Itron Management Discusses Q2 2012 Results - Earnings Call Transcript

| About: Itron, Inc. (ITRI)


Q2 2012 Earnings Call

August 01, 2012 5:00 pm ET


Barbara J. Doyle - Former Vice President of Investor Relations

Steven M. Helmbrecht - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

LeRoy D. Nosbaum - Chief Executive Officer, President and Director


Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Zach Larkin - Stephens Inc., Research Division

John Quealy - Canaccord Genuity, Research Division

Benjamin J. Kallo - Robert W. Baird & Co. Incorporated, Research Division

Amir Rozwadowski - Barclays Capital, Research Division

Noah Kaye - ThinkEquity LLC, Research Division

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

Shawn E. Lockman - Piper Jaffray Companies, Research Division

Scott Reynolds


Good day, everyone, and welcome to the Itron, Inc. Quarter 2 2012 Earnings Conference Call. Today's call is being recorded. For opening remarks, I would like to turn the call over to Barbara Boyle, Vice President of Investor Relations. Please go ahead.

Barbara J. Doyle

Thank you, Marisi. And good afternoon to everyone on the call. This is Itron's Second Quarter Fiscal 2012 Earnings Call. And on the call today, we have LeRoy Nosbaum, Itron's President and Chief Executive Officer; and Steve Helmbrecht, Senior Vice President and Chief Financial Officer.

We issued a press release earlier today announcing our results. The press release includes replay information for today's call. We also have prepared slides to accompany our remarks in this call, and these slides are available through the webcast and through our corporate website under the Investor Relations tab.

Our earnings release and financial presentation include non-GAAP financial information that we believe enhances the overall understanding of our current and future performance. We have included reconciliations of differences between GAAP and non-GAAP financial measures in our earnings release and financial presentation.

I'd also like to cover our Safe Harbor Statement. 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 call and in the Risk Factors section on our Form 10-K, Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements.

Now please let me introduce Steve Helmbrecht, Itron's CFO, who will start our call.

Steven M. Helmbrecht

Thank you, Barbara, and good afternoon. I will begin with a summary of our Q2 results on Slide 4, starting with revenue.

Second quarter revenue of $575 million was down 5% from Q2 2011 to almost entirely the foreign exchange rates. The average euro-U.S. dollar rate in Q2 was $1.28, compared with $1.44 in Q2 of last year.

On Slide 5, you see the stronger dollar reduced revenue by $35 million. Adjusting for the impact of currency, total revenue was about flat compared with last year. The impact of FX on earnings was more muted. The stronger dollar negatively impacted GAAP operating income by $1 million and non-GAAP operating income by about $3 million, compared with last year.

Gross margin of 34% was 270 basis points higher due to special -- reduced special warranty expense and operational improvements in both Energy and Water. Lower special warranty expense, primarily in the Energy segment, drove more than half of the margin improvement over last year. Warranty expense in the quarter benefited from a $4.3 million reduction in our warranty reserve related to the satisfaction of a customer warranty issue at a lower cost than originally estimated. Excluding that item, gross margin would have been 33.2%, up 190 basis points over last year and up 115 basis points from Q1 2012.

Non-GAAP operating margin of 11.6% was up 80 basis points from last year, reflecting the improved gross margin, partially offset by higher R&D, sales and marketing expenses and the inclusion of SmartSynch in our results beginning this quarter.

Consistent with improved non-GAAP operating margin, adjusted EBITDA margin of 13.9% was up 80 basis points over last year with adjusted EBITDA of $81 million. We had GAAP diluted earnings per share of $0.79 for the quarter, compared with $0.84 a year ago. Our non-GAAP earnings per share, which exclude the impact of restructuring charges, acquisition-related expenses, amortization of intangible assets and prepaid debt fees were $1.16 per share, compared with $1.20 a year ago.

Slide 6 summarizes the year-over-year bridge for non-GAAP EPS. You see interest expense in taxes both impacted GAAP and non-GAAP EPS in the quarter. We refinanced our debt in August 2011 with more favorable rates and we have continued to pay down debt. These actions drove a $6 million year-over-year reduction in interest expense in Q2 compared with last year.

Our tax rate in Q2 was approximately 27%, as expected. Our income tax expense in the quarter was approximately $10 million higher than last year due to onetime discrete tax benefits recognized in Q2 last year.

Reduced share count resulting from share repurchases drove about $0.03 of EPS benefit in the quarter. In Q2, we repurchased 419,600 shares for $15 million. From last October through today, we have repurchased 1.6 million shares at an average price of $36.67 for a total of $60 million. That represents about 4% of our outstanding shares as of last October and still leaves us with $40 million in buyback authorization.

Now moving to Slide 7, I will review revenue by business line. Electric revenue was up 2% in constant currency. Revenue was driven by strong North America OpenWay shipments to BC Hydro, as well as the inclusion of 2 months of SmartSynch activity.

Gas revenue was down 6% year-over-year at constant currency, mainly driven by lower gas module shipments in North America due to project timing.

Water segment revenues increased 6% year-over-year in constant currency. Our Water business continues to grow. We had double-digit Water segment revenue growth in all regions except EMEA, which was down 2% due to several projects winding down. We had 12% growth in Water revenues in North America.

Slide 8 summarizes our key financial metrics reported for the Energy segment. Energy gross margin increased by 300 basis points year-over-year. The improvement was driven by reduced special warranty expense, higher margins on our OpenWay projects, lower manufacturing costs and improved efficiencies we are beginning to see in operations and procurement driven by the restructuring actions we began in Q4 last year.

Non-GAAP operating margin in Energy was 13%, up 120 basis points compared with Q2 '11. This reflects improved gross margin performance and includes some increases in R&D and sales and marketing as we ramp up efforts for a multitude of large new smart grid projects around the world. In addition, SmartSynch added $4 million in operating expenses in Energy.

Water segment results are shown on Slide 9. Water gross margin increased by 130 basis points year-over-year. With our focus on high-value smart water solutions, we are seeing benefits in product mix and volume. We are also benefiting from operational efficiencies including an improved procurement strategy and enhanced product design leading to lower material costs.

Non-GAAP operating margin in water increased by 60 basis points. This was primarily driven by the improved gross margin, partially offset by higher R&D for the new global smart meter water systems development.

Slide 10 summarizes our key non-GAAP metrics at a consolidated level. I'd like to use this slide to touch on 2 points: operating expenses and free cash flow. Q2 non-GAAP operating income is up 150 basis points, driven by our improved gross margin compared with last year. It also reflects higher operating expenses.

On a constant currency basis, total non-GAAP operating expenses are up about $12 million compared with last year, driven by the inclusion of SmartSynch and increased development, sales and marketing expenses to cover significant new opportunities ahead of us globally.

G&A is a different situation. On a constant currency basis, non-GAAP G&A expenses in the quarter declined by 5.7% year-over-year. This is a reflection of our efforts to reduce G&A, both in short-term discretionary items, but also over the long-term as we drive standardization and sustainable improvements in our processes, and implement a global ERP system.

Q2 free cash flow of $27 million was down from $34 million in Q2 last year and for the first half of the year, free cash flow was $69 million compared with $59 million a year ago. We expect free cash flow in the second half of this year to be higher than the first half, a pattern which is similar to what we saw in 2011.

I will move on to bookings and backlog using the next 3 slides, starting with Slide 11. Our total backlog as of June 30 was $1.1 billion and 12-month backlog was $637 million. Total backlog includes $60 million of acquired SmartSynch backlog.

The backlog trend you see on Slide 12 reflects the successful deployments on the top 5 large OpenWay contracts in North America over the last few years shown in the yellow bars. You can also see 3 consecutive quarters of increase in our base business backlog as shown in the red bars.

Now let's review trended quarterly bookings on Slide 13. The total book-to-bill ratio in Q2 was 0.77:1. Importantly, our core businesses book-to-bill ratio was about 1:1 with water -- 1:1 with water at 0.9:1, electric at 1.3:1 and gas at 0.6:1.

In gas, I would note that the Q2 booking and the book-to-bill ratio does not include the full value of an award we recently announced for 745,000 gas meters in Turkey.

Although the full order has been committed for this contract, we are recognizing a booking when product ships. This is yet another example of a situation where we have more visibility to future revenues than is depicted in our backlog.

Turning to Slide 14, we have a $16 million increase in our debt in Q2. We drew down $70 million from our credit facility to fund the SmartSynch acquisition, the remainder of the acquisition price was funded with cash on hand.

Subsequently, we repaid $54 million of debt and ended the quarter with debt of $455 million, basically the same level as December 31, 2011.

In July, we repaid an additional $10 million of debt.

Assuming the LIBOR rate stays at its current level, we expect interest expense to be around $2.5 million to $2.6 million per quarter, compared with approximately $9 million per quarter last year.

We have flexibility in our balance sheet structure, which provides the ability to fund growth, as well as to repurchase shares when it makes sense.

Now let's move to guidance, turning to Slide 15. We anticipate full year 2012 revenues in the range of $2.1 billion to $2.2 billion and a non-GAAP diluted EPS range of $3.80 to $4.00.

This guidance includes SmartSynch, which is now a part of our operations. The acquisition remains on track to our original expectations and we expect it to be accretive beginning in 2013.

Our revenue guidance reflects a stronger dollar, which impacts the high end of the range. Otherwise, our revenue is fairly consistent with our business outlook at the beginning of the year.

Our non-GAAP EPS guidance reflects a minor impact of the weakening euro on our earnings due to having significant European operations and euro-denominated costs, which serve as a natural hedge.

We expect gross margin for the full year to be 33.5%, plus or minus 50 basis points. Our gross margin guidance reflects strong first half margin improvement, product mix considerations, lower special warranty charges and the scale and pace of our restructuring and global procurement initiatives.

Our updated guidance assumes a euro to U.S. dollar exchange rate of $1.23 for the second half of the year, average shares outstanding of approximately 40 million and a non-GAAP effective tax rate of 27%.

In addition to improved gross margin, our earnings guidance reflects reduced operating expenses in the second half of the year before the -- below the first half run rate. What's the driver for the lower run rate? It's a focus on improving the profitability of our operations as LeRoy will discuss.

And with that I will turn it over to Leroy.

LeRoy D. Nosbaum

Good afternoon, everyone, and thanks for joining us today. Steve, thanks for a good overview of the quarter.

Let me give you some color both about the quarter we have ended and how I see the quarters ahead.

Overall, Q2 shows improved execution and follow through on the initiatives from last year. Revenue is expected and nice improvements in gross margin have made for a good quarter.

In electricity, we had a good quarter at BC Hydro, which helped North America to be up. The rest of the world was flat to down slightly.

In gas, we were a little short of last year. I would call that normal period-to-period fluctuation.

In Water, we were up nicely everywhere, but the U.K., which was down slightly.

In North America, our Water business was up. But remember our Water business is not water meters in North America, but water automation in systems. From Itron's perspective, the automation systems business is holding up nicely in the U.S. and our water team is doing a great job.

As we head into second half, I think our forecast and thus guidance is solid. We will have a drop-off in OpenWay revenue in North America. Gas will be flat to up, water will continue to grow. In total, we expect about $1 billion of revenue in the second half versus $1.2 billion in the first half. That is how we get to revenue for the full year of $2.1 billion to $2.2 billion. So in my view, we are executing well on the revenue plan we had in place as we came into the year.

Let's turn to gross margins. 34% in the quarter, 270 basis points higher than last year, margins up in Energy and in Water. We are showing nice improvement in OpenWay from a design for cost effort. And good results from our factory rationalization initiatives started last year where we will achieve $15 million in cost reductions projected for this year, part of which we have seen and part of which will come in the second half.

Good progress on the global procurement initiative started last year. We have now saved over $10 million in Energy and are moving in a similar direction in Water. Savings will continue into the second half.

We will have lower volumes in Oconee, however, here in the United States. We are adjusting our manufacturing footprint at this facility to accommodate lower volumes in the second half.

We have announced the downsizing of headcount by 300 people and we will take other measures in the factory to maintain good utilization.

We are very focused on continuing to make Oconee one of our most efficient operations and the leadership in people in Oconee are dedicated to making that happen.

So we get to a second half gross margin of approximately 34%, which I view is very achievable. We have spent a lot of time in the quarter looking at operational expenses. G&A, sales and marketing and product development. Simply said, they are too high. It is easy to say that, what to do about it, that's a bit more difficult. In G&A, we made some progress in the quarter, particularly because the number of onetime expenses of last quarter are less or gone.

SmartSynch is done. Consulting work, to more effectively organize finance and accounting, is completed. Our leadership transformation project is ongoing but at a lower spend rate. It is also producing great results with the potential for improved efficiencies across the enterprise.

We have ongoing work installing a new ERP system, so that added expense continues, but will eventually help to materially reduce G&A cross -- G&A costs and improve efficiencies throughout the company.

We have made progress in G&A, but there is more to do as we move forward. We will see additional goodness in the second half.

In sales and marketing, we are both investing and relooking at our structure and our people. In the quarter, we had a very modest downsizing where prudent. We choose to be very careful in sales and marketing with so many critical customer opportunities being out for tender or soon to come to market.

We also added general management and sales management in Latin America, which positions us well for market building and growth in the quarters and years to come. As well, we are building a team in Asia Pacific, how could we not?

And what about R&D, which is growing again this quarter. This one is not so easy either. What project and opportunity should we not pursue? Japan, Iberdrola, Brazil, Ireland, L.A. DWP in the U.S. We have to pursue all of these and many more around the world. So we continue to spend R&D dollars in this period of time when huge opportunity is before us. The unfortunate fact is we spend today to have to achieve the success you want and we want in the future.

That does not mean we're not watching R&D expense. This month, we reviewed all of the material R&D projects in the company. Looking for what we could stop, looking for synergies, looking for where we could reduce expenses. I look forward to improved expense reduction in the future both in quarters coming and in quarters in the future. We have a lot of focus on OpEx. It will produce some reduction in the second half and continued improvement in 2013.

To sum up, revenue will be a little lower in the second half. Gross margins will be approximately 34%, and with continuing serious effort on operational expenses across-the-board, we come to EPS for the year of $3.80 to $4, which given the state of the market in North America and around the world and FX headwinds, I think is pretty good.

Let me also comment on SmartSynch, which we now call Itron Cellular Solutions. We closed the transaction to acquire SmartSynch on May 1. The financials for Itron Cellular Solutions are embedded in Itron results effective in Q2. I will say that the integration team has done a superb job and that process is now almost complete. I will also say that the value we acquired is more than we had hoped for as we compete for business in North America and around the world. Itron Cellular Solutions is now an integral part of our product offering and a serious contributor to Itron's value proposition to our customers.

To close, let me turn to 2013. To be clear, what I'm about to say is not guidance. That comes in February. What I am trying to do is give you some color from my perspective, so let me start with water and gas on a worldwide basis.

In 2012, water is growing everywhere with the exception of Europe, particularly the U.K. where it has slowed a little. We should see good growth in most parts of the world in water in 2013.

In gas, our most profitable area. The growth rate has slowed a little in 2012, some of that is economy, some of that is contracts winding down, my view is 2013 is flat to up a bit on a worldwide basis.

Electricity is far more complex, so let's look at that by region starting in North America.

The second half of this year turns down with large the OpenWay contracts tailing off. While we are reloading the wagon with other OpenWay contracts, which I will talk about in a minute, in the aggregate, they will not have sufficient impact to cause growth in the first half of 2013 in North America.

Thanks to Itron Cellular Solutions, we have the contracted Entergy where implementation will be gradual across their various properties. We also thank Itron Cellular Solutions for a nice contract at consumers, 1.8 million points of communication with further potential in other areas. We have the contract at Duquesne Light with 700,000 points of OpenWay. We expect regulatory approval in Q1 with a 5-year rollout. We have signed the contract with FortisBC, which we have announced today for Itron's OpenWay solution featuring Cisco routers with Itron's meter data management software. This will be a Q3 booking for $21 million, shipments will occur through 2015.

At Duke Energy, we have received a $43 million contract for the Carolinas and Ohio.

At FirstEnergy, Itron is involved in the evaluation process for 2 million points in Pennsylvania utilizing both OpenWay and Itron's Cellular Solutions. And we're involved in a DOE load control program using Itron's Cellular Solution to monitor usage.

At Hawaiian Electric Lightning company, we have a pilot order for OpenWay. This is still a competition as others have pilots as well. This one is very interesting as it's being used in conjunction with solar and wind generation.

Beyond these specifics there are others that we cannot talk about yet but they, along with the specifics I have mentioned, begin to reload the wagon for late 2013 and beyond in the U.S.

A caution, however, these are not the very large orders that we have seen in the past. They are great orders and good progress that will produce more traditional revenue growth pattern into the future versus the 2 to 3 years of overheated activity we have seen.

In Europe, not a lot has changed since last quarter. We will see some tenders come to market during the first part of '13, but real shipments do not begin until 2014. We will be qualified in the fourth quarter of this year by Iberdrola. Similarly, we are working on being qualified in the U.K. In France, ERDF, who is ahead albeit on a slower schedule than originally forecast as the change in government slowed the process. So we will see a tender in early 2013 with deployment in 2014. The commitment, the smart metering in Europe is as strong as ever.

In Latin America, Itron is growing stronger. Our new management team is making a difference and beginning to grow the business. We have work to do, but we have the right people and place. The big opportunities, smart meters in Brazil still looks like a 2014 event.

In Asia Pacific, the opportunities continue to grow. The business continues to grow, but the competition is also becoming stronger, particularly out of China for some locations. That said, we are focusing on many opportunities in Asia Pacific and winning important projects like Sydney Water. And as everyone knows, the opportunity in Japan at TEPCO looms large.

Let's spend some time on that one. 27 million smart meters in total. The intent to move forward reiterated in a July 12 press release stating deployment plans through 2023, including an emphasis on International standards.

Behind the scenes, there has been a huge amount of specification work in which Itron has been deeply involved. This work on specifications has moved. The first round of bidding from October of this year to April of 2013 with likely first shipments into 2014.

We are early in a long process in Japan. I like our progress and I like our positioning. So where do we end up for 2013? My view at this point is 2013 on an overall basis looks a lot like 2012. First half of 2013 will somewhat mirror the last half of 2012, and then smart contracts in North America, pilots and the rest of the world and some general improvement in our overall business contribute to growing the business in the back half of 2013.

Through the year, water will show steady growth, gas will show slow growth and electricity will be the variable lower, lower in the front half and growing in the back half as we see it today.

Let me leave you with 3 thoughts: Itron's level of competitive excellence in North America has markedly improved; Itron is meeting its guidance; Itron's OpEx is too high and we are prudently dealing with it.

With that, let's open to questions.

Barbara J. Doyle

Before we go to questions, I would like to remind the callers that there is long queue. [Operator Instructions] So we really would appreciate you respecting that so we can get more people in on the queue.

Question-and-Answer Session


[Operator Instructions] Our first question comes from Sanjay Shrestha with Lazard Capital Markets.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

LeRoy, 2 quick questions. First, I apologize if I missed this, but did you give an update how do you sort of see opportunities unfolding in Japan with TEPCO, and where are they in terms of selecting the vendor and things like that?

LeRoy D. Nosbaum

Yes, Sanjay. Japan has come through, I think, a very useful and worthwhile process in that they have been working on specifications and talking with various vendors for the last several months. That has pushed the actual date for them to come to market with a bid out until looks like April of next year and probably not actual shipments until early in '14. We think we are positioned well. We have played a heavy role in reworking of specifications, which feature International standards now, which gives the guys outside the -- outside of Japan a real opportunity to participate.

Sanjay Shrestha - Lazard Capital Markets LLC, Research Division

Got it. One quick follow-up if I may then. So given this recent, sort of what was an unfortunate event in India, a lot of talk about a need for a smart grid because of the grid failure, a lot of people out of power, can you remind us your presence in that market, and what kind of an incremental opportunities that could turn into for you guys and for the entire smart metering industry, if you would?

LeRoy D. Nosbaum

Yes, Sanjay, first, let me start, if you will, by just saying a tough tragedy for those people. We feel deeply concerned as we, too, have people that live and work in India, working for Itron, 60 in total. About 30 of them are actually affected by the current blackouts. Currently, we do about $15 million of revenue in India, about half of it is water, half of it is energy. The water stuff is outside the area affected and it is a smart water project around Mumbai. The energy stuff is largely gas. We actually have not been doing business with power grid on a usual basis. However, in most recent weeks, interestingly enough we have been talking with them about a smart grid project in the southern part of their territory utilizing smart electric meters, as we all know them. I suspect that project will get highlighted in the future as being one of the things that could have helped them avoid the level of blackouts and the length of blackouts that they are currently experiencing. I mean put most simply, this is a matter of too many people using too much electricity, and it's difficult to control. So I look in a perverted sort of way at -- this could be good for the smart meter, smart grid community as India assesses how better to deal with their electricity problems.


Our next question comes from Zach Larkin with Stephens.

Zach Larkin - Stephens Inc., Research Division

First question, LeRoy, you talked about mix in the quarter, and I wonder if there's anything specific you could highlight on kind of on mix shift. Wondering how much of the improvement in mix was due to AMR ready meters, which seem to be catching on around the world?

LeRoy D. Nosbaum

Well, Zach, most of the goodness of mix was clearly OpenWay in the U.S. and 2 things: one just volume of it, mostly to BC Hydro, as you would imagine; the other one is we have in recent times done a lot of good work on redesigning the OpenWay product to take cost out of it. When I mentioned a design for cost program, that was it. So the margins in general were better in that project so a lot of good work going on there in the quarter. Other than that, I don't know that there was anything particularly unusual remix.

Zach Larkin - Stephens Inc., Research Division

And then just a quick follow-up. I wonder if you could give a little bit more color on the management project you've been working on, is there anything specific you've noted kind of culturally or changes that you could talk about?

LeRoy D. Nosbaum

Well, I could use one word to describe it. Wow! I have been incredibly impressed far more than my expectations at how much the new processes were working, how much the change in culture relative to commitment based management and speeding up decision time, it's been tremendous across the 220 people that we're putting through. And even more important, it's spreading to the rest of the company so we're delighted and I would describe it, wow, what an effect.


We'll take our next question from John Quealy from Cannacord Genuity.

John Quealy - Canaccord Genuity, Research Division

So 2 questions. First, LeRoy, CEO search. Can you update us where we're at, what timing should be expected, you're quickly coming up to your year anniversary. And then secondly, Steve, I'm going to give you that same question I give you every quarter. So you gave us a look at '13, can you walk us through cash flow expectations? I assume what you meant with your comments for '12 is we're looking over $140 million of free cash, can you extrapolate trends anyway for '13?

LeRoy D. Nosbaum

Yes, John, I'll start. I knew somebody would ask, so we didn't put it in the prepared remarks. Thank you for reminding me that I've been at this for almost a year now. First of all, I'm having fun, most days. The search is ongoing and we continue to talk to interesting candidates, we have probably talked to 15 or so at this point, we continue to look at candidates, putting some in the go-back bucket and some banking further interest in Itron. My current expectation is within my commitment, which was to be here till the end of '13, we will have a new CEO designated and a good transition handed off, so I'm comfortable with where we're headed at this moment.

Steven M. Helmbrecht

John, this is Steve. In terms of free cash flow, as I mentioned, we expect the second half of the year, we tend to see that type of second half seasonality, customers pay, we drawdown inventory for year end spending and so forth and being more heavily weighted. Just bigger picture, and we've averaged about a 7.5% to 8.5% free cash flow yield for the last couple of years and the drivers for that have been no major change really in our working capital metrics. We built some inventory up as we ramp up projects and that can come down a little bit, and so we don't see any major with that. Our CapEx remains fairly low and I don't see that changing in a material way next year, as well as our interest profile remains obviously quite low. And there may be a little change in the cash taxes, but again, not meaningful. So I would say, our ability to generate strong cash flow into '13 should continue.


We'll take our next question from Ben Kallo with Robert W. Baird.

Benjamin J. Kallo - Robert W. Baird & Co. Incorporated, Research Division

First, LeRoy, you mentioned Duke in your prepared remarks. Can you talk more about the opportunity there, and what exactly you're doing, if that can expand overtime. And then, Steve, on the cost front, how much more can you do on the gross margin front, and can you just talk about maybe in the percentage of what -- how far you've gotten so far?

LeRoy D. Nosbaum

Yes, on Duke, I'm going to be guarded in my comments here because it's early days. We have been shipping some stuff to Duke on and off for a while now. We were fortunate enough in the quarter to receive a $40-plus million contract with them for deployment in Ohio, in the Carolinas. That will rollout on a schedule that Duke will give us. As for opportunities beyond that, I'm not just going to speculate on that at this moment, it's incumbent upon us to do a good job. I know we can because we have done a great job at our 5 major contracts and we're doing good work at others as well. So that's all I can say on that one at this point.

Steven M. Helmbrecht

Ben, on the cost front, and margin front, as LeRoy talked quite a bit about the work being done in procurement savings and very much focusing on a manufacturing footprint, we're starting to see those benefits. LeRoy talked about 34% second half of the year as we look ahead. We continue to see focus on maintaining that or continuing to focus on improving the gross margin from that level. One of the big wildcards has been special warranty, so it remains that in the future. But again we're pleased with the progress we've made on the quality front as well but that's something that certainly weighs in on the number.


Our next question comes from Amir Rozwadowski with Barclays.

Amir Rozwadowski - Barclays Capital, Research Division

Just tailing off on that gross margin question, certainly, we've seen pretty big improvements from you folks last quarter, this quarter and with respect to your guidance. What are the sort of elements that can help drive further appreciation on the gross margin side? And if we -- if I may, the second part of the question, really, if we look at those opportunities sort of internationally, I suspect that they're going to be competitive, where should we think about sort of the different elements from a pricing standpoint versus an innovation standpoint along those lines?

LeRoy D. Nosbaum

That's a good series of questions. Let me just say that the -- the elements on gross margin are clear. Steve mentioned one, stay away from the special warranty. We've done an awful lot of work across the company on quality, that work continues and it will continue indefinitely, forever. It's just important and we put some people in charge of that, but I think they're doing a bang-up job. The other -- another one that's been really important is we adopted global procurement across energy and across water and then across both of them. That activity has started a while ago, but it begins to -- it takes time to ramp that up and it begins to show itself, small at first and then become meaningful and I think we're into the phase where meaningful is starting to show up. Certainly, so far this year, over $10 million in energy, meaningful; coming along in water, similar pace. We're pleased with that. There's a long way to go there and that includes just buying on a global basis, but also where do you buy? Where do you set up your procurement mechanism? And we've got along way to go so I think as we move through the rest of this year and on into '13 since I've called '13 flat, important for us will be to focus, focus, focus on cost and gross margin is in that area, and I think we can do some good work there. Also, our factory rationalization is helping our gross margin where we're putting more volume through on a fewer number of factories with more automation and the right kind of automation. That is always going to yield good process and I will tell you, I am very comfortable with what we're doing in that area, and we've seen some really meaningful cost reductions with our factory rationalization. So as we push ahead in time, those are the places we'll continue to give pressure in order to achieve gross margins and notwithstanding the fact, as I mentioned on OpenWay, we do an awful lot of cost reduction just because we design for cost after the product is a bit more mature and so through time, we'll see that, which leads me to your tag-on question. As you look around the world, certainly, we face price competition every place, but we generally feel that outside the United States, we sell at a little bit stiffer competition in Europe because the volumes are so high and as I mentioned, we're seeing more and more competition out of China, in a few places in Asia Pacific. So it's incumbent on us to work hard to be competitive and as long as we can compete on same quality, same accuracy, we're as good at manufacturing as anybody is. I'll give you a specific example of that. As we acquire SmartSynch now Itron Cellular Solutions, we will actually move some board activity out of China to Waseca, Minnesota and all in save $11 a board. So just because they make it in the far east doesn't mean they make it cheaper. It might mean they don't make it as good, it might mean they don't make it as accurate, but it doesn't mean they make it for less cost.


We'll take our next question from Colin Rusch with ThinkEquity.

Noah Kaye - ThinkEquity LLC, Research Division

Noah Kaye for Colin. Can you give us a little bit of an update on how the distribution automation program development is going. You've announced a meaningful collaborations obviously in the last 6 months. I wanted to hear an update.

LeRoy D. Nosbaum

Well, we're certainly doing a lot of work with Cisco and a bunch of other partners relative to smart grid. And the smart grid subject for me is always one of magnitude. In its totality, smart grid is an extraordinary opportunity around the world. When you get down to the specifics, it gets a little harder and the numbers get smaller quickly, so we work routinely with about 50 to 100 different partners in the general area of smart grid. It tends to be what I call customer-specific where we're partnering to do some specific thing. To be honest, Colin, it's hard for me to give you any degree of specificity beyond that.

Noah Kaye - ThinkEquity LLC, Research Division

Sure, sure. Maybe go back to procurement savings. Just wondered if it would be possible to get a little bit more detail on that, where do you see are some of the core components where you can do a little bit better?

LeRoy D. Nosbaum

That one is reasonably easy. If you look at the things we do all over the place, we put some kind of silver content on top of -- on down on a circuit board. We buy circuit boards in half a dozen different locations. We buy electronic components, used to, in a half a dozen different locations. We buy batteries in about 5 different places. And so when you start looking at those things you say, "Okay, how much purchasing power can we wield if we go to the various vendors?" And we say, "Okay, how would you like a contract that's 4x as big as the 1 you've been getting from us and maybe even with some extra time considerations?" The other thing that we begin to look at very, very carefully is we're not continuously requalifying vendors on a part that a different part of Itron is already qualified or knows a lot about. And from time to time, we also disqualify people because we haven't been getting good parts in one corner of the globe and we're getting them in the other. The other one, we have taken some serious action on is it helps you if you're buying particularly electronic components out of a purchasing group that is located someplace in Asia Pacific and so we've been moving along in that direction as well in order to do well. Now, we have 1 great big purchase of copper that's out of water, we. Have managed that historically very well and we manage it today very well, looking ahead and buying ahead and trying to give our best eye on where the copper market is going as we look at water meter and the copper content in water meters.


We'll take our next question with Ben Schuman with Pacific Crest Securities.

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

Can you just give us a quick update in terms of the PRIME meter development and what you're hearing in France in terms of the political situation as it relates to ERDF?

LeRoy D. Nosbaum

Sure. Let's start with PRIME, which is Iberdrola. Our view of Iberdrola is it's going to move forward on essentially the schedule it has had. It's got $1 million or 1 million point contract that's working off. Our view is that gets worked off shortly after the first of the year, they go back out. We have been in almost constant communication with Iberdrola showing them a product. We will be in test at the front end of October with them. We are well enough -- and well enough conversing with them to know that we will come out of that with an approved product that should be able to participate on their next tender when that occurs. Our guess, the front end of 2013. Now that said, I would be remiss if I didn't add that we recently had signed off on our meter data management system there, which is working well, are collecting data from other people's meters, unfortunately, not ours but we'll soon fix that. In France, with ERDF, the government change there is an unfortunate circumstance in terms of timing, but not one in terms of how they view smart meters and the Linky project in general. We come through a change of government that means we're going to have a new Energy Minister, that means we're going to have some shuffling down of people change. So our view of that and it has been fairly public -- publicly stated by ERDF is that they will come back out early into '13 with a tender process, and that will move to shipments in the 2014 time frame. So I don't know that there's been any -- well, I will say it differently. There has not been any change of heart relative to smart meters. There has been a change of timing. And there's a great actualization over there that a smart meter project across France adds a huge number of jobs. When I asked the question how many, I was told something in the range of 10,000. That's good for the new administration.

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

Okay, great. And then when Toshiba was rolled out -- or when Landis+Gyr was rolled out into Toshiba, did you see any kind of competitive disruption or opportunity? And can we expect anything similar with Elster changing ownership?

LeRoy D. Nosbaum

I think there's a fundamental change between the 2. Landis+Gyr, we saw no competitive difference, we see no competitive difference at all. We did see some nervousness on the part of -- particularly senior people at LNG. I think that's all died away now, and that's to we expected. At Elster, yes, there's going to be some nervousness as they have a new set of bosses but, by and large, they went from 1 financial guy to another financial guy but, no, change so far.


Your next question comes from Ahmar Zaman with Piper Jaffray.

Shawn E. Lockman - Piper Jaffray Companies, Research Division

This is Shawn for Ahmar. I was wondering if we could -- you could give us just a little more detail on what you are sort of saying and targeting for your OpEx improvement. You've given us some detail but just wondering if you guys can give us a sense of what might be a goal in terms of a run rate and how you might get there.

LeRoy D. Nosbaum

Yes, it's LeRoy. I'll start, if Steve wants to add some additional color he can. First of all, we're going to be real cautious about that. I know I've got the pressure and I know I've got the focus. We will see some reduction in the level of R&D spending. We will see continued reduction in the level of G&A spending. Sales and marketing is going to be harder because as I said we're going to be very cautious about doing too much in sales and marketing because there's just too much tender activity either ongoing or about to be ongoing in our view. Having said that, while we've got some numbers targeted, I have no intention of telling you what those numbers are at this point. What I will say is that we're comfortable with the guidance we have given you, top, bottom and margin and you can sort of back in if you run the math to what you think the overall OpEx number is going to be.

Shawn E. Lockman - Piper Jaffray Companies, Research Division

Very good. And if we -- if you could just give us an update on your initiatives in Brazil, progress there and what you're hoping to accomplish there in the next 6 to 12 months as we -- as you talk about sort of a 2014 roll-out period.

LeRoy D. Nosbaum

You've got -- Brazil is exciting. It's a huge opportunity and one of the things we've recently done is we changed up sales management down there, but I think more importantly, we put a new general manager in charge of energy down there who comes out of that industry, he is steeped in it. And I'll just say it because if you work hard you can find out, he used to work for Silver Spring. And so we have what we think hired a very good guy who is well aware of the competition, he is well aware of the market and he knows personally the chief set many of the utilities. So we have a very good sense of positioning relative to Brazil. We have also been able to participate in some of the recent trials down there. We have been selling commercial/industrial meters into some of the trials and so we the like that. Our view is this is a 2014 event, if you will, I don't think we're going to see tenders before that time period, and our job at this point is just to be ready.


We'll take our next question from Jesse Pichel with Jefferies.

Scott Reynolds

This is Scott Reynolds for Jesse. A question on the FX and the change in FX. So your taking FX rate down by about 10% in the back half of the year. On a constant currency basis, what else was stronger that offset that decline for you to be able to maintain guidance? And also, can you remind us what change in FX and how that affects the bottom line?

Steven M. Helmbrecht

Sure. So as I mentioned in some of my initial remarks, Scott, we, in the case of the euro, that's our largest exposure to -- that's the largest nondollar exposure, but keep in mind that over half our revenues are dollar-denominated and not impacted by FX overall and in the case of the euro, we are not an exporter into the Euro zone from the U.S. so we are not affected competitively by changes in FX rates primarily, but we're we are affected is in the translation of that revenue back to dollars. The reason why it doesn't flow through very significantly into the EPS line is that we also have a large part of our cost structure there. That's where we manufacture the products, so it acts as a natural hedge overall. And if you think about the last 6 months, unlike a few years ago where all currencies were kind of moving in lockstep with the euro, it's been the euro that has been moving down based on pressure whereas a lot of the other currencies have held up fairly well against the dollar including the Canadian dollar. So we have large increase in Canadian dollar exposure given the work that we've been doing up there, as you know. So the impact bottom line on earnings per share resulting from the stronger dollar is more muted as compared to what it does to the revenue line and that is certainly -- that certainly shaped the modeling we did internally and we know that -- have actually talked about that before and that's really been proven out. So we are seeing. We were originally at $1.37, we are at $1.23 up in the second half of the year and that accounts really for the bulk of the reduction on the top of the end of the guidance range down because of FX, which is at least 75% of that number.

Barbara J. Doyle

Scott, does that answer your question?

Scott Reynolds


Barbara J. Doyle

All right. Thanks very much. Before we close, LeRoy, would you have some final comments for the call?

LeRoy D. Nosbaum

Yes. First of all, thanks for the questions, appreciate it. Thanks for joining us today. Let me close by saying we've got a lot of emphasis here on cost to build product and cost to run the company, and so we're working that one really tight, we had a lot of questions around it today. We are seriously working costs because we know that the top line on the company is not going to grow appreciably in the second half and it's not going to grow appreciably in '13, so our job at this point is to get every order we can, but to make sure we're doing it as efficiently and effectively as we move through time running the company. We are doing just that, and spending time and time on it. We look forward to speaking with all of you again next quarter. Thanks very much.

Barbara J. Doyle

Thanks, everyone.


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