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Echelon Corporation (NASDAQ:ELON)

Q4 2007 Earnings Call

February 7, 2008 02:00 pm ET

Executives

Kenneth Oshman – Chairman, CEO

Beatrice Yormark – Pres Chief Operating Officer

Chris Stanfield – CFO

Analysts

Michael Carboy – Signal Hill Group LLC

Joe Maxa – Dougherty & Company LLC

Bill Gibson - NollenBerger Capital Partners

Shaun Boylan – Analyst

Mark Rogers - Arthur Andersen & Company

Chris Borat - Analyst

Operator

Welcome to the Fourth Quarter 2007 Results Conference Call.

(Operator Instructions)

I will now turn the call over to Ms. Bea Yormark.

Bea Yormark

During this presentation, representatives of Echelon may make statements related to future plans, events or performance, these forward-looking statements are based on certain assumptions and are subject to number of risks and uncertainties.  We encourage you to read the risks described in our earnings release as well as in our SEC report, including our 2006 report on Form 10-K and subsequent reports on Form 10-Q for 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.  This presentation will also include a description of certain non-GAAP financial measures that we believe provide our management investors with useful information relating to our financial condition and results of operations.  A reconciliation of these non-GAAP amounts to GAAP amounts is included in the financial statements accompanying today’s Earnings Release and is also available on Echelon’s website.

I will now turn the call over to Chris Stanfield, Echelon’s CFO.

Chris Stanfield

All non-GAAP amounts exclude the impact of any stock-based compensation charges.  For the fourth quarter of 2007, revenues were $46.9 million compared to $13.9 million for the same period in 2006.  Echelon’s revenues for the fourth quarter were comprised of $27.7 million from our NES product line, $13.1 million from our LWI product line, and $6.1 million from the Enel project.

For the full year 2007, revenues were $137.6 million compared to revenues of $57.3 million for 2006.  Full year 2007 revenue consisted of $70.6 million from the NES product line, $52.8 million from the LWI product line and $14.2 million related to the Enel project.

While we have reported our revenues in accordance with US GAAP, we believe it is important to consider at least two factors in comparing amounts for 2006 and 2007.  We are providing this information so that you could understand year-over-year business level changes through the eyes of management.

Q1 2007 NES product line revenues included shipments of hardware products that were accepted and in some cases paid for in 2006.  However, the company could not record this revenue in 2006, since all of the requirements to recognize this revenue under US GAAP had not been met.  Had these revenue recognition criteria have been met, NES product line revenues for 2006 would have been approximately $14.4 million greater and revenues for 2007 would have been approximately $14.4 million lower.  This would have reduced the overall annual NES growth rate from 8820 % to 269%.

Full year LWI revenues for 2006 were reduced by a one time reduction of $3.9 million as we transitioned to sell end to sell through accounting for our sells through distributors.  Full year 2007 revenues for LWI products increased by 7% over full year 2006, however, this change would have been a 1% decrease, except for the effects of the one-time reduction in 2006.

Enel project revenue increased by 100% in 2007 from 2006 levels.  Total revenue for the full year 2007 increased by 140% from 2006 levels.  The year-over-year growth rate would have been 63% except for the factors I have just discussed.  Non-GAAP gross margin for the quarter and year were 41.7% and 37.1% respectively.  We had GAAP and non-GAAP profitability of $0.03 and $0.09 per share, respectively for Q4 2007.  We had a GAAP and non-GAAP loss of $0.36 and $0.20 per share respectively for full year 2007.

For ease of reference we have prepared a complete non-GAAP statement of operations for the three and 12-month periods ending December 31, 2007.  This additional information can be found by going to the non-GAAP financial information link in the Investor Relations section of our website at www.echelon.com.

For the first quarter of 2008, revenue is expected to be approximately $32.5 million.  We expect NES product line revenues to be approximately $18 million, LWI product line revenues to be approximately $13.5, and Enel project revenues to be approximately $1 million.

Full year revenue is expected to be approximately $178 million.  We expect NES product line revenues to be approximately $110 million, LWI product line revenues to be approximately $58 million dollars, and Enel project revenues to be approximately $10 million.  On an annual basis we expect total revenue to increase by 29%.  This is comprised of a 56% increase for NES product line revenues, 10% increase for LWI product line revenues and a 30% decrease for Enel project revenues.  We expect non-GAAP gross margin to be 37.7% for Q1 2008 and 40.7% for full year 2008.

We expect non-GAAP operating expenses to be $17.5 million for Q1 2008 and $69 million for full year 2008.  This would be a 10% increase for the quarter and a 7% increase for the full year over the same periods in 2007.  We expect interest and other income to be $1.3 million for Q1 2008 and $5 million for the full year 2008.

We expect the provision for income taxes to be $100,000.00 to $50,000.00 for Q1 2008 and $1 million for the full year 2008.  We expect charges for stock-based compensation to be $2.8 million for Q1 2008 and $13 million for the full year 2008.  We expect a loss of $0.10 per share on a non-GAAP basis and $0.17 per share on a GAAP basis for Q1 2008 based on 40,750 primary shares.  We expect earnings of $0.16 per share on a non-GAAP basis for the full year 2008 based upon $45 million fully diluted shares.  We expect a loss of $0.14 per share on a GAAP basis for the full year 2008 based upon 41 million primary shares.

I will now turn the call over to Bea.

Beatrice Yormark

Hello everyone and welcome to our Q4 conference call, as I am sure you know if you follow the company, we set a goal at the beginning of the year to achieve non-GAAP profitability in the fourth quarter.  Everyone at Echelon has remained focused on this goal throughout the year and as you saw in our earnings release and heard from Chris, not only did we achieve our goal, we also achieved GAAP profitability.  Everyone at Echelon worked extraordinarily hard to accomplish this and I am both pleased and proud of their efforts.

Looking into revenue, our Networked Energy Services product line performed very well both for the quarter and the year.  We entered 2007 with a significant portion of the NES revenue clearly identified as part of the specific project with specific shipment schedules or so we thought.

However, one attribute of the advance metering market that we have come to understand is that while schedules maybe identified, given the massive scale of the deployments being undertaken, they are subject to change, being speed up or more often slowed down based on holidays, weather, installation rates and so on.  The result of this is that while we met our target for Q4 revenue, it came from different sources than we had planned at the beginning of the year.

For example, at this time last year, our project with EAC in Russia was not identified.  In fact, we had even begun discussions with them, yet, we ended up shifting a significant number of meters and data concentrators to them this past quarter.  Likewise, of our partners, ES-1 and we fulfilled a large portion of a project with Halmstad, a city utility in Sweden this past quarter that was not part of our original Q4 plan.

As Chris just mentioned, we expect to generate NES revenues of $80 million during the first quarter of 2008.  To give you an apples-to-apples comparison to the first quarter of 2007, we would need to adjust the Q1 2007 number to remove that portion of the revenue related to revenue that was deferred from the fourth quarter of 2006 due to undelivered software and recognized at Q1 2007 as actually Chris pointed out.  On this basis, NES revenue associated with products accepted during the first quarter of 2007, were approximately $10.5 million.  So we expect a roughly 71% increase in NES revenues for the first quarter of 2008 as compared to Q1 2007.  Similarly on a year-over-year basis, we currently expect full year 2008 NES revenue associated with products accepted during the period will increase by approximately 96% over those generated in 2007.

As we entered 2008, we have fewer NES meters in “backlog” than we did in 2007.  However, we are entering the year with at large number of partners working a larger number of identified prospects than we did last year, and potential for follow-on orders from existing customers this time.

While we do not believe that our partners will win every project they are pursuing, nor do we believe that all of these will be awarded this year, we do believe a sufficient number of these will move to volume deployment and support the guidance Chris just provided, and as was the case this past quarter, I am sure there are opportunities out there that we do not see today that can become significant revenue in 2008.  The advanced metering market is evolving rapidly across the globe.  It is really an exciting time.

Turning to our LonWorks Infrastructure Product Line, performance this past year was disappointing.  While we saw a good growth from customers pursuing demand response and energy management application, we saw a decline from some of our OEM in the traditional controls industry that offset this growth.  Overall, the LonWorks Infrastructure Product Line was virtually flat in 2007 with North America turning in the most disappointing results.

This is unacceptable to me and to all of us at Echelon, the ability to monitor, manage and control energy consumption is becoming increasingly important worldwide and our LonWorks Infrastructure Products are key ingredient making this happen in commercial buildings, homes, outdoor lighting systems and other systems.  Now is our time.

As I discussed in our last conference call, in a large part, this is a channel and awareness issue, where end-users are not being told and then told again about the energy saving possible LonWorks network.  To help address this, we are stepping up both our press outreach to help get the word out and our efforts to attract partners.  We are also working with key-end users to help make them successful, and like in NES we are pursuing a number of very exciting opportunity.  One important example is McDonalds and their kitchen of the future project. While we do not expect a lot of revenues in 2008 from McDonalds, we do see this year as one where the McDonalds suppliers will begin to deliver the smart energy aware product to the market.

Looking forward to 2008, we expect our LWI product line revenue to increase by about 10%, much of this growth will be from existing customers rolling out more solutions and from new customers that will begin to ramp to volume.  We have some exciting new customers and prospects with large opportunities for delivering solutions for energy savings around the world.

Before I turn the call over the Ken, I would like to close by saying, we believe 2008 will be a very big year for Echelon.  We know we have a lot of work ahead of us to meet the targets we have set out.  We have new business to book, large volumes of products to build and ship, and specific programs to complete.  We also know that we have momentum, accessible projects we can point to and market forces on our side.  We are in the center of the convergence between control networks and energy management networks.  This is the sweet spot of our two decades of experience.

Thank you all for your interest and support, have a wonderful year.  Now, I will turn the call over to Ken.

Ken Oshman

Hello everyone, thank you very much for joining our call today.  As you have just heard from Chris and Bea, we are very pleased with our results for this past quarter and excited about the outlook for 2008.  Before I share with you some insight into what we see driving our business in 2008.  I would like to spend a few minutes reviewing 2007 against the goals we set for ourselves and shared with you throughout the past year.

At the beginning of last year, I told you that we saw energy as a killer application, driving both our LonWorks Infrastructure and NES product lines, monitoring it, managing it, controlling it, conserving it.

As energy cost continues to rise, as concerns about the impact of global warming and carbon dioxide emissions grow, consumers, businesses and governments are increasingly asking what they can do and they are finding that Echelon, our products and our partners provide solutions.  While I cannot tell you that everything unfolded last year exactly according to plan, I can tell you, we made very important progress in 2007.  In our LonWorks Infrastructure product line, we saw growth among our demand response oriented customers, such as EnerNOC growth that we expect to accelerate in 2008.  We introduced the new i.LON SmartServer, which includes important new capabilities for our partners deploying Smart street lighting systems and provides a platform for creating custom applications and drivers for building advanced energy management strategies.

We expect growth in both of these areas as SmartServer shipments begin later this quarter.  In our NES product line, we recently reached a very important milestone, shipping our one million Smart NES meter.  As best I know, Echelon is unique in the advanced metering market and that we have a global platform.  All of the meters we ship worldwide are based on the same core set of electronics, firmware and networking.  This not only gives us unmatched scale, but also lets us put our wood behind one arrow.  We can learn from the best practices of utilities and markets across the world and focus our R&D efforts on one target platform, thereby moving forward faster and with more functionality than competitors with fragmented regional offerings.

We also introduced our third generation metering platform this past year, third generation.  I see this as another sign of our maturity and our lead in this market.  This third generation platform offers additional functionality to our customers and incorporates learning from our first two generations of meters to reduce our manufacturing cost.

NES meters are currently approved in 17 countries and it will take more time to bring out and certify this GEN3 platform in each of these jurisdictions.  But as GEN3 meters become a bigger part of our shipments.  Our gross margins will improve.  One specific NES goal I shared with you last year was that we intended to establish a beachhead in North America.  I am pleased to say that we did not just establish a beachhead, we did much more.  Duke Energy with their utility of the future project, is I believe at the leading edge of defining the Smart grid for our country.

Duke has announced plans to install the NES system in about 57,500 customer sites across three different cities.  The North American AMI market is a bit murky and it is hard to know what is real and what is just a plan, but based on what we know, we believe that when completed, this large deployment would be the largest and most functional AMI system in North America.  I have heard from investors that they wished we had made a bigger splash to announce the Duke project.  I wish we could have as well.  However, as is true with every company we work with, we view our customer’s projects as their project and we respect their wishes with regard to how, when and if they are announced as we did in this case.

I had the pleasure of meeting with Jim Rogers, the CEO of Duke last week, after the DistribuTECH Conference.  I could not be more honored and pleased to be working with such a great utility and a great partner.  DistribuTECH is a very large utility industry conference with hundreds of exhibitors and thousand of attendees.  A large focus of this year’s conference was advanced metering infrastructure, demand response in the Smart grid.  This was the first year, had a booth on the trade show floor, our coming-out party for the US utility market.  We had a fantastic booth, not only in terms of how it looked but more importantly in what it showed.  The booth was very busy with visits from utilities, potential partners and of course our competitors.  We were demonstrating how Smart utility metering systems, Smart street lighting systems, home networks and building control systems, all of the devices attached to the electric grid can work together to create a complete Smart grid and enable utilities and energy consumers to work together to simply and effectively manage energy consumption and reduce demand in times of limited supply.

In other words we were showing the power of our 20 years of device networking expertise, the power of our products and our partnerships, all of the things that differentiate Echelon from its competitors.  It is this that we see when we look forward to 2008.  I believe energy will continue to be the driver of our growth.  Around the world our NES value added reseller partners are working on many tenders, trials and prospects and we expect some number of these to begin volume deployments in 2008.

We see continuing growth from our demand response oriented customers and in energy management applications in retail change, quick serve restaurants and commercial buildings, increased activity in street lighting systems and growth in the digital home alliance.  And most importantly we see the beginning of utilities business and consumers looking to interlink these previously disparate systems to build a Smart grid which is right at the heart of our strength.

2007 was a great year for Echelon; it was great in part because we are in the right place at the right time, but most of all, 2007 was great because of the outstanding and at times amazing efforts of the dedicated people of Echelon, obviously from the people at the heart of our product development, sales finance and operations teams, but also from people everywhere in the company from shipping and receiving to customer support to order administration to project management to financial planning.  We have a wonderful team of people at Echelon and I am proud to be part of the team.

2007 is now in the history books, so we turn to 2008.  It will be a challenging year as we continue to strive to achieve dramatic growth and revenue and continued improvement and profitability, but we are all dedicated to accomplishing our goals and feel confident that we can.  Thank you again for joining our call, I would like to now open it up for questions.

Question and Answer Session

Operator

(Operator Instructions)

Our first question comes from Michael Carboy, please state your question.

Michael Carboy – Signal Hill Group LLC

Congratulations on a achieving the profitability on both GAAP and non-GAAP this quarter.  A couple of questions for you, let us first chat a little bit about the pace of solicitation activity that you had mentioned Bea, I think you said it was at surprisingly high levels, can you put any metrics around that for us to help us understand how that thread of exploration and examination of the utilities has changed over the past year?

Beatrice Yormark

Yes, you know I think what is happening is we are seeing a lot more activity than we have before in different parts of the world.  A little more activity in Asia than we have seen before.  In Europe, our partners are beginning to expand both in terms of utilities that were already involved in and countries that are already involved in as is demonstrated by the Halmstad thing that we were unable to announce, but that in fact that ES did.  ES is our partner with E.ON in Sweden and they continue to get more projects in Sweden, Halmstad being the first of what we expect would be even more projects, so we are digging deeper by our partners and we are seeing new partners begin to expand into new and different markets.

Michael Carboy – Signal Hill Group LLC

And Ken, with regard to LonWorks, in the past you have talked about the increasing nature of some of the traditional system vendors to revert to more closed systems.  How are they countering the art of positive ROI experience?  The people like Bower and McDonalds have had with the LonWorks systems.

Ken Oshman

Well, I think the best counter that they have is that they also provide open LonWorks systems and they can, and they do when someone challenges the ability to do that, and in fact I just got a presentation for a large community development project that uses LonWorks and it is one of the traditional suppliers that is the supplier, but it is being done by an integrator, an independent integrator and they showed that there was about a three-year payback just from energy savings and reduced maintenance cost because of the open system.  So there is about a three-year payback on the control system for this new project.  And by the way, they compared it to the original simple control system, closed control system that had been originally quoted for this project.  So when people really press for energy savings and are not necessarily focused on first costs, but really projects life-cycle costs, everybody or most companies will respond for LonWorks and open LonWorks.

Michael Carboy – Signal Hill Group LLC

So, it is not really a matter of bud being tossed out by the traditional guidance.  It sounds like it is more a matter of customer awareness and knowing for something being available.

Ken Oshman

Absolutely, and that is what Bea is talking about. We are going to try and get the word out better.  It hard for us to get the word out, only because if you stop and think about it, every building owner, get the word but our revenues for a building, the wonderful thing is there are hundred of thousands of LonWorks buildings today, but the bad news is that the revenue per building for us is not enough that we can afford to send sales people to every building owner, every project, so we have got to find ways to leverage that word with partners and with better PR and better presence and we are working hard on that this next year.

Michael Carboy – Signal Hill Group LLC

Okay, and this is the last question for Chris if I may.  Chris, it looks like, just looking at the NES business here this quarter and looking ahead of the Q1 outlook.  It appears that there will probably be, at least by my calculations, a pretty significant decline in the incremental gross margin in NES, I was wondering if you could elaborate a little bit on why we are seeing what is likely to be a pretty significant compression in NES gross margin in Q1.

Chris Stanfield

Well, we do not really break out margins by product line.  I think what you are probably referring to is simply having the effect of having a reduced revenue level because as you know, there is a very significant portion of cost that is contained with the cost of goods sold that is effectively fixed.  And so when you are amortizing that costs over $45 million or $46 million that represents a much lower percent of sales than when you are doing it over a lower number and that perhaps is the most significant factor on a quarter-to-quarter basis.

Well, the only other thing I want to tell you is that, in terms of all of our businesses, we have done some careful work and we believe we do understand our cost; we have identified the transactions that we expect revenue in.  And we think that the guidance is solid.

Michael Carboy – Signal Hill Group LLC

Okay, because I had been looking back at Q3, when it looked liked at least from my calculations, it was kind of about a break even with your 4% or 5% gross margin business.  Here in Q4 it looks like the incremental gross margin was not easing up at 40% in any aspect and then going forward, even factoring in the fixed cost and it looks like there had been some compressions, so I was curious if there was a mix shift away from the cost reduced meters of some of the older styled meters that was hitting you.

Chris Stanfield

I mean the margins in NES, you know once again we do not state that, as Ken has stated before, we are trying to push them towards what are viewed as the industry standards, which is a 35% to 45% range and we are certainly not in the single digits, but in terms of the products at this period, we are shipping GEN3 and we are shipping GEN2 products.  And I think Ken made the point or Bea made the point perhaps that you have to get these platforms promulgated in each individual country, but I think we see solid volumes for both platforms and we expect to be shipping those platforms throughout the year.

Operator

Our next question comes from Joe Maxa, please state your question.

Joe Maxa – Dougherty & Company LLC

Thank you, questions along the line of your NES revenue for 2008 certainly with the guidance of $18 million in Q1 and $110 million for the full year you have some expected ramp.  I am looking for an idea of timing of shipments from once you get an order until they shift, in other words, in the back half of the year, which seems to be certainly the biggest chunk, when you need to do you need to have, or see these contracts in over to pick up those revenue targets.

Chris Stanfield

Well, I think as Bea has made reference to, you know, you have this event, which is the booking of an order, but you know, often times we have been working closely with who that partner is.  We have gone through the process so that partner making a proposal to its customer, its customer asking questions and that kind of stuff.  And so, there are times in which we have taken action what was going to happen and a good example of this was the project that Bea mentioned earlier of Russia, where we know what was going to happen in the summer.

We took the actions because our customer had some timing requirements that we needed to support and we were able to do that.  This really comes down to the planning; I think that Kevin made reference to.  We are fortunate that we have just a wonderful operations organization.  They work very closely with our sales team.  They make procurements of long lead products and thus far, they have been able to respond in the needs of our customers.  I do not know if that helps but it is not really a fixed time.

Joe Maxa – Dougherty & Company LLC

Well, you also indicted that, “backlog” was a little bit less going into 2008, compared to 2007.  So, I am just kind of thinking about the timing of these revenues and knowing that there are a period of, probably months to a minimum to ship the NES because it suggests that Q2 and even though I know you are not giving guidance would be more in line with Q1 because we are just starting to see that big ramp go up?

Beatrice Yormark

I think a good assumption is that, we will see much of this revenue in Q3 and Q4, certainly over to Q2.  But again as Chris said, all sorts of things happen within the rush of things was a very good example, the Halmstad thing was a very good example.  Those things basically, booked and shipped and went out in almost a quarter’s worth of time.  So anything can happen.  We are working on a lot of things, but I think your assumption that the last half of the year will have higher NES revenue in the first half is a good assumption.

Joe Maxa – Dougherty & Company LLC

Can you give us a ball park with that Halmstad, what that revenue was to give us an idea of how big the revenue was and that you can turn around in one quarter?

Bea Yormark

The Halmstad was 50,000 meters and so about $80.00 a meter.

Joe Maxa – Dougherty & Company LLC

Chris, on the operating expenses, it looks like Q1 is going to be the high point of the year based on your guidance.  Can you walk us through that or maybe just kind of give us some commentary on why that would be?

Chris Stanfield

Sure, as you know, one of the things that we do is carefully manage expenses, but when you come into a quarter like this, you would have to carry over the effect of the staffing increases that were achieved last year.  But the biggest effect is simply because that comes in such as payroll taxes that often times are concentrated in the first quarter of the year and in addition to that, just given the realities of families having children in school, vacation accruals tend to really peak during the first three months of the quarter.

Joe Maxa – Dougherty & Company LLC

And then lastly, I will just ask another question and then jump in the queue, can you give us an update on what you talked about before, maybe they are in your filings, your larger or your significant customers, can you give us any breakdown on those for the quarter?

Chris Stanfield

In terms of the most recent quarter?

Joe Maxa – Dougherty & Company LLC

Yes, right Q4.

Chris Stanfield

Well, we have not done it right away but obviously, the most significant customers from an NES perspective would be the people that Bea has mentioned.  Telvent and ES and those are our partners and then EAC, these would probably be the most significant ones in terms of the LonWorks product line, it is a whole range of folks ranging from Honeywell to EnerNOC.

Joe Maxa – Dougherty & Company LLC

Do you have the numbers or do we have to wait for the file?

Chris Stanfield

We do not disclose specific numbers, we sort of list them in a sequence, obviously Telvent is a very significant portion of our revenue and then I forgot to mention Enel and obviously Enel is a very important customer.

Operator

Our next question comes from Mark Rose (ph), please state your question.

Mark Rose - Analyst

Congratulations on a great year.  Let me try another NES feasibility question if I may, I appreciate Bea’s discussion of this in her prepared comments.  In the second half of last year, you told investors that about 90% of your NES revenue guidance was booked or in backlog under contract and that was very helpful.  I realized it is very early in 2008 so much smaller percentage would be in that category now.  But I wonder if you can be so kind as to divide up your $110 million NES guidance into perhaps three buckets.  Bucket one would be again booked or in backlog under contract, bucket two would be orders that you can specifically identify and you expect that they will come through, get filled and be recognized in 2008 but there is no signed PO yet.  And bucket three is stuff you have to scramble for and cannot specifically identify with confidence.  Could you divide this 2008 NES guidance and do those three buckets?

Chris Stanfield

Sure, about 30% of our guidance is currently booked.  That means we have a purchase order in-house, against which we are performing, in some obviously those good have already left.  The remainder of our guidance is identified by customer.  Now that does not mean that it is going to be just as we had said it would be, but we have identified projects with specific products and specific timing that we are planning to.

Like any forecasting process, what we do in that process is we de-rate opportunities, we exclude some opportunities from our analysis and we include others and that was the reason for Bea’s comments because as hard we worked on all of it, I am sure that one or more of those customers will do better than we thought and there will be somebody who will come in and do much better than we thought, and some people will not do as well, and even if we had all of the orders and backlog as Bea has indicated, we would still have changes because we respond to the market place and so to the extent that there are weather problems, that other factors happen, actual installation schedules sometimes get pulled in and sometimes get pushed out, but we have a plan as a management team that we believe is credible that would lead us to the guidance that we had provided to you.

Mark Rose - Analyst

So, in that 70% you were talking about, are there projects that you are simply bidding on and competing with other meter companies at this point in time that you are just hoping that you will get or is it more definitive than that?

Bea Yormark

We try not to put in a bunch of things that we just hope that we are going to get, in our forecasting have looked at the opportunities, both the ones that we hope that we are going to get and the ones that we feel we are a little further down that they had gone and the 70% includes more of the ones that were further down the pygon which includes the kinds of things that I had mentioned in my call notes, expected or hoped for additional orders from existing customers and then some of the things where we already passed one or two of the hurdles and so those are what is in there.

In addition to that, I think what Chris alluded to is we have got a lot of other things in the hopper which I believe would be and hoped for competitive kinds of things that should one of these things fall out or not happen as we expect them, by the way, expect it, we would turn to those.  So the 70% I would think is in that first category, less open and more knowledge and not certainty.  I just want to be careful about that.

Mark Rose - Analyst

Ken, in the Q4 conference call, you indicated that there was no sign of price erosion in the Smart metering businesses around the world.  Is that still the case?

Ken Oshman

Certainly, we have not seen around the world any price erosion.  I would say that prices are pretty steady; I have to tell you that in North America, things are very murky.  It is very hard for us to see, what actually is happening, what the costs really are or what prices really are, but we do not think and I mean it is hard to see anywhere, but we do not think there has been any price erosion.

Mark Rose - Analyst

I presume that $20 million increase in the accounts receivables from Q3 was related to the recent large NES shipments, but is there anything you can comment on with regards to that?

Chris Stanfield

Yes, it is exactly as you state, in a sense that your receivables tend to be comprised of your most recent transactions and we do a very careful job of monitoring our accounts receivable and we do not see any issue there and that was expected and I think as I had said in the previous call, since we knew that the timing of GEN3, we had expected a concentration of activity in Q4 that was sort of driven by one week of chip GEN3.

Mark Rose - Analyst

Sometimes one sees in a newspaper or magazine a column entitled “Whatever happened to blank?”  And I wonder if in that spirit, if I could ask whatever happened to first the deal with Kolon Data Communications in Korea and two, the SAMS open tender in Sweden and then three, the opportunity for a really big order from Nuon in Netherlands.

Chris Sanfield

Let me think, the Korea guys.  They are doing fine, they are proceeding.  Our business in Korea is doing well and they are a part of our continued Korean business, so they are doing fine.  The SAMS order, actually pretty much, it is still in place.  There are some people that under the SAMS order bought very simple systems and we think eventually they are going to regret that.  There are some people that bought LonWorks System and Hamstad is a very good example of that.  That is one of the reasons, this was something that was sort of unexpected happened and then quickly shipped because there was a contract in place, the SAMS contract was in place, so the SAMS contract is still going on, but surprisingly, the leading utility in creating the SAMS proposal went off and did something totally outside of SAM, so it was crazy, but I am sitting in a room with Bea and Bea just looked at me and gave me a look when I said crazy because I am going to get a letter from somebody, it was not crazy, it was surprising what they did.  They are going to attempt to put a different kind of system than they were originally thinking.

But anyway, SAMS is still there and still available for utilities to use if they want to purchase through that.

Nuon is still there too and Nuon is doing fine.  We think they are very happy customer of ours.  We know that they are in the process of preparing their next tender, their next tender documents.  We believe it is going to be somewhat substantially larger than their last tender was.  We cannot tell you exactly what the timing of that, we wish we could.  We do not know, we think we are in a very good position to win a large portion of whatever they do going forward this year.  We do not actually believe much of Nuon will ship this year.  I mean we are forecasting some but not gigantic Nuon revenues this year.

Mark Rose - Analyst

One really quick question, Do you know how many meter companies Duke is working with right now?

Chris Stanfield

Only us, I believe so, now understand they work with lots of meter companies in replacing their electro mechanical and solid state straightforward meters as they fail and as they need some replacement, but in terms of the utility of the future project, it is my understanding that we are currently the only meter company that they are with.

Operator

We have Bill Gibson on line with a question.

Bill Gibson - NollenBerger Capital Partners

Just a little fine tuning, Chris, in regards to your operating expense guidance, is there more of a waiting for an increase in R&D versus sales and marketing or is that spread between the two?

Chris Stanfield

You know that is a very good question.  I think that on a full year basis, it is pretty much spread across the business, there are some increases in sales and marketing particularly in the NES base, but here are also healthy increases in R&D.  The lowest increase would be in G&A.

Bill Gibson - NollenBerger Capital Partners

We saw that stock comp number, but in terms of Enel, I know the CEO had been in London speaking of installing Smart meters in Spain, had there been any follow on conversations with them about that or anything definite on that front?

Bea Yormark

Actually there is nothing definite, as far as I know I do not know that Enel has made any decisions on how to move forward on what they are going to do in Spain and yes we continued to have ongoing discussions with Enel on a variety of things, but as far as I know, there are no decisions that have been made.

Bill Gibson - NollenBerger Capital Partners

You guys left me up there in the hope for a category.

Beatrice Yormark

That is the hope for category that is about 70% I can tell you that.

Operator

We have Shaun Boylan on line with a question, please state your question.

Shaun Boylan – Analyst

If I could I want to go back to one of the first questions in which we talked about the gross margin, I just want to confirm, so the drop in gross margins from the fourth quarter to the first is primarily scale rather than mixed shift within Enel?

Chris Stanfield

A very significant portion of the effect is simply the fact that we have so much more revenue in Q4, I mean that is one important factor, but there is also as you note, a less Enel revenue in the first quarter too.

Shaun Boylan – Analyst

Okay, and as we go through 2008, given stronger revenues in the back half, is it fair to think about the NES revenues and gross margins ramping quarter to quarter through the year?

Chris Stanfield

Well, you know, there is sort of what is the if you will the margin on the average dollar of revenue for each of the product lines and then there is the companies results and so, I think, if you are looking from the NES area, what we expect is those margins will tend to improve over time as the extent of people moving to GEN3 increases, but we have encouraged people to assume that that will be a gradual change, because inertia being what it is, people tend to take what they bought yesterday.

Having said that what is going to happen is that, Bea talked earlier about the fact that we expect once again this year that our revenues in NES are going to be highly variable between quarters and obviously in quarters in which NES revenues represent a much greater percentage of total revenues, that will tend to hold down our overall average gross margin as a company.  Does that make sense?

And then the last part is obviously to the extent that we have big revenue quarters than those fixed cost that I alluded to, drop rather significantly as a percentage of revenue.

Shaun Boylan – Analyst

So maybe the way to get the final clarity on this is in terms of just the NES revenues, with the mixture toward GEN3, do we expect to be at that 35% to 45% target may be by the back half of the year in its heavier quarter.

Chris Stanfield

I do not want to get there yet in terms of that because as Bea said, as time moves on we move away from the stuff that we have actually booked to the stuff that we are planning to book and so, we will provide that clarity when we can see it.

Shaun Boylan – Analyst

On LonWorks if I may, can you just comment on the linearity within the year?

Chris Stanfield

Yes, well the effects that we do have is that there is an effect that we sometimes see in the summer, often times see in the summer associated with European vacation periods, as you know a very significant portion of our revenue for the LonWorks infrastructure product line across in Europe and there is often times an effect in the fourth quarter associated with the holiday period, it is not unusual that in Europe they take off from before Christmas through Epiphany and so those are probably the things that you can count on year in and year out.

Shaun Boylan – Analyst

So maybe a drop in third quarter?

Chris Stanfield

Well, I do not know, as Ken said earlier, we are having a change in mix here.  Historically, our revenue has been driven by the sale of components to people who are running the production line that are building products for shipment and increasingly we are selling system products like i.LON’s and I have no idea what the seasonality for those will be.

Shaun Boylan – Analyst

In terms of, Bea, your comment on the weakness in LonWorks infrastructure last year and the OEMs in North America, was that company specific or was it more related to perhaps a slow down in spending, I am just wondering on the growth of economic sensitivity here with LonWorks Infrastructure.

Bea Yormark

I actually looked at that very, very carefully and I have not been able to convince myself that it was a lot about economic slow down.  I think in some cases it was, but in some cases, we actually saw some increases in some of our OEM as well as decreases with some of the OEM’s were higher and I think that in North America, that may have been reflective of a slow down from the capital spending on building growth.

Chris Stanfield

Can I add to that?  For sure at the end of the third quarter we did not believe that this was the result of an economic slow down.  However, we still do not have enough evidence one way or the other, and Bea is absolutely right, I agree with her a hundred percent, we cannot really see that, but I think we have seen as we have said in our call, as we have seen a negative growth.  We have seen a slow down in some of our traditional customers.  We do not think, we do not have enough information to tell you exactly why that is, we do not think it is the result of their not using LonWorks, in fact we are pretty confident that is not the issue.  We think that it could be just seasonal things, but there definitely was a slow down in the traditional customers.  It also could be, it very well could be  economic because after all, the building industry of all the places that is questionable in this economic turbulence that we are certainly living through, the building industry is part of that, and so it could very well be that we are seeing economic slow down in the building controls business and such.

That is a very hard industry to use as an economic indicator, however, I will tell you because, it is a lagging industry, money gets put in place to build a building and the controls piece of that happens two years later and so, what really may happen is two years from now, we will see the economic effects or a year from now.

Shaun Boylan – Analyst

So, the 10% growth that we are forecasting now in 2008 is based on this kind of current view of the world as we know it based on the tough environment we are looking at right now.

Ken Oshman

And it is also but based on our expectation that our mix in our LonWorks infrastructure business will begin to shift toward energy management.  The worse the economy, the more pressure there is to save money and it becomes actually, a bad economy becomes a driver, high energy cost become a driver and so, we actually think there will be growth, it is just a question of how much of the other traditional sorts of control systems because economic things might see declines.

Shaun Boylan – Analyst

Last question on the LWI, in terms of the win with McDonalds and moving toward the kitchen of the future, and that not being a material contributor to revenues in 2008, can you just help us a little bit if we think about wins like this and let us talk about the time line here and what it takes to get these to the point of deployment where we do start to see these material revenues.

Beatrice Yormark

That is a pretty hard question to answer only because McDonalds, a lot of that would also have to do with some of the economic slow downs in business in general because McDonalds is not forcing a change through all of the stores.  Stores can make these changes as they see fit.  So there may be some of their franchisees, for example, that decide to put this off for a while.  I believe we will start seeing revenue from the manufacturers of the equipment as the equipment stores roll them in, but then as they tie those into their energy management and some of their other things with the i.LON, I cannot really predict.  I certainly think that we will see more revenue in 2009.

Chris Stanfield

If I could add something I would say that what we see is the significance of McDonalds.  I mean, there are a number of things that are very important about the McDonald’s decision, but one of the main the main things is we see McDonalds a leader in the quick-serve industry and a good model for the rest of the industry and so we are very excited about McDonalds from that perspective.

We also see McDonalds as doing fundamental change in the way they are going to procure equipment for their kitchens and so on.

And so the result is that the design cycle and production cycle for McDonalds are quite long.  By contrast, we have worked with other quick-serve restaurant chains, and in a matter of months we are installing i.LONs to integrators of ours, who are providing some sort of energy management or control system service for them as a retrofit to their existing establishment.  So there is a long design cycle when one type of equipment is being turned into Smart communicating equipment there is another design cycle and someone is just going to work within existing air-conditioning system and lighting system and are along with its infrastructure.

Operator

Our next question comes from Mark Rogers, please state your question.

Mark Rogers - Arthur Andersen & Company

I was just trying to get an idea because it sounds like the hardest thing you guys have in front of you is convincing your customers that indeed there is a payback and that that payback is a short enough period that this investment is worthwhile.  So with that said, are you targeting areas where the rates are high and at the same time budgets for commercial construction are strong enough that they can afford to pay for this investment.

Ken Oshman

The answer is that I think your first assumptions are wrong, it turns out it is not hard at all to convince an end user of the value of an open line system both for saving money and energy and for saving money in the long-term cost system.

The difficulty is getting the word to the end user.  And so, we are working on that and the energy rates all over the world are adequate to make these systems have good payback.  It is not hard to convince somebody of that.  We just have to tell them it is possible and more importantly our partners have to go in and see what they are doing and how they are doing it and find ways for them to improve their energy usage and change their energy, and reduce other costs along the way, so it is not dependent on variable and energy rates from place to place and it is actually not a hard story to tell, it is just a story that we need to find a better way of telling.

I think, ladies and gentlemen that we try and hold these calls to about an hour and so, I think it is probably time to take one more question and then conclude, if there is another question.

Operator

Our next question Chris Barrack (ph), please state your question.

Chris Borat - Analyst

I think you guys have mostly covered it but if I could come at the pipeline activity in a slightly different way, if you look at the un-booked portion in terms of booking at the pipeline versus this point last year, where would you put it across the various levels of the bucket set where an earlier participant asked, multiple relative to that in terms of deals or number of customers you are talking to, is it equal to 1x, 2x, 0.5x.

Chris Stanfield

That is not really the way we do it and so, I have a hard time of applying that model to it.  We seat down and we work with our sales teams.  We understand the opportunities that are out there.  We go through the process that I described to you, but we do not really do it in the fashion that you have described so I am not really able to answer that question.

Chris Borat - Analyst

Well, let me look at it this way.  I got the impression from your discussion that it seems like you are extremely busy in terms of bid activity.  Is it fair to say then, you are busier overall, if you look at sort of what is on your plate, quite a bit busier than you were at this point last year?

Beatrice Yormark

Yes, absolutely!  I think we have far more identified opportunities at this point this year than we had at this point last year.

Chris Stanfield

So, thank you ladies and gentlemen for joining our call.  As I said, we think 2007 was a great year.  We had lots of challenges in 2008 but we are confident.  We feel really confident about meeting those challenges and having a great 2008.  Thank you very much for joining our call today.  We will talk with you again at the end of our first quarter.

Operator

Thank you ladies and gentlemen, this concludes today’s conference.  Thank you for participating, you may now disconnect.

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Source: Echelon Corporation Q4 2007 Earnings Call Transcript
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