Barbara J. Doyle - Itron, Inc. Philip C. Mezey - Itron, Inc. Joan Schweikart Hooper - Itron, Inc. Thomas L. Deitrich - Itron, Inc..

Tyler Charles Frank - Robert W. Baird & Co., Inc. Joseph Osha - JMP Securities LLC Luis Amadeo - Oppenheimer & Co., Inc..

Good day, everyone, and welcome to the Itron Incorporated Q3 2017 Earnings Conference Call. Today's call is being recorded. For opening remarks, I would like to turn the call over to Barbara Doyle. Please go ahead..

Thank you, Renee. Good afternoon and welcome to Itron's third quarter 2017 earnings conference call. We issued a press release earlier today announcing our results. The press release includes replay information for today's call. We have also prepared presentation slides to accompany our remarks on this call.

The presentation is available through the webcast and through our corporate website under the Investor Relations tab.

On the call today, we have Philip Mezey, Itron's President and Chief Executive Officer; and Joan Hooper, Itron's Senior Vice President and Chief Financial Officer; and Tom Deitrich, Itron Executive Vice President and Chief Operating Officer.

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

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

We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties.

Actual results could differ materially from these expectations because of factors discussed in today's earnings release and the comments made during this conference call, and in the Risk Factors section of our Form 10-Q, 10-K and other reports and filings with the Securities and Exchange Commission.

We do not undertake any duty to update any forward-looking statements. Now please turn to page 4 in our presentation, and I'll hand the call over to our CEO, Philip Mezey..

Thank you, Barbara. Our third quarter results were below our expectations, and we fell short on our objective of delivering business predictably this quarter. Non-GAAP earnings per share were $0.77 on revenues of $487 million.

As we continue to realign our business, we have been consolidating manufacturing operations, increasing our deliveries of new solutions and transitioning our supply chain.

We experienced some ramp up issues in the quarter as part of our planned transition of circuit boards to external sources, resulting in lower revenues in the third quarter primarily in our Electric and Gas segments. We quickly took actions to address these issues and they will not impact our fourth quarter results.

While we're disappointed by the impact on our Q3 results, we are confident that the initiatives underway provide a foundation for greater long-term benefits. We are significantly transforming our business in line with our strategy and driving increased profitability and scalability for growth.

Another important growth driver is customer adoption of our OpenWay Riva smart solutions. Riva shipments increased in the quarter, resulting in some constraints in our field deployment. However, we are very pleased with the level of demand and are investing in field deployment capacity to meet the needs of our growing customer base.

I've spoken with many current and prospective customers in recent months, including at our Itron Utility Week in October. Customers are excited about the possibilities provided by OpenWay Riva and the value proposition of a unified IoT platform for smart grids and smart cities.

Through these conversations, I am fully aware of how critical the network platform is to our customer successes, and the entire team at Itron is intensely focused on delivering business outcomes with our Riva solution. Now, I will cover bookings and backlog on slide 5 before turning the call over to Joan.

Total backlog at quarter end of $1.5 billion was roughly flat to backlog a year ago. 12-month backlog of $850 million was 16% higher than last year. There's also over $325 million of business that we have been awarded that is not yet reflected in our backlog, providing good visibility for forward revenue growth.

Third quarter bookings were low at $343 million, driven by timing of customer contracts and awards. We continue to see a healthy pipeline of opportunities across all three segments and have been awarded several new contracts since the quarter ended.

Our outlook includes a significant sequential increase in bookings in the fourth quarter, which we expect will result in a book to bill greater than 1:1.

Notable bookings in the quarter included a Riva contract with Vectren Energy Indiana-South to implement advanced meter solutions as part of its smart energy future plan that received regulatory approval in September. Customer interest in our Riva IoT solution continues to be strong across each of our segments.

Vectren was our 18th OpenWay Riva customer and the list continues to grow. We also signed a 10-year contract extension with Southern Maryland Electric Cooperative for demand response. We are very pleased with the addition of distributed energy management solutions to our portfolio.

In its third quarter report, Navigant ranked Itron as a leader in residential demand response, and Itron was the only company ranked leader in both the strategy and the execution categories. Navigant noted that Itron has the strongest foothold within the residential demand response market, offering a turnkey service for utilities.

The former Comverge team is now fully integrated into our operations and we are on track to achieve the expected benefits from this acquisition. In the Water segment, we were awarded several contracts subsequent to the end of the quarter including Sanepar in Brazil and contracts in Jordan, Saudi Arabia and Malta.

These contracts are in addition to the Q3 water backlog, which was up 30% from last year. Now, let me turn the call over to Joan to review our financials..

Thank you, Philip. Turning to the third quarter results, consolidated GAAP results are shown on slide 6 and non-GAAP results are shown on slide 7. In the third quarter, Itron delivered modest gross margin improvement on lower revenue of $487 million.

As Philip just mentioned, revenue was impacted by short-term issues related to factory consolidations, supply chain transitions and new product ramp ups that caused shipment delays. These transitional items impacted third quarter revenue by approximately $35 million.

Gross margin improved 30 basis points year-over-year to 34%, driven by favorable product mix and reduced warranty cost. Other highlights in the third quarter include GAAP operating margin, which increased to 7.7%, and non-GAAP operating margin which remained flat year-over-year at 10.2% despite the revenue decline.

GAAP net income was $26 million or $0.65 per diluted share compared to a loss of $10 million or $0.26 share in the prior year. GAAP net income last year included $40 million of restructuring charges related to the 2016 program. Adjusted EBITDA as a percentage of revenue was 11.8% in the quarter.

Non-GAAP net income increased 2% to $31 million and diluted EPS remained flat year-over-year at $0.77 per share. We were able to partially offset the earnings impact of the delayed revenue with lower warranty cost, reduced operating expenses and a lower effective tax rate.

Itron generated operating cash flow of $21 million in the quarter versus $31 million last year. The decrease is primarily a result of changes in working capital due to timing of accounts payable and a larger tax payment compared with the prior year. We also had higher inventory due to the supply chain transitions.

Year-to-date cash flow from operations was $115 million, up 40%, compared with the same nine-month period, last year. Cash and equivalents at the end of the quarter totaled $138 million, up $10 million from the end of last quarter. Total debt at the end of the quarter was $323 million, while net leverage was 0.9 times adjusted EBITDA.

Looking at the year-over-year revenue bridge on slide 8, Electricity's revenue decreased in the quarter reflects lower product volumes due to the operational issues experienced in North America, partially offset by strong smart solution volumes in the EMEA and Asia Pacific regions, as well as the addition of distributed energy management revenue realized through the acquisition of Comverge.

Year-to-date, Electricity's revenue was up over 5%. The year-over-year decline in Gas revenue is largely due to lower smart project business in EMEA, and short-term production capacity constraints on new products in North America.

You may also recall that the third quarter of 2016 was an exceptionally strong quarter for Gas, which impacts the year-over-year comparison. Lower revenue year-over-year in Water reflects the delays of several large customer projects in North America and EMEA.

These delays are an overall industry issue and consistent with reports from peers in the water industry. This decrease was partially offset by growth in Latin America and Asia Pacific. This is the fourth consecutive quarter of year-over-year growth in Latin America, driven by an increase in residential project demand.

Looking at the year-over-year non-GAAP EPS bridge on slide 9, reduced operating expenses contributed $0.09 of year-over-year improvement driven by lower professional fees, variable compensation and reduced head count in G&A functions. A lower non-GAAP effective tax rate of 31% versus 39% last year had a positive $0.09 impact on non-GAAP EPS.

The lower tax rate is due to the timing and mix of taxable income by jurisdiction. These positive EPS impacts were offset by the flow through of the lower revenue, higher other expense which is primarily due to foreign exchange losses related to the balance sheet in a higher diluted share count.

The net result was non-GAAP EPS was $0.77 flat year-over-year despite the revenue decline. Slide 10 through slide 12 show results by business segment. Itron's Electricity business delivered another strong quarter with revenue of $240 million and a gross margin of 31.8%, up 70 basis points due to favorable product mix and lower costs.

Gas gross margin of 35.1% reflects a year-over-year decline due to lower volumes and product mix primarily lower communication module shipments. The gross margin in the Water segment improved to 37.1%. The 440 basis point improvement is primarily due to lower warranty costs this year. Turning to slide 13 to discuss our full year outlook for 2017.

Factoring in the third quarter results, we expect non-GAAP EPS to be at or above the low end of the guidance range we provided on last quarter's earnings call, which was $2.95 to $3.15 per share. We anticipate total revenues that are at or modestly below the low end of our prior revenue range which was $2.03 billion to $2.06 billion.

Our revenue outlook assumes current foreign currency exchange rates and some recovery of the delayed third quarter shipments offset by the impact of market-driven delays in water projects. Our EPS guidance continues to assume a non-GAAP effective tax rate of 35% and average diluted shares outstanding of 39.5 million for the full-year of 2017.

As you can see from our outlook, we expect substantial sequential and year-over-year growth in the fourth quarter for both revenue and earnings per share. With that, I'll turn the call over to Philip..

Thank you, Joan. The short-term execution issues in the quarter were a disappointment for us given the record of strong performance we have been building over the last two years. In one respect, the margin and EPS results in the quarter showed the continued progress and increased resiliency in our financial model.

Gross margin improved year-over-year despite the temporary revenue impact, and operating expense declined even after absorbing costs added with the Comverge acquisition.

The business transformation initiatives that we are executing will help drive our performance to our mid-teens EBITDA margin target and beyond, and will also make us more nimble and able to capture new opportunities to provide even more value for our customers. We're still early in this transformation.

We've addressed the short-term transition-related issues in the third quarter and we feel very good about the forward momentum in our business. We continue to advance important operational improvements across our company while ramping up deliveries of our new solutions.

We believe we have the best industrial IoT platform and smart solutions available for customers, and the acquisition of Silver Spring Networks that we announced on September 2018 will further strengthen our value and choice for customers.

We are excited about the Silver Spring acquisition, which advances our strategy of delivering value generating solutions for the critical infrastructure within utilities, smart cities and the broader industrial Internet of Things sector. Customer feedback has been positive and encouraging.

Investors have indicated that they see a strong business rationale for the combination, and our integration team is up and running with key members from both companies planning for critical integration activities upon close of the transaction.

The process to complete the key milestones to close the transaction at the end of 2017 or early 2018 is well underway and moving forward as expected. Operator, now let's open up the call for some questions..

Thank you. And we'll take our first question from Tyler Frank with Baird..

Hi, guys. Thanks for taking the question. Just to start, can you discuss the several hundred million in awards that is not in your backlog currently? I think you had a similar number at the end of Q2.

So are these the same deals or are these new deals? And then, in terms of outsourcing, how do you know the issues have been resolved for the circuit boards? And can you also provide some color on just your overall outsourcing strategy and where you are in that cycle of identifying partners and outsourcing some aspects of your manufacturing?.

Okay. Sure, Tyler. Thanks. On the backlog front, it's actually – we indicated $325 million.

The $700 million referenced is actually the 12-month backlog number is that approximate number, and so those are deals that are already booked and scheduled within the next 12 months, the $325 million are contract approvals that have not met all of our backlog criteria.

And while there has been some change in that number, they basically are the two large contracts that we have referenced before. And on the outsourcing front, I will refer the question to Tom Deitrich..

Very good. Thanks, Tyler. Maybe I'll start with the point that Philip made earlier on in our prepared comments. We're disappointed in the third quarter results, and perhaps no one more so than I am.

The drag on the results themselves really fell into two categories; one that you mentioned which was factory transitions and the other one is product ramp up. But the results you saw were a combination of the two.

On the factory transition side of things, I would note that we announced a restructuring back in 2016, and that's a pretty broad sweeping type of activity. It touches a number of factories on a couple of different continents, most of those transitions are progressing smoothly.

We did get caught up in one issue which is the one that you referenced in your question. We had some problems with the product complexity and the mix of the transfer. Really, what happened was it led to a number of delays in the qualification buildout of those boards, and we ended up having shipments that delayed out of the quarter.

Very disappointing but we worked through the majority of that now, those qualifications are done or we've done the builds to make it happen. We've added some additional capacity to protect and buffer against this in the future. On the other half of the issue, you didn't ask about it, but I do want to take a moment to hit on it.

The production ramp-up side of things, we're blessed with strong customer demand for a lot of new products.

In Q3 we have startup the issues that on the production and the field deployment side of things that again delayed some things, but steadily during Q3, we added capacity on the field deployment side of things and tightened up processes to be able to meet the demand.

Both of those issues that I talked about are indeed transient, they're both self-help remedies, if I can use that as a term, and we've taken the right steps to make sure we are attacking the issue both near-term and creating a longer-term stronger company.

Why do we have confidence that this is behind us? I don't know that I have to look any further than that EPS guidance that we just gave even taking into account the disappointing results of Q3. We're talking about an EPS range that's at or above the low end of the range.

The second part of the question that you asked on the side EMS side of it, the strategy that we have for using outsourced manufacturing. The words that I would give you on that would be, we want to use outsourced partners for what they are good at, we get to use some of that the capital that is already deployed which is a very efficient system.

It gives us some burst capacity and can allow us to have a more robust model through the normal ebbs and flows and product transitions themselves. It would be a mistake, I think, to count on them for things that they are not good at.

There are some products in our portfolio and some steps in the manufacturing process that are better off inside, and that will be the strategy that we would have.

You should expect us to continue to have a mix of insourced and outsourced to manufacturing, and of course we want to make sure we're working with a few number of partners but still maintain good competitive dynamic in the marketplace..

Got it. Thank you..

Thank you. Our next question comes from Joseph Osha with JMP Securities..

Hello there. Thank you for taking my question. I've got two. First is as you think about the post combination entity, Philip, you've talked about operating cost targets for Itron on its own.

I'm wondering what your thought is about whether you're willing to talk about additional synergies on the Itron side from the combination, and if not, if you could at least remind us what your current thinking is on the longer term targets for operating costs for Itron? And then I have one other question..

Okay, Joe. Thanks.

So yes, of course we've talked about this target of getting to mid-teens and beyond and that was prior to announcement of the combination, and so we remain committed to the very important steps that you have heard us discuss on this call of product selection and investment of supply chain improvements and other cost reductions that are underway.

To your reference about our target cost model, in order to get beyond this mid-teens number, we have talked about a target operating model of approximately 8% of sales and marketing, 8% R&D and 6% or so on the G&A side, and those are the numbers that we continue to aim at.

To your reference about post combination, the comment that we made is that we expect $50 million worth of synergies across the whole P&L, and we see those synergies coming from the combined Itron company. So thinking of those as being specifically identified within Silver Spring is not the way we are looking at this.

We're looking at as a scale business how we can run most effectively. So you'll get a better view here of what that combined outlook looks like as we provide our 2018 guidance in February..

Okay. Thank you very much. And then one other question before Barbara throws me off.

OpenWay Riva, has there been any reaction from potential customers now that they're trying to understand how OpenWay Riva might fit together with the Silver Spring technology platform? Is anyone saying, hey, let's wait a minute and see how this fits together? Just curious as to a comment there and I'll jump back in queue..

Yeah. I mean, given the long-term nature of the selection process and the structured process it's gone through, we really haven't seen a particular disruption in that process and, certainly, it does not reflect upon our result in the third quarter in any way. There are questions about how to think about the combination going forward.

And again, I would refer back to the comments we made when we announced the transaction, which is there is tremendous promise in the convergence of these two platforms. And so we really do provide the opportunity for these customers to make investments that will be supported in the future and shortly converged onto a single platform.

So that discussion with our customers and prospects has gone well in that regard..

Thank you very much..

Thank you. Our next question comes from Noah Kaye with Oppenheimer..

Hi, this is Luis Amadeo for Noah.

Can you comment on the feedback you're hearing thus far from customers on the merger with Silver Spring? What are the concerns that you had to address and what opportunities are coming out of the discussion?.

So, Luis, I would say – in my comments, I said that generally customer feedback has been supportive, that the marketplace understands the transaction and the rationale.

And we've really had to just reiterate the points in our initial webcast, in particular, around this notion of open standards supporting other meter providers of providing choice and value in the market.

And so this open competitive network is just clarifying that point has really been a primary issue along with the comments that we've made about our absolute support for contracts underway in installed customer base as to how it is that we intend to support them on a going forward basis..

Okay. That's very helpful.

And if I can ask one more, looking at 2018, how should we think about normalized organic growth, does mid-single digit range still seem right as you go through the project activity and strength of the pipeline?.

Luis, hi. This is Joan. Let me take that. We're not really in a position to provide guidance about 2018. Our typical process would do that on our fourth quarter call which will be late-February.

So, on that call, hopefully, if the Silver Spring transaction closes as we expect it to, we'll be in a position to provide combined guidance for the two companies together and be able to give that color.

That said, if you listened to some of the comments Philip made about the backlog and the 12-month backlog and some of the operational initiatives underway to improve margin performance, I think those are all positive signs as we enter 2018..

Okay. Fair enough. Thank you..

Thank you. And we will take a question from Tyler Frank with Baird..

Hi, Tyler. You're back..

Hi. I am, yes. Thank you for taking the question.

Can you just clarify Joe's question that he had? Should we think about the $50 million of synergies in addition to the August cost reductions or the (26:04) cost reductions to the ongoing savings, or is that included?.

No, it's incremental. So there was a series that Tom talked about the 2014 program is basically complete the 26 program we're still on the midst of executing on. And then as we combine the two companies, there's an incremental $50 million, as Philip said, between the two companies that would be over and above the restructuring we've been doing..

Okay, great.

So I guess how should we think about that in terms of an overall number looking into 2018?.

Well, again we don't have the 2018 guidance. When we announced the acquisition on September 18, we talked about a $50 million synergy target achieved by the third year, and so we're still in the midst of integration planning. Obviously, the transaction hasn't closed yet.

So again, hopefully if the transaction closes in late 2017, early 2018 as we expect, in the Q4 call we'll be able to give 2018 guidance with the combined company and the synergy impacts to the extent there are some in 2018 will be embedded in those numbers..

Got it. Thank you very much..

But if you think about the color we provided on synergies, R&D will probably take the longest given some of the comments we've made about the technology, the need to support customer contract, the G&A will probably be the fastest as these were two public companies combining.

So we'll be able to give that color, but full $50 million is really year three..

Got it. Okay. Thank you.

You're welcome..

Thank you. And it appears we have no further questions at this time. Mr. Philip Mezey, at this time I'll turn the conference back to you for any additional or closing remarks..

Thank you. We had a tough turn here in the third quarter, but we remain extremely optimistic about the steps that we're taking in order to improve predictability and profitability inside the company along with the strong growth initiatives that we've taken, the acquisition of Comverge and its successful integration.

This pending transaction with Silver Spring that gives us tremendous opportunity in the market of really being a wider player in the Internet of Things and smart city space, as well as this highly competitive space that we're operating in within the utility space.

And again, customer feedback and investor feedback has been very supportive and the process is coming along very well. We are strongly on track for our Q4 performance that we have indicated here and look forward to talking to you again to provide our 2018 outlook on our next call. Thank you very much..

Thank you. There will be an audio replay of today's conference available this afternoon. You can access the audio replay by dialing 1-888-203-1112 or 1-719-457-0820 with the passcode of 9357766, or go to the company's website at www.itron.com. This concludes today's presentation. Thank you for your participation..