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Echelon Corporation (NASDAQ:ELON)

Q2 2012 Earnings Call

August 7, 2012 5:00 pm ET

Executives

Annie Leschin – Investor Relations

Ronald A. Sege – Chairman, President and Chief Executive Officer

William R. Slakey – Executive Vice President and Chief Financial Officer

Analysts

Joe Maxa – Dougherty & Co. LLC

Colin W. Rusch – ThinkEquity LLC

Craig E. Irwin – Wedbush Securities, Inc

Sean K. F. Hannan – Needham & Co. LLC

Scott Reynolds – Jefferies & Co., Inc.

Pavel Molchanov – Raymond James & Associates

Paul Coster – JPMorgan Securities LLC

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2012 Echelon Corporation Earnings Conference Call. As a reminder, this conference is being recorded for replay purposes. At this time, all participants are in listen-only mode. (Operator instructions) We will be facilitating a question-and-answer session following the presentation.

I would now like to turn the presentation over to your host for today’s call Annie Leschin from Investor Relations. Please proceed.

Annie Leschin

Thank you, operator. Hello, everyone, and thank you for joining us this afternoon for Echelon’s second quarter 2012 earnings conference call. With me today are Ron Sege, Chairman and Chief Executive Officer; Bill Slakey, Executive Vice President and CFO; both of whom will present prepared remarks

By now, you should have received a copy of the press release that we issued a while ago. If you would like a copy, please visit our website at www.echelon.com. Additionally, we will refer to a set of slides that we have posted on the IR section of our website to help walk through the quarter’s results and our outlook for the market.

Before we begin, I would like to let everyone know that during the third quarter, Echelon will be participating in Canaccord’s Annual Growth Conference on August 15 in Boston, Wedbush Securities’ Clean Tech & Industrial Conference on September 12 in San Francisco, and Credit Suisse’s Future of Energy Conference on September 20 and 21 in New York. As additional events are scheduled, we will make other announcements.

Now, I’d like to remind everyone that during the course of this call, we may make statements related to our business outlook, future financial operating results, accounting matters and overall future prospects. These are forward-looking statements based on certain assumptions and are subject to a number of risks and uncertainties. We encourage you to read the risks described in our press release, as well as in our SEC reports, including our report on Form 10-Q and subsequent reports on Form 10-K for a more complete disclosure of the risks and uncertainties related to our business. The financial information presented in this call reflects estimates based on information that is available to us at this time. Actual results can differ materially. Echelon undertakes no obligation to update or revise these forward-looking statements, and guidance will not be updated after today’s call until our next scheduled quarterly financial release.

And now, I’d like to turn the call over to Ron Sege. Ron?

Ronald A. Sege

Thank you, Annie, and thank you for joining us for our second quarter 2012 earnings conference call. Today, I’ll begin with a summary of the quarter’s results and review progress in our systems and sub-systems businesses, and then finish with a few words on our outlook.

Turning to Slide 3, we had a solid second quarter with total revenue of $40.8 million. This was a slight increase sequentially, with 69% coming from our systems business and 31% from sub-systems. For the fourth time in the last six quarters, we achieved non-GAAP profitability through tight expense management. We generated $3.4 million in cash to end the quarter with $60.4 million.

Our goal of sustained profitability remains critically important to us, and our recent cost reduction initiatives position us to benefit as the markets recover. Our increasingly cost-focused culture led to a sequential non-GAAP operating expense reduction of 7% this quarter. As we continue to carefully manage expenses and increase operational efficiencies, we will also continue to pursue key areas of product innovation and go-to-market programs. This includes beginning to fund our joint venture with Holley in China. This is crucial to our China go-to-market strategy and to our long-term cost competitiveness. Nevertheless, we do understand the importance of being intelligent on expense controls, especially given the challenging outlook, which I will discuss later in my remarks.

Turning back to our results, one of the highlights this quarter was our successful Partner Conference in Budapest, Hungary, where we doubled our attendance from last year and welcome Alstrom and LG CNS as new sponsors. One of the consistent pieces of the feedback at the conference was how our partners see strong benefits from running multiple applications on a single platform, giving them the ability to offer a broader portfolio of solutions to their customers.

During this event, we highlighted our new COS software release, which allows our Smart Meters to be upgraded in the field to function as multi-parameter grid sensors. In addition, we launched our Streetlight pilot-in-a-box program, so that partners new to the market can rapidly deploy a small pilot without having to become street lighting experts.

Let me now give you a brief update on each of our markets; turning to Slide 4. In our systems business, shipments to Duke Energy in Ohio and Fortum in Finland drove the majority of sales this quarter. Our rollout with Duke in Ohio continued strong in Q2, with a total of approximately 500,000 of our meters installed to-date. We are excited by the prospects of implementing some of the advanced features at Duke, including outage management and power quality measurement. We believe our demonstrated success in Ohio positions us well for future roll-outs in Duke’s other territories, when they are ready to proceed.

We also made strides in other regions this quarter, particularly in Eastern Europe. In Russia through our value-added reseller EAC, we won a 17,500 meter deployment from Tyumenenergo, which provides electricity to nearly 600,000 people. Deployments are already underway and we expect them to be complete by the end of the year. Since 2007, Echelon has deployed more than 300,000 smart meters throughout the multi-million meter Russian market, establishing us as a key player in this region.

Moving on to Slide 5; while some territories that we are targeting have yet to take meaningful steps forward to meet government mandated deadlines; others, where we do see specific near-term potential include Norway, Germany and the Middle East. In Norway, the smart grid is poised to expand. The nation’s regulator recently mandated that all 130 utilities, serving the country’s 2.6 million customers, must deploy smart metering systems with highly specific features and attributes by 2016.

In July of 2011, Echelon secured the first award in this region with Norway’s seventh largest utility, Fortum, which is on track to roll out 100,000 electricity meters from 2013 to 2015. Other utilities are gearing up to deploy as well, and given our success in Scandinavian countries, we believe Echelon has a great opportunity to be a meaningful player there.

Another country that we are watching closely is Germany. With over 100 pilots with the utilities that represent over 50% of the 44 million meter market, Echelon is well positioned in this region. Conversions from pilots to full-scale deployments, however, have been slowed by uncertainty around the still evolving government mandate on security and privacy. To counter this uncertainty, we are taking action with one of our VAR partners to catalyze the market. In Q2, this partner released an innovative voucher for German utilities that assures compliance with the government mandate once finalized.

Finally, let’s turn to the Middle East, where rapid population growth is leading to increasing electricity needs. Even though many countries in this region are net exporters of energy, they are looking to improve the efficiency of their own grid to avoid waste and to innovate across all aspects of the energy value chain from alternative generation sources to demand response. Though no government mandates currently exist, according to recent research by Ernst & Young, power and utility companies in the Middle East are expected to invest $200 billion by 2015 to upgrade metering, transmission lines and communications to create a new smart energy system. Working closely with influential partners, we are in discussions with several utilities in different countries in the Middle East and are optimistic about our prospects.

Before I move on to our sub-systems business, a word about our systems outlook. As some of our large deployments roll off in the near-term, we’d hoped to fill the gap with opportunities in our sales pipeline. It is clear now that the current slow pace at which awards are being made and converted into orders and revenue will not meet our earlier expectations. Macro uncertainty continued to cause utilities throughout the world to wrestle with tight budgets, reducing visibility into the timing of new smart grid awards and deployments. As an example, the recent Presidential election in Russia may result in a change of its current distribution grid model and priorities, leaving the timing of future smart meter roll out there unclear.

Turning to our sub-systems business on Slide 6. In the second quarter, our joint venture with Holley Metering submitted our power line solution to the state grid for approval. We anticipate that approval in the next few months. Once received, we will be able to market this technology to utilities throughout China.

Currently, we have 15,000 meters deployed in nine active pilots in China. One in particular is with Henan Utility, which serves the third most populous province in China, with almost 100 million people and 25 million homes. We are seeing broadening interest in our solution throughout the country and are excited with the prospects of significant market penetration and revenue growth in 2013 and beyond.

Turning to Brazil, ELO is piloting nearly 6,000 meters based on our technology across 15 sites throughout the country. In particular, ELO recently won a large pilot with Electrobras, a utility with 3.3 million meters across its six locations. We continue to believe that these and other pilots will convert into more meaningful revenue throughout 2013.

Another country ideally suited for our sub-systems strategy is Japan. TEPCO, one of Japan’s leading utilities, recently announced its intention to deploy 17 million smart meters out of a total 78 million meter market by 2019 to assist the country in managing its energy consumption.

The government has specifically instructed Japan’s utilities to look to foreign players in selecting a best-of-breed solution for smart meters. We believe partnering with Japanese OEMs and VARs around our sub-system portfolio is the right strategy for this market, and we are exploring a variety of such partnerships.

Finally, turning to Slide 7 and our sub-systems offerings for cities and building applications. Our street lighting deployments in Oslo, Norway, and Saudi Arabia continue. While many other cities have implemented pilots, they have not yet turned these into full-scale deployments in part due to the large number of dispread elements that must be integrated into the full solution.

To help address this issue and propel the market forward, Echelon is introducing its own outdoor lighting controller to complement our segment controller and to simplify the sourcing of a complete solution. In combination with our Street Light in-a-box, our goal is to reduce the time and complexity required to win a pilot and convert that to a large deployment.

On the building sub-system side, we experienced growth in North America this quarter, driven by the continued roll-out of an energy management project that we announced in Q2, 2011. Unfortunately, this was more than offset by continued declines in the European market.

In summary, we are pleased that we were able to manage expenses closely and deliver non-GAAP profitability in the first half of 2012. However, as Bill will discuss, we are experiencing a significant contraction in revenue for the third quarter. In retrospect, as I said earlier, we have not been able to convert pipeline into revenue as quickly as we previously expected, and as a result, our projected performance is below where we would like to see. We are certainly disappointed in our near-term outlook.

To counter these trends, we are working to expand our distribution channels, especially with Tier 1 partners, who want to provide end-to-end solutions with the benefits of power line communication and multi-application support. We are looking to enter additional attractive markets, such as Japan and the Middle East, just as we have done in the past few years with China and Brazil.

We also continue to look for ways to expand our product offerings into adjacent markets, such as transformer monitoring and analytics, important areas of focus for our customers, all while carefully managing our operating expenses. While none of these will deliver near-term revenue, they have the potential to drive growth longer-term. In addition, we will look for every opportunity to continue to control expense and expand gross margins.

Despite these near-term headwinds, we continue to believe in the fundamental attractiveness of the smart grid market over the next several years. With regulatory deadline across multiple geographies approaching and the ongoing evidence of the effectiveness of our solution, the long-term opportunity for the smart grid and for Echelon is significant.

While we do not have legacy products or broadly diversified product lines of some of our competitors, we believe Echelon’s greatest advantage lies in our flexible multi-application platform, which allows us to adapt our technology to a variety of regions and markets, internally or with partners. As a focused smart grid technology company, we suffer more during pauses in the market, but believe that we can benefit inordinately as global markets accelerate.

Before I turn the call over to Bill, I’d like to thank all of our employees for their continued hard work, dedication and support. We appreciate your confidence in our strategy and our company. We all believe in the power of our solutions and are dedicated to maintaining strong strategic focus and good execution during this period of limited visibility and to carefully balancing the needs of customers, employees and shareholders. Bill?

William R. Slakey

Thank you, Ron. Good afternoon, everyone. Thank you for joining us on our second quarter earnings call. Please note that all references to non-GAAP amounts exclude stock-based compensation and restructuring charges.

For ease of reference, we have prepared a complete non-GAAP statement of operations for the quarter ended June 30, 2012, which can be found on the Investor Relations section of our website. We had a good Q2, I believe, with solid revenues and the early paybacks from our restructuring activities, leading to a non-GAAP profit and solid cash generation.

Beginning with Slides 9 and 10, total revenues for Q2 were $40.8 million, down 7% from $43.7 million in the second quarter of 2011. System sales, primarily from Duke and Fortum, Finland, were $28 million versus $29.3 million a year ago. Sub-system sales were $12.8 million, including the $1.5 million from Enel. Sub-system sales were down 12% from $14.5 million in Q2 a year ago, but up 10% sequentially from Q1.

Moving to Slide 11, non-GAAP gross margin for the quarter was 39.5%, down from 46.5% of sales a year ago and 43.6% in the previous quarter. As a reminder, in the first quarter of 2012, gross margins included a one-time benefit of approximately 220 basis points from the delivery of firmware associated with the CNX 3000 hardware module.

Gross margins in Q2 were lower than we had projected at the beginning of the quarter primarily due to an increase in inventory reserves taken as a result of our lower revenue outlook, which I will discuss in a moment.

Turning to expenses, non-GAAP operating expenses in the second quarter were $15.7 million, a decrease of 10% from $17.4 million in the same period last year and a decrease of 7% sequentially from Q1.

On a year-over-year basis, R&D declined 11% to $7.2 million, sales and marketing expenses decreased 8% to $5.2 million, and general and administrative expenses decreased 11% to $3.3 million. These operating expense reductions are the result of various cost reduction activities over the last year, including our workforce reduction in Q2.

Interest and other income was $254,000 in the second quarter, up from interest and other expense of $153,000 in the same period last year. Income taxes were $144,000 versus $120,000 in the same quarter a year ago. This led to non-GAAP net income for Q2 of $237,000 or $0.01 per share, compared to a non-GAAP net income of $2.2 million or $0.05 per share in the second quarter of 2011.

As expected, we incurred a restructuring charge of $1.2 million during the quarter for cost reduction activities, primarily related to the workforce reduction announced last quarter. These actions were largely completed during the quarter, with the remainder to be implemented by the end of Q1, 2013. The restructuring charge added approximately $0.03 per share to our GAAP loss for the quarter.

During the quarter, stock-based compensation expenses were $942,000 compared to $2.8 million in the first quarter. A large portion of the sequential decline was driven by a one-time reversal of approximately $800,000 of unvested equity compensation for employees no longer with the company. This was due to our workforce reduction and the retirement of the company’s long-time CFO. Looking forward, we expect stock-based compensation will be approximately $2 million a quarter.

Moving to the balance sheet on slide 12, we had a very solid first half of the year for working capital management and cash generation. Cash provided by operations for the first six months of the year totaled $4.1 million, of which $3.4 million was generated in Q2. This was the result of our non-GAAP operating profit along with reductions in working capital account, most notably accounts receivable. In total, we’ve generated nearly $2 million in net cash so far this year and ended Q2 with cash, cash equivalents and short-term investments of $60.4 million.

Finally, I would like to turn to guidance for the third quarter on Slide 13. As we ended the second half of the year, we expect revenues from our large deployments at Fortum, Finland and Duke Energy to ramp down.

As Ron mentioned, we have been disappointed in our ability to turn our promising pipeline into near-term revenue, and as a result of these two trends, we now expect our Q3 revenues will be below performance over the last several quarters with total revenue for the third quarter of 2012 to be in the range of $26 million to $30 million.

We anticipate that sub-system revenue, including Enel, will account for approximately 40% of total revenue. We expect that non-GAAP gross margin will increase sequentially to approximately 42% of revenue, due in part from a richer mix of sub-system versus system revenue.

We anticipate operating expenses in Q3 will be in line with Q2 levels. We will see additional benefits from our Q2 restructuring activities, but at the same time, we will begin to incur expenses from our China joint venture with Holley Metering. As a result, we expect operating expenses to be approximately flat quarter-over-quarter.

Finally, we estimate our non-GAAP earnings per share for the third quarter will be between a loss of $0.06 and a loss of $0.12 per share. We expect our GAAP loss per share to be between $0.11 a share and $0.17 per share, including approximately $2 million in stock-based compensation expense.

While we’re disappointed in this near-term outlook, the long-term opportunity for Echelon remains large. As the environment for the smart grid improves, we believe our sales efforts, geographic expansion and continued investments in technology will allow us to create long-term values for our shareholders.

And with that, I would like to now turn the call over to the operator for the questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) And your first question today comes from the line of Joe Maxa with Dougherty & Company.

Joe Maxa – Dougherty & Co. LLC

Thank you. Good afternoon.

Ronald A. Sege

Hey, Joe.

Joe Maxa – Dougherty & Co. LLC

So, along the lines of the winding down of Duke and Fortum, are you seeing the majority of that winding down here in Q3, you expect it to be at kind of the same level going forward or even lower, if this is a tail in this quarter?

William R. Slakey

Joe, this is Bill. What we expect is that it will come down here this quarter. We don’t want to make too many projections going forward. But it’s likely to take a few quarters to run its course entirely.

Joe Maxa – Dougherty & Co. LLC

Right. And I saw that Eltel bounced back up a little bit in the quarter from – if I looked at that correctly, from the last couple…

William R. Slakey

That’s right. Eltel is supplying a number of different deployments in Europe. So, depending on those schedules they can bump up or go down. It tends to be a little bit spotty.

Joe Maxa – Dougherty & Co. LLC

I do want to ask a question – one of your competitors announced a large contract with Duke on their call. Didn’t give a lot of color, but is that something you were involved in? Did you bid on that project?

Ronald A. Sege

Hey Joe, it’s Ron. So as near as we can tell, those were for meter forms that we don’t provide in our product line, and this is something that Duke has indicated they needed since we did our original deal with them. So these are not products that we have chosen to offer. We knew it was coming and it’s in that sense, it’s complementary to what we’re installing today.

Joe Maxa – Dougherty & Co. LLC

And lastly from me and then I’ll jump off, regarding Brazil, you talked about some meaningful revenue coming next year. Is that – I mean is it possible to quantify that somehow?

Ronald A. Sege

No. I’m sorry about that. For two reasons, one, given the market environment, we’ve got to be very circumspect about quantifying stuff that far out. And second, our partner ELO has chosen kind of as the matter of competitive strategy to be very quiet about their plans, because it is such a competitive marketplace down there. So as we get closer and as we get more confident in our outlook there, we’ll share as much as we can.

Joe Maxa – Dougherty & Co. LLC

All right. Thank you very much, guys.

Ronald A. Sege

Okay. Thanks Joe.

Operator

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

Colin W. Rusch – ThinkEquity LLC

Thanks for getting me in early. Your inventory has come down to a fairly low number. Can you talk about what that flush is and should we be expecting you to be working out older products from the mix and introducing new products here or how should we think about that number coming down to $10 million?

William R. Slakey

Well, inventories and receivables both have been coming down, Colin. That’s just a question of trying to manage the working capital well when the forecast is what it is.

Going forward, we’ll continue to manage the working capital as well as we can. I’d love to bring those numbers down a little bit more and generate a little more cash out of there. I’ll stop short of projecting it. It’s very dependent on exactly where revenues go and how we do in forecasting mix of product, et cetera.

Colin W. Rusch – ThinkEquity LLC

Okay, great. And then just on the gross margin, you’re holding up fairly well even with the fairly low revenue run rate. How should we be thinking about what’s really driving those margins to stay as high as they are?

William R. Slakey

You bet. So this particular quarter, we had projected $41 million. We came in a little bit light that was primarily taking some inventory reserves in the face of the forecast going forward. As we go forward, two things we think can help the gross margins. One is that as the mix of our revenue shifts more towards sub-systems, that is good for our gross margins as a percentage of revenue, so that should help.

Secondly, we will be rolling into the revenue line or I should say the cost line, lower cost designs for meters. We’ve been talking about those for several quarters now, those will start to contribute in the second half. So that can help the gross margins as a percentage of revenue as well. And then, of course, ultimately volume plays a role there. So we need the volumes to hang in there.

Colin W. Rusch – ThinkEquity LLC

Perfect. Thanks a lot, guys.

William R. Slakey

Thank you.

Ronald A. Sege

Thanks Colin.

Operator

Your next question is from the line of Craig Irwin with Wedbush Securities.

Craig E. Irwin – Wedbush Securities, Inc

Good evening. Thank you for taking my question.

William R. Slakey

Hey, Craig.

Craig E. Irwin – Wedbush Securities, Inc

So, as we start to look at the pipeline for your utility related customers. I know there are a lot of opportunities internationally and there is always a lot of uncertainty in the broader utility customer base. But can you talk about the mechanics on how you would have to book customers in order for them to materialize as revenue in 2013? And I guess direct way to ask this question would be, would you need to have an award within the next quarter or so in order for us to see revenue of a similar magnitude to Duke and Fortum in 2013?

William R. Slakey

Orders large as Duke and Fortum, typically, yes, I think we’d probably have to have that or at least the award, the tender in hand by the end of this year in order to be projecting a large amount of revenue from it for next year. Other deals can move more quickly, smaller deals. It was brought up earlier on the call that Eltel’s revenue bumped up several million dollars this quarter versus last. Those sorts of things can happen during a quarter or with one quarter’s notice. But a large deployment, something in the neighborhood of $30 million or $40 million a year, we have to have that in hand by the end of year, I would think.

Ronald A. Sege

And one of the dynamics that’s changed since we did the original Fortum and Duke deals is we worked hard to get a lot more volume into our pipeline. And by virtue of that, we are working on many more smaller deals than we were a couple of years ago. So, it’s possible, sales cycles typically are shorter there, so the deals can book and ship more quickly than they can with a huge deal like Duke.

Craig E. Irwin – Wedbush Securities, Inc

Great. The next question I wanted to ask is about the R&D budget. So Echelon spent something close to $300 million in R&D over the last decade and the sales have gone in fits and starts. Obviously, you have a much broader, much more comprehensive portfolio of products today. But where do you draw the line as far as – what meets the criteria for R&D investment at the company today? And is this something where you have flexibility to either decrease or adjust the portfolio as far as what you’re working on?

Ronald A. Sege

That’s a great question, Craig. And one of the things we’ve been focused on the last couple of years here is to gradually concentrate our R&D budget on core differentiating technology. So in other words, to kind of get away from sort of the packaging stuff, the sheet metal and the plastic, and focus more on, what we call, our energy control networking platform. And you’ve seen us presenting our three-tier architecture and all that. So Echelon has not been exceptionally good over the years at doing that and I believe, the current management believe, it’s absolutely critical. So we don’t have a precise measure of it, but I’d say particularly in the last year a much greater percentage of our R&D is going investing in that core differentiating platform. Having said that, we still have a bunch of legacy commitments we made to our customers to build meter types and that kind of thing. And in the metering business in particular, there are many different standards and many different specific implementations that vary country-by-country and even within a country.

So that limits our ability to reduce our R&D as aggressively as ideally we would like and you would like. So there is just a certain minimum investment level, kind of the price of being in this business, below which you can’t maintain your strategic differentiation. And of course, we don’t like to get expenses immediately inline with revenue and so on, but we have to maintain our strategic differentiation and we have to be able to compete in a broad enough set of markets, there we can grow our revenues even in difficult times.

Craig E. Irwin – Wedbush Securities, Inc.

Great, and then my last question. So previously you’ve been targeting full-year non-GAAP profitability. I know that there might be very challenging in this current economic environment. But is that a longer-term goal that you’d really like to achieve over the next handful of quarters? Is that something where you’re willing to make adjustments to the model that might have to be made if the demand environment doesn’t come through? Or how should we be looking at this as far as your commitment to growth and how you balance that with the rest of your strategy objectives?

William R. Slakey

You bet. So, A, commitment to profitability is very high on the list, and so absolutely, we want to get there, we want to get there as quickly as we can. We can reduce our cost a little bit more. We’ll turn over every rock. We’ll do everything we can to pull down expenses. We’ve reduced head count a fair amount. So the next logical step would be to reduce facility size, et cetera. So there are things that can be done there to pull expenses down a little bit more. But ultimately achieving profitability will require revenues higher than what we’ve guided to for next quarter. We can’t cut expenses so much that we can get to profitability on that kind of a revenue level. So we’ll try, as ever, to be more efficient, spend less money, but we will need to grow the revenue from these levels to get to profitability.

Ronald A. Sege

Yeah. And Craig, just to assure you that we’re focused on profitability, the management team’s bonus and half of my total compensation is tied up in bonus is driven in significant part by our ability to achieve full-year non-GAAP profitability. So, we are very incented to do that. But we’ve got to do it in the context of having a viable business over the long haul, because we’ve got to be well positioned when this market comes back.

Craig E. Irwin – Wedbush Securities, Inc.

Excellent. Thank you very much for taking my questions.

William R. Slakey

Thank you.

Operator

Your next question comes from the line of Sean Hannan with Needham & Company.

Sean K. F. Hannan – Needham & Co. LLC

Yes, good evening. Thank you.

Ronald A. Sege

Hey, Sean.

Sean K. F. Hannan – Needham & Co. LLC

So, just a follow-up on some of the SG&A. I know you did a nice job at least in being able to pull some of that down in the quarter. Obviously, the expectation is that coming down a little bit more, offset by the investments you’re making with Holley. Can you perhaps, Bill, give us a little bit more clarity around how that should continue to navigate through the fourth quarter and into next year, kind of the organic SG&A offset by the Holley investments?

William R. Slakey

Yeah. Sean, I’m reluctant to make too many projections beyond Q3. But I think it’s fair to say we’re very committed to continuing to bring expenses down within the context of there comes a point where you need to maintain your sales footprint, your R&D spending, et cetera, the public company apparatus in the G&A. So, we’ll continue to look to bring it down, but it will be modest. We’ll manage it. It’ll be modest overall, because the JV expenses will be in there. But in general, I think you should expect operating expenses to be coming down little by little.

Sean K. F. Hannan – Needham & Co. LLC

Okay, that’s helpful. And then, Ron, if you can elaborate a little bit on some of your comments earlier. You talked about the pilots with Holley as well as ELO. Is there any insight you can provide us around how many vendors are involved in the utilities with those current pilots? And then, kind of part two to that, to what degree are you familiar with at least goals for when decisions can be made there?

Ronald A. Sege

Sure. So, let me start with Brazil. It is quite a contested marketplace. I’m sure you’ve seen the variety of announcements from competitors around Brazil. Everybody understands that’s one of the few growth markets in the smart grid over the next year to 18 months. So, those folks are all competing in these pilots.

We have two distinct advantages, we believe. One is; we received our approvals to sell Smart Meters first. So we have a number of months, six-month head start on the competition there. Second is, unlike many of our competitors, who are going in on their own, we are partnering with the largest manufacturer of electromechanical meters with the largest installed base down there. So we believe – they have account control; they’ve got credibility. So we think those two things give us strong competitive advantage.

In terms of when decisions will be made, we’re in an increasing number of pilots. There are mandates in Brazil. Having said that and having wanted to have forecasted better the second half of the year, I’m really reluctant to set your expectations. But my confidence level that when those awards come, we’ll be strongly in the mix is quite high. And then, as far as China is concerned, virtually all of the competitors in China are local indigenous players. And one of the reasons that there is so much interest in our solution is those local players just aren’t performing very well.

So, one way of looking at it is, there is lots of competitors in these Chinese deal, another way of looking at it is, we are effectively the only Western vendor competing with this technology in China, and so we think we’re quite differentiated in that regard as well.

Sean K. F. Hannan – Needham & Co. LLC

Thanks Ron.

Ronald A. Sege

Okay. Thank you.

Operator

Your next question is from the line of Scott Reynolds with Jefferies.

Scott Reynolds – Jefferies & Co., Inc.

Hi guys, thanks for taking my questions. So, you talked a couple times about your pipeline. I know you can’t talk about the specific projects, but is there any way you could size, what you’re looking at for a pipeline relative to the Duke and Fortum projects that are winding down?

Ronald A. Sege

Yeah, you’re right, it’s very difficult to quantify. So, I’m not even going to try. We’ve worked very hard in the last couple of years to dramatically increase the pipeline. We’ve reported previously that the value of our pipeline is three times what it was a couple of years ago. But again, especially in these uncertain market times, heck, in the old days at – in my enterprise days at 3Com, we felt really good if we had three times the value of pipeline relative to what we were forecasting for revenue. And in this kind of a market, shoot, maybe you need five times or 10 times. It’s just hard to know.

So the handle we can pull most readily is to aggressively grow the pipeline, and we’re doing that both by focusing on markets that are currently growing, like China and Brazil, and to get into new markets that we think will grow in the future, like Japan and the Middle East. But again, again it’s – we’ve got to be very careful about committing to when that pipeline is going to convert to orders and going to convert to revenue, and we’ve got to run our business very conservatively until the market comes back.

Scott Reynolds – Jefferies & Co., Inc.

Okay. And with Holley, you guys had talked about a fairly large pipeline opportunity there. How fast can that ramp? Are we talking six months, a year, or is it more near-term?

Ronald A. Sege

I’d say, again, with the caveats of very limited visibility, it’s six months to a year to get anything that’s meaningful in the context of the overall company. We’ll be in pilots shortly after we get approvals, which we expect in the next couple of months, and revenue will start coming in. But for it to move the needle, given sale cycles, it’ll be more of a six month to 12-month kind of a horizon.

Scott Reynolds – Jefferies & Co., Inc.

And with Fortum, what are we looking at for the second phase of deployments? Do they have a timeframe for when they’re going to award those?

William R. Slakey

So when you say second phase, you mean Norway?

Scott Reynolds – Jefferies & Co., Inc.

Yes.

William R. Slakey

Again, somewhat uncertain, but sometime in 2013 is what we expect.

Scott Reynolds – Jefferies & Co., Inc.

Okay, thank you.

Ronald A. Sege

Thank you.

Operator

Your next question is from the line of Pavel Molchanov with Raymond James.

Pavel Molchanov – Raymond James & Associates

Hi guys, I apologize for dialing in a little bit late. So if you addressed this already, my apologies. Given what happened in India last week and presumably a stronger commitment on the part of the Indian government to investment in the grid, I’m curious how you perceive your position there. I know you had some micro grid projects and a few other ties to the Indian market, so just thoughts on that.

Ronald A. Sege

Yeah, sure, first of all, obviously it was a great tragedy that involved a considerable amount of suffering, and for that, our hearts go out. While I think they’re still unraveling what caused the whole thing, I think it’s pretty clear that there was a significant supply and demand imbalance, and that’s one of the primary things that you deploy a smart grid to resolve.

So while you wouldn’t want it to happen this way, it’s our belief that this tragedy will ultimately accelerate the opportunity for smart grid in India, and it will be a huge market. And we are targeting that market. I didn’t mention it in my prepared remarks, because it’s very early days. And as I’m sure doing business in India is not the most straightforward thing. But it is high on our list to get in there with partnership, almost certainly using our sub-system strategy. So, partnering with a local metering company and going to market that way, much as we’re doing in China and Brazil. So, I hope in the next couple of quarters that we’ll have something more specific to report. But it is definitely on the shortlist of our hit parade.

Pavel Molchanov – Raymond James & Associates

Then, just a quick follow-up on that. In 2008, I believe, you formed a partnership with HCL Infosystems from India. Is that still in effect?

Ronald A. Sege

No, not that I know of, I wasn’t around at the time, but it’s certainly not something that is front and center in our strategy going forward.

Pavel Molchanov – Raymond James & Associates

Okay, understood. Appreciate it, guys.

Ronald A. Sege

Okay, thanks.

Operator

Your next question comes from the line of Paul Coster.

Paul Coster – JPMorgan Securities LLC

Yes, thanks very much for taking my question. I think most have been all asked, but one is really, have you lost any, are there any programs out there, any contracts large or small that you feel that you’ve lost in a head-to-head situation? And is the competitive landscape, as far as it relates to the sub-systems business, changing at all?

Ronald A. Sege

Okay. So, Paul, when you’re asking about wins and losses, is that in the systems business or…

Paul Coster – JPMorgan Securities LLC

Yeah. Primarily in the systems business, though you’re welcome to comment on the sub-systems business as well, which I imagine is much more diversified and there’s wins and losses all over the place?

Ronald A. Sege

Yeah, yeah. I think it’s quite a tough question to answer in the context of sub-systems. In the context of systems and metering in particular, it is a very competitive environment. As the number of deals has diminished and sales cycles have prolonged and none of the competitors have exited the market, every deal is just that more hotly contested. So, we’re focused on two things. One is getting our cost down, so we could be a better cost competitor. And the other is getting in early and creatively influencing deals, so that we can create a bias for our particular set of features, topology mapping, power line communication, power quality metrics, that kind of thing.

So, those two things allow us to compete both in the dimension of differentiation and the dimension of low cost. Having said that, first of all, the vast majority of deals in our pipeline are just moving to the right. We’ve won some small deals. We lost some small deals. When we’ve lost, it’s just been because the pricing has been totally irrational. And that’s just indicative of a lot of competitors in a slow market. But I’d say losses is not our problem right now, it’s lack of decisions that are our problem. And in the sub-system business, particularly as it relates to cities and buildings and that kind of thing, it’s really – it’s not so much wins and losses. It’s just the slow macro-economic environment, very few building starts, not a lot of tenant improvements and that kind of thing, and those are the two drivers of demand in that business.

Paul Coster – JPMorgan Securities LLC

And then just to be clear, on the sub-system side, the weaknesses you’re witnessing is in Europe. You’re not seeing a spillover effects in North America?

Ronald A. Sege

Well, I would say and I think I mentioned this in the prepared remarks. We saw reasonably good results in North America, but it was largely driven by one big retail chain that we’re deploying as kind of an uber project. The underlying demand in the U.S. is somewhat soft, although not as soft as in Europe.

Paul Coster – JPMorgan Securities LLC

Thank you very much.

Ronald A. Sege

Okay, thanks.

Operator

Ladies and gentlemen, this concludes the question-and-answer portion of the call. I’d like to turn the call back over to Ron for some closing remarks.

Ronald A. Sege

Okay. So I just want to thank you all very much for your attention, and we’ll be talking to you after the call and in our conferences in the next few months. Take care.

Operator

Ladies and gentlemen, thank you so much for your participation today. This does conclude the presentation, and you may now disconnect. Have a great day.

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