if there is any variables that might be changing that dynamic?

Philip Mezey

Sure, I mean, Jeff, first point I'd make which I think I made before is that one of the desirable elements in Tom's background was that at Flextronics he ran the mobile headset division, so that he had in his background a very strong level of expertise about how that marketplace operated and how it is that he would manage in that type of an environment. And so by specifically selecting him and bringing in, it was - that was one of the really conscious choices that I made in that evaluation process. And we’d absolutely need to selectively look at how it is that we use contract manufacturing in order to balance our loads and make sure that we are operating as efficiently as we can. And I agree that as we move to high automation solid-state technologies that the opportunities for outside manufacturing have increased, that the industry - that our industry is not necessarily been the fastest mover there, but there are a strong opportunities for us that we'll see in the future.

Jeff Osborne

Got it. So the type of RFP that you had with I’d say Southern California few years ago that you have at in your South Carolina facility for those types of variables around domestic manufacturing and in-house PCB manufacturing and things like that, those are the variables that are no longer at play I assume?

Philip Mezey

No, Jeff, I wouldn't go so far as to say they are no longer in place. I mean the specific contract you referenced, we had practically continuous monitoring quality assurance. I mean there is an embedded nature of how that was delivered. I think it is evolving over time, but I don't want to say that this is - that we've gone through a complete industry shift yet in that regard.

Jeff Osborne

Got it. Two other quick ones. One is, is the company's policy still that they guide just on the after Q4 in the mid-year and the July call, or given the wider range in the uncertainty on the broader macro, is there any thoughts about updating that on a quarterly basis?

Mark Schmitz

No, we've got no plans to update guidance at this time.

Jeff Osborne

Okay. In the past, I think you reaffirmed it or change it in July, but fine, you don't want to comment on that. Any thoughts on the December 10 press release that you had around the Value Enhancement Committee? When we should expect any kind of outcome from that Board study and what the medium of that delivery would be from, either on an earnings call or some other events?

Philip Mezey

Yes, Jeff, I mean I wouldn't think of it as something that's waiting a report or an outcome. This is a continuous process in a collaboration between management and the Board and looking at the opportunities for us to enhance shareholder value that are very consistent with the types of initiatives that we’ve discussed on the call today and the actions that we've been taking in which we look at operational optimization and market dynamics, and what we in-source, what we outsource, all those types of things. So this is not a study-and-recommend kind of process. This is an ongoing and very, very healthy dialog about enhancing long-term sustainable shareholder value.

Jeff Osborne

Got it. Thanks so much for the clarification there, Philip.

Philip Mezey

Sure Jeff.

Operator

Thank you. That does conclude today’s question-and-answer session. There will be an audio replay of today's conference available this afternoon. You can access the audio replay by dialing 1 (888) 203-1112 or 1 (719) 457-0820 with the pass code of 297230, or you can go to the company's website at www.itron.com. That concludes today's conference and thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!