Itron: Putting on a real nice clam bake
In the midst of earnings season it can be a difficult choice to decide which potential articles to prioritize. Some choices are easy - Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), Salesforce (NYSE:CRM), Oracle (NASDAQ:ORCL), SAP (NYSE:SAP) are obviously the stars of the enterprise IT world these days. It would be hard not to prioritize those. Some companies intrigue me one way or the other - I might put Tableau (NYSE:DATA), Square (NYSE:SQ) and NetApp (NASDAQ:NTAP) in that category, with the understanding that intrigued is not the same as liked. And then there are companies whose results are such a huge outlier from expectations and which seem not having been on the radar screen of investors - companies whose results are perhaps the harbinger of an inflection point in their fortunes. I think that Itron (NASDAQ:ITRI) and the results of its just reported quarter fit that category and investors should take a look at the shares even at current levels.
Itron was once one of the darlings of Wall Street. As recently as 2007, the shares peaked at $107/share. A little more than a year ago the shares were $30. I initially recommended the name when the shares were $50. Back then, I described the company as having survived a near-death experience. The question now is can Itron return to significant sustained and profitable growth? And can the company achieve the recognition and the valuation of other green-tech names, particularly Silver Spring (NYSE:SSNI).
Like anything else that involves the future, those kinds of answers may not be apparent. Yesterday's share price action, after an earnings-related spike, brought the shares to just below $61 before they finished at $58 in the midst of a continuing market pullback. That is a heck of a lot of alpha in the last year or even the last few months and the question must be is there more where that came from.
One sentence answer - I do think there is more where that came from and I do think that Itron has competitive solutions and the resources and market presence for it to be a major contender in its smart grid space. And as I have written in the past, I think that after years of promise but little in the way of substantive financial progress the industry is finally starting to achieve a part of its potential.
Itron does not provide the kind of quarterly guidance that is particularly helpful for commentators like myself in making earnings estimates. That said, it did raise guidance explicitly at the end of Q2 and at that time it forecast non-GAAP EPS of $2.20-2.45 with revenues just shy of $2 billion. The results posted for Q3 were both above the consensus and certainly suggest that the most likely scenario is for a significant 2016 earnings and revenue beat.
Were the results of Q3 an outlier with regards to EPS? They were obviously substantially greater than the cadence contemplated in that prior guidance. Analysts on the conference call tried every which way to get a commitment from the company - it can be scary in making your own earnings estimate. About the best that the CFO was willing to do was the following reply to one question: "No, we can't give you guidance on what to assume going forward. 100 bps, or 150 bps. I can tell you though that we're looking at a number of significant opportunities, both in gross margin and in the OpEx categories, that give us. I think an opportunity rich environment as we move forward." "Opportunity rich" is supposed to be about target opportunities in a bombing raid, I think, but it is also CFO speak meaning "hell yes, we have loads of costs in this organization that we can rip out and we are committed to doing so." Overall, revenue generation was better than anticipated and that led to some positive volume variances. There had been some one-time costs in the first half that were reported in non-GAAP and the company has been restructuring for a couple of years now and it continues to do so.
There also was a mix shift to more lucrative products in the mix. I think it is reasonable to expect that there will be a secular swing to more software and more complex networks which will carry higher gross margin opportunities. The company has had a 25% increase in its gross profits this year on a 9% growth in revenues suggesting the strength of the trend which has lasted through the last 12 months.
The company reported non-GAAP EPS in the quarter of $.77 which compares to prior expectations for $.61 in EPS. That brings nine-month non-GAAP EPS to $1.87. The prior consensus expectations for the full year were EPS of $2.37, which would imply Q4 earnings of perhaps $.50-.60 per share based on the comments of the CFO Mark Schmitz during the conference call, who said, "We should emphasize, however, that one should not expect uninterrupted straight-line improvement in operating results on a sequential, quarter-to quarter basis. The timing of revenues as well as mix have particularly favored quarter three. This observation, coupled with uncertainties associated with the execution of our restructuring program lead us to expect the quarter four results will not be as robust as we have seen in quarter three. Nevertheless, we do expect our full-year results to be at or a little above the top end of our guidance range and we look forward to continued operational improvement."
Normally Q4 is the strongest quarter of the year based on seasonal factors. Given the company's recent near-death experience it is reasonable to anticipate cautious guidance, particularly in the wake of an unusually strong quarter. But it would be surprising if EPS did not continue to show improvement. The last three quarters have seen upsides from the prior consensus of 38%, 52% and 26%, respectively, and last year, Q4 earnings turned out to represent almost all of the earnings for the year and were $.74. Based on management commentary and the level of margins on an absolute basis, this was not really an outlier quarter and there is certainly a significant amount of runway in terms of both margins and growth that Itron can realize.
The title of this article comes from a song made famous by Marlene Dietrich and originally sung in German. The song has been parodied and re-released countless times since it was initially performed in 1930. A group called The Adicts released a version most recently. Knowing nothing of the Adicts, I will simply stick with the version I know.
The question here is whether investors can come to love Itron again as they did a decade past? I have used the metaphor of a clambake in much of the article that follows. Simply put, a couple of additional quarters that have the ingredients of Q3 should have a visible impact on investor perceptions of this name and restore it to at least the edge of growth stock territory in terms of valuation. Companies with consistent double digit growth, a favored market position and rising margins do not long remain valued at one time revenues.
The lead in, as mentioned, comes from a song in the Rodgers & Hammerstein musical Carousel. And the fact is, this was an exceptionally strong quarter for Itron - they put on a really great clambake for their investors. Not only were headline numbers significantly above expectations, which might have been anticipated, but bookings showed very favorable trends and suggest that the company has found its footing as a competitor in the green tech space.
An obvious question is going to be is Itron better than Silver Spring. They both sell comparable solutions although Silver Spring has concentrated its efforts more on the development of managed service platforms of smart devices rather than just selling low margin meters. This past quarter, Itron had one of its best bookings quarters it has ever seen. How many deals were those won against Silver Springs is hard to say. What is the win/loss ratio in deals where the two companies face off? That is not going to be knowable. The hardware components of a smart grid are pretty fungible. There really aren't some quantitative measurement components in comparing software in this space. Most of the data that users want to know and to analyze is pretty straightforward and presumably both companies have offerings that address user issues effectively. It seems likely that Itron was late to the party but it has apparently caught up - at least that would be the message of Q3 bookings. If the green tech story and the adoption of smart grids forecast prove to be accurate, multiple companies are going to achieve a reasonable level of success.
Sales execution is a key component of success, at least as much as product capability. The market for smart grids is said to be large and nascent. There ought to be room for several vendors of scale in the space.
Who has the best technology or the most effective solutions is, I believe, more situational than anything inherent in either platform. SSNI has had some high visibility wins in the space and a very high visibility takeaway from Itron and now Itron has had a better bookings quarter than SSNI. Will Itron be the Cubs of the World Series? I think the analogy breaks down in that there are winners and losers for individual deals. That does not mean there can't be and won't be multiple winners in the space.
The most obvious answer is that some folks like vanilla and others chocolate. Itron is a value name by some measures and SSNI is certainly not. I think SSNI can and is likely to grow faster over the years (although that was certainly not the case this past quarter). I personally own SSNI and I do not own Itron - but I own growth stocks more than value names.
What are the ingredients of a nice clambake?
One of the great old New England institutions is the clambake. You can still buy pre-made clambakes in some places and there are plenty of recipes that will tell you how to make one. Lobster, mussels, crabs, clams, quahogs all steamed over layers of seaweed. Bring it on.
Itron dished out a tasty meal for investors. Overall, revenues rose by 8%, mainly driven by revenue growth from the company's electric segment. Non-GAAP EPS rose to $.77 from $.44 - and this was not the result of rising stock-based comp. The major difference between GAAP and non-GAAP was the $41 million one-time charge the company took for restructuring. There are likely to be additional one-time charges as this restructuring program results in about $60 million of severance and other personnel related costs, although management expects $40 million ($1.00 share pre-tax of annualized cost savings).
The star of this clambake were quarterly bookings. The book to bill was 1.3X. Quarterly bookings were $670 million and that was up from $337 million in 2015. The backlog jumped year on year from $1.2 billion to $1.5 billion. Most of the increase in backlog took place last quarter. Sequentially, bookings grew by 92%.
This company announced a number of major wins. Recapitulating all of the wins announced on the conference call seems unnecessary but a few of the more prominent included a 400,000-meter win at Avista, a utility in Washington State. The customer wanted a network that could evolve into "smart city" capabilities. The largest award was for 2 million G3 Linky smart meters which will be rolled out over the next 18 months by the French electric supplier. (And I make no excuses for calling anything Linky although I get the point). Overall, the project involves 35 million meters with Itron likely to supply what it describes as a substantial volume.
Another substantial win was a contract to supply National Grid, a multi-state, multi service utility with 1.5 million communications modules and some substantial number of gas meters in Mass.
At this point, Itron still mostly sells meters and other kinds of sensors (end-points). Its statement of operations simply records revenues and its disaggregating puts revenues into categories for electricity, gas and water.
But part of the longer-term story for this company, and indeed for all of the companies in the green tech space, are their initiatives to provide managed, value added services to their customers. Itron's valuation has been constrained for many reasons. One of those, of course, was its abysmal record of financial performance in the earlier years of this decade. But the other significant factor has been that it did not have a strategy to exploit the potential financial opportunities of green tech by developing a managed services platform and building a recurring revenue source based on the cloud. Now it does!
Itron calls this offering Total Outcomes, and Total Outcomes has significantly higher margins than the business of selling meters to utilities. Itron has constructed a service that runs on Azure. For a company that calls one of its key products "Linky," calling its service offering "Outcomes" is pretty tame. Itron offers users the end to end management of a complete network that includes data collection, billing, field deployment, analytics and consumer engagement. The company also has engaged with SAP (NYSE:SAP) to provide customers a service to manage data collected from meters. SAP HANA already offers a relatively advanced IoT capability and Itron is plugging into the HANA platform which will allow utilities to integrate operational data and data from their meters. These are initiatives that are years past due - but they are in place now and solidify the company's competitive positioning.
Itron has been in the software business for years. Most of the software it has sold has been relatively basic. Most of it can best be characterized as a primitive level of data analytics, Managed Outcomes is really the next step. At this point, Itron has 75 cloud customers, a trivial number, running Managed Outcomes. If it works the program will provide the company with recurring revenues of some magnitude and will serve as a vehicle to sell more services in years to come.
The company generated $82 million in CFFO, up by 4X from the prior year. The increase was mainly driven by increases in net income and a massive improvement in inventory turns. Never have a nice clambake without serving some cash.
Do the guests go home or are there clambakes to come?
As it happens, in the Rodgers & Hammerstein song the guests are going home and thanking their hosts for throwing the party. But I would think that there is reasonable evidence that Itron ought to be throwing more clambakes over the years, although it is hard to say just how many quarters will see such a strong growth in bookings. Granted, bookings are lumpy but sequential and annual bookings growth of close to 100% is unusual for a company of this scale. And observers like myself really have no insight into the trajectory of bookings over the next few quarters although the size of the short-term backlog is such that investors do have a far better perspective on near-term earnings.
Itron provides investors a set of attractive and colorful charts to supplement its earnings release. It disaggregates its revenues carefully and provides elaborate bridges to help reconcile GAAP and non-GAAP. But nowhere will one find mentioned even the barest expectation for longer-term growth.
The estimated growth rate for smart meters is supposed to be 10% for the next few years. (I thought it interesting that some of the smart meter sales this year are coming from the 2009 stimulus-remember shovel ready?) That ought to be a minimum growth aspiration for this company. But the growth that is of more interest I think is the number of IoT connections and the proliferation of those applications. The latest analysis I have seen is from Verizon (NYSE:VZ) which offers IoT platforms as a service. It is calling for 58% growth in the number of connections this year. As to how large the overall smart grid market might be, there are several different and varying estimates. They are all high enough to suggest that the TAM ITON has is very high and it would be issues of execution that keep its growth from re-accelerating smartly from Q3.
Growth estimates for Itron next year are less than 5% and before this quarter, based on the performance of the first half, full-year top line growth had been estimated at less than 6%. That suggests that there is a huge amount of room to still be conservative with growth estimates but to expect strong increases in the top-line projections by analysts.
For a company with $2 billion in run rate revenues, the company has a modest coverage of seven analysts. And based on the conference call transcripts, I think it is fair to say that Itron is not on the top of anyone's list as a priority to recommend. Maybe it is because the company is headquartered in a suburb of Spokane. Again, the point here is that Itron sits in a dusty corner of a very hot space without a large cohort of covering analysts. That's a great set-up for potential upside - this name hasn't be considered by aggressive investors for years.
Itron shares retain a modest valuation despite the recent share price action. The company has an enterprise value of about $2.4 billion. That equates to EV/S of a bit under 2X. The P/E is about 22X and probably around 18X expectations for 2017.
As mentioned earlier, the company generated $82 million of CFFO through the first nine months and free cash flow of $51 million. Based on the trends of the part quarter, I think free cash flow this year can surpass $70 million. That is a free cash flow yield of about 3%.
I would think that earnings and cash flow will grow more rapidly than revenues going forward - how much so is not easy to determine. Because of the large restructuring charge recognized in the quarter, disaggregating the income statement is not a useful undertaking since the charge is unequal across expense categories. But overall, given the very low EV/S, I think valuation metrics favor investors strongly at this point.
I do think that Q3 was most likely an inflection point. Inflection points are an overworked phrase, no doubt, and many of them are called and never seen again. But all of the signs of an inflection point have appeared. I think the risk/reward ratio is quite favorable and the opportunity for substantial alpha is significant. Bring on the next clambake!
Disclosure: I am/we are long SSNI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.