Kenneth Gianella - IR Philip Mezey - President, CEO & Director Joan Hooper - SVP & CFO Thomas Deitrich - EVP & COO.

Chip Moore - Canaccord Genuity Noah Kaye - Oppenheimer Joseph Osha - JMP Securities Pavel Molchanov - Raymond James & Associates Sean Hannan - Needham & Company.

Good day, everyone, and welcome to the Itron Q3 2018 Earnings Call. Today's call is being recorded. For opening remarks, I would like to turn the call over to Ken Gianella. Please go ahead..

Thank you, Operator. Good afternoon, and welcome to Itron's Third Quarter 2018 Earnings Conference Call. We issued a press release earlier today announcing our results. The press release includes replay information about today's call.

A presentation to accompany our remarks on this call is also available through the webcast and on our corporate website under the Investor Relations tab.

On the call today, we have Philip Mezey, Itron's President and Chief Executive Officer; Joan Hooper, Senior Vice President, Chief Financial Officer; and Tom Deitrich, Executive Vice President and Chief Operating Officer. Following today's prepared remarks, we will open the call to take questions using the process the operator described.

Before I turn the call over to Philip, please let 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 the 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 the Risk Factors section of our Form 10-K, 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 turn to Page 4 in the presentation, and I'll turn the call over to our CEO, Philip Mezey..

Contracted backlog of product and services and purchase order-related business. Our backlog tends to be multiyear contracts with a highly visible 6 to 12 month delivery plan. Our purchase order-based business is typically requested by customers to be booked and shipped in the same quarter.

These orders cover over 10,000 products, and the product mix and order size vary quarter-to-quarter. Historically, we've been able to plan and replenish inventory to fulfill purchase orders within the quarter. We now have over 550 individual components across all of our lines of business that have lead times over 6 months.

These elongated lead times are impacting our ability to meet customer demand and efficiently manage our factory utilization. This ultimately increases our operating costs and reduces predictability of our in-period revenue.

To partially mitigate these risks, we are increasing inventory, expediting shipments and improving our processes for demand predictability. We are well underway on our supply chain transformation and do expect continued improvements in performance.

Those external factors that are not in our control -- prices and lead times of components -- appear to have plateaued, but we have not yet seen movement back towards more typical levels.

We continue to aggressively pursue tight discretionary spending, including the elimination of this year's management incentive compensation and the acceleration of synergies from the Silver Spring Networks integration.

As we work through these near-term challenges, it's important to remain focused on our customers and how our solutions can best support them today and into the future. A few weeks ago, we hosted over 800 customers, partners and suppliers to participate in our industry-leading Itron Utility Week.

We presented plans for our converged network platform, Riva6, that protects customers' assets and extends our leadership in the industry. By bringing together Itron OpenWay Riva and Gen5, we are taking the best attributes of each to create a unified network as seen on Slide 5. Itron remains committed to open and secure standards.

This gives customers the peace of mind that an investment today will not be stranded tomorrow. Our convergence plan has been well received, and we're seeing continued bookings of both our OpenWay Riva and Gen5 networks. Now turning to Slide 6 in the presentation, I'll cover bookings and backlog. Customer pipeline continues to be healthy.

Our book-to-bill ratio in the quarter was approximately 1:1, and based upon current contract activity, we anticipate strong fourth quarter bookings to end the year with a book-to-bill ratio above 1:1. Our total backlog at the end of the quarter was $3.1 billion, and our 12-month backlog was $1.4 billion.

Now I'd like to highlight a couple of notable deals recently signed. Entergy, building upon their AMI tech, will begin to build one of the largest distribution automation projects awarded this year, the strong validation of our Gen X network technology.

Entergy, which serves approximately 2.9 million customers in Arkansas, Louisiana, Mississippi and Texas, will expand its Itron Gen X network by adding 33,000 distribution automation endpoints to its existing AMI solution.

Entergy's network expansion for distribution automation will build on its existing Itron Gen5 network, which is designed to support multiple applications, including AMI, distribution automation and other smart utility and smart city applications on a single network platform. Next, we would like to announce an OpenWay Riva win in Thailand.

One of the largest utilities in Southeast Asia, Provincial Electricity Authority, or PEA, agreed to deploy the utility's first advanced metering infrastructure using Itron's OpenWay Riva solution in the city of Pattaya.

The network, coupled with Itron's meter data management solution, will help PEA transform its operations and improve its distribution system. This initial deployment will help meet PEA's goal to better understand the benefits of AMI and to prepare to potentially rollout AMI nationwide to its over 18 million customers.

I'll now hand the call over to Joan to discuss our Q3 results and our 2018 outlook..

The acquired Networks segment, which added approximately $0.15 to third quarter EPS; OpEx reductions, including discretionary cost controls. Benefits from restructuring and lower variable compensation contributed $0.21 per share improvement.

Other operational improvements from higher revenue, partially offset by the elevated supply chain costs, contributed $0.09 per share. The non-GAAP effective tax rate in Q3 was 19%, which is below our anticipated full year rate due to the timing of jurisdictional income. The lower tax rate contributed $0.17 year-over-year EPS improvement.

Offsetting these EPS benefits were increased interest expense on the additional debt used to fund the acquisition of Silver Spring Networks, which lowered year-over-year EPS by $0.17 and the release of a special warranty reserve that provided a $0.09 benefit in the prior year period.

Slides 12 through 15 show results by business segment for the third quarter. Electricity revenue was $237 million on gross margin of 31.5% and non-GAAP operating margin of 12.3%. The slight gross margin decline was due to higher component and commodity costs and higher international product mix.

Operating margin reflects lower variable compensation as well as benefits from restructuring. Gas revenue of $157 million on gross margin of 35.6% and a non-GAAP operating margin of 20.2%. The operating margin increase of 420 basis points was driven by higher revenue and lower operating expenses.

Water revenue was $113 million in the quarter and gross margin was 31.2%. The gross margin was down approximately 600 basis points due to higher commodity costs, lower module shipments and a tough year-over-year comparison. Q3 2017 included the release of special warranty reserves, which added 390 basis points to last year's gross margin.

The Networks segment gross margin was 35.2% and non-GAAP operating margin was 7.9%, which represents significant improvements over the first half of the year due to higher revenue and better product mix. We continue to be pleased with the segment's contribution to Itron's overall results.

Integration synergies are ahead of schedule, resulting in meaningful OpEx reduction. Now moving on to updated guidance on Slide 16. There are several factors impacting our outlook that have changed since the last earnings call. I'll provide the updated full year revenue and EPS outlook and bridge back to our prior guidance.

As Philip mentioned, the continued long lead times on purchase impacted our ability to meet customer demand, particularly for the purchase order-based business. As a result, we now anticipate full year revenues of $2.37 billion to $2.39 billion. The midpoint of this range is $70 million lower than the previous guidance we provided on the Q2 call.

The supply chain issues are also driving incremental costs of approximately $20 million to $25 million versus our earlier estimates. The lower revenue and higher supply chain costs have been partially offset by excellent OpEx controls. The net impact is a reduction in our full year non-GAAP EPS guidance to between $2.40 and $2.50 per share.

At the midpoint, this is a decrease of approximately $0.37 from prior guidance. Slide 17 highlights the major drivers of the decrease in EPS guidance. The primary causes of the reduced guidance are lower revenue and additional supply chain costs. The margin fall-through associated with the lower revenue results in approximately a $0.46 EPS reduction.

The incremental supply chain costs reduced expected EPS by $0.42. To offset these headwinds, we can continue to take aggressive actions to lower cost by executing on our restructuring plans, controlling all discretionary spending, and eliminating this year's management incentive compensation.

In addition, we are delivering accelerated synergies associated with the Silver Spring Networks acquisition. Our revised outlook for 2018 includes approximately $25 million of realized synergies. The net impact of all these cost actions is an increase of approximately $0.40 per share versus previous guidance.

And finally, we expect lower taxes will drive $0.11 higher EPS than previously estimated. While 2018 results are lower than anticipated from last quarter's call, we are still projecting 17% to 18% revenue growth year-over-year.

We continue to see solid customer demand, and this, coupled with the ongoing benefit of restructuring programs, gives us confidence in our future earnings potential. Now I'll turn the call back to Philip..

Device solutions, Networked Solutions and Outcomes, beginning with our Q4 earnings release in late February 2019. We anticipate this new structure will accelerate growth in our higher value network and outcome-based solutions while providing investors valuable insight into our operations.

We will have separate informational calls in 2019 to provide the investment community more details on how to view these new segments versus our historical ones. In addition, we plan to have an Investor Day in 2019 where we will go deeper into the new business structure, product roadmap and our long-term strategy and milestones for success.

We are positioning the company for the future and working on improving near-term execution. Solid bookings, year-over-year growth in our business and a technology uplift from our recent acquisitions, combined with a focus on strong cash flow generation, will continue to strengthen our position as an industry leader. Thank you.

Operator, please, let's open up the call to take some questions..

[Operator Instructions]. And we'll go first to Chip Moore with Cannacord Genuity..

Wonder if we could start with the component issue, and maybe you can talk about the updated revenue guidance.

Is that contemplating solely the elevated lead times? And is the bulk of that in purchase orders?.

So, Chip, yes, as we mentioned on the purchase order side of the business, that the quicker turn purchase order business is really what led to a higher impact for us. These elongated lead times and components have made it more difficult to us to fulfill the amount of purchase order demand that we routinely have, and that's the primary area.

But there are -- the secondary effect of these increased prices and lead times leads to some internal operating inefficiencies that we also continue to work on.

So we're very actively working on improving, as we said, internal inventory management, the stage parts to offset as much of that purchase order, business strain that these lead times represent component qualifications, cost reductions and other activities..

And Philip, can you talk a little bit about customers, conversations you're having with them.

Given these elevated lead times, it's an industrywide thing, are they understanding? And are there things they can do to work with you guys?.

I mean, we are being very transparent about this. And as you said, this is an industrywide phenomenon, and so they are generally aware of the issue and have been supportive of us.

At the same time, there are clearly impacts and strains associated with not being able to make all of our commitments here, which is why we're so focused on improving predictability and performance..

Got it. And just one more. You talked about things, it sounds like plateaued. Does that imply that it's fewer parts out of that? I think it was 500-plus you mentioned on components with a significant lead time.

Are you seeing that on fewer components now?.

Chip, this is Tom. I'll jump in and take that one. I would say the way to think about it is that the lead times that we see, specifically in the electronics portion of the portfolio, it's passives, capacitors, resistors, inductors, op end things of that sort, have been constrained across the industry for the last several quarters. That carries on.

We haven't seen lead times start to pull back to be more typical. We haven't seen any further increases, but it's almost running to stand still in the component market overall, is what we've seen..

Got it. That's helpful. And one last one for me. The new strategy with the single global sales force, we've been -- that's been in the works for a while. Good to see.

Can you talk about, Philip, maybe how you're thinking about synergy potential from that?.

Yes. Thanks, Chip. I mean, we certainly see -- we have operated an electric gas and water separate sales forces with the addition of the Silver Spring Networks acquisition, a separate networks sales force. So this absolutely gives us the opportunity to integrate the sales forces, I think, to focus on common sales excellence.

But another thing that was also going on under the covers is, we have always had a number of combination, electric and gas, utilities, electric and water.

But as we move to smart cities and multiple use networks, there are frequently needs that -- across the commodities, and an integrated sales force gives us the opportunity, really, to serve our customers more broadly.

And as we've said, to really emphasize the opportunity we have to manage the value of the data that we're collecting through these networks to provide greater levels of both managed services but also data related and analytics and outcomes to drive further value..

And we'll go to our next question from Noah Kaye with Oppenheimer..

To go back to the constraints in the purchase order business, what's your ability to get greater price in that part of the business at this point given these constraints, these elevated prices, and the fact that it's an industrywide thing?.

Yes, Noah, Tom here again. I'll take that one. The ability to price differently is pretty selective. It remains reasonably competitive out there. That business generally starts to move at the same pace, so I don't see a great ability to move price. We do it when we can, but by and large, it remains pretty competitive.

So the best medicine we have here is really self-help, and it's doing things like staging inventory, it's alternate sourcing, it's expediting shipments and it's working with our customers to get the best visibility on lead times of the products and the services that they need. That tends to be the best medicine for the problems that we see..

All right. So if -- it follows from that, if there's not much of a pricing uplift, but let's say, this $70 million or so of revenue that you've guided to down from the prior guidance, let's say that $70 million gets pushed into next year.

And I believe you talked earlier about confidence in the strong bookings number for Q4, so higher book-to-bill again to end this year.

Should we be thinking about low to mid-single-digit organic growth as achievable next year just given those two factors?.

Noah, I would say that the purchase order business tends to be book and bill. It if we're unable to fill, I would not think of that as business that pushes out. Others are able to fulfill that, unlike our backlog business which is a firm and predicable contract. So some of it does push a small amount.

Others -- if others are able to fulfill those purchase orders, then that business tends to move elsewhere. I would say that's our -- based upon our ability to fulfill. As we improve our ability to fulfill that purchase order business, we can absolutely recapture where we have been.

And the -- as we have discussed many times before, the level of bookings activity, the state of the backlog, the level of market activity that we've seen is the best predictor of future strength in the business. Typically, the demand on the purchase order side has remained strong, and so we are optimistic about our opportunity in 2019.

And I would not want to really go further in terms of a percentage growth rate that suggests at this point..

Sure. And thank you for the bridge. Again, just the walk from prior to current guidance. So if I can just ask, you mentioned management incentive comp and greater synergies as kind of the two big moving factors.

Can you just kind of give us a little bit more dimension, if possible, in dollars, what those were as we think about what's repeatable for '19?.

Yes. I can give you a little bit of color. I don't know that I'm going to be able to break out the exact amount. But the piece that we did put in the script was the Silver Springs synergies. So when we started the original guidance for the year, we were assuming about $10 million of realized synergy benefits, primarily OpEx in the P&L for the full year.

Last quarter, we increased that by about $7 million. And this quarter, we're increasing it by about another $8 million. So we are now expecting a full $25 million of the source from synergies in this year. If you recall, the full amount of synergies was roughly $50 million. So think about half of it being achieved and realized this year.

The remaining $25 million will be split equally roughly between 2019 and 2020. But we haven't provided the exact amount of our incentive comp, and so as we give guidance in February, we might be able to provide a little bit more color..

Yes. And just a quick one if I could sneak in a follow-up.

Any update to that $50 million, now that you've gotten through $25 million already?.

No. I mean, I just mentioned -- obviously, we will strive for more, but our number is still $50 million. But we've had -- I would say it's really all in the G&A area. We've had -- we were able to go quicker than we anticipated to merge organizations and get the heads up that we are planning to get out.

But I would still say $50 million is the right number to think about with, again, the remaining $25 million split equally between 2019 and 2020..

And we'll go next to Joe Osha with JMP Securities..

Sorry about that management incentive comp..

It's appropriate..

Yes.

So to follow-up on that previous question then, does this mean that I can think about operating expenses staying at the sort of $155 million to $160 million level as we move through next year? Is that a reasonable expectation?.

Well again, there will be some continuation of the restructuring programs and the Silver Spring integration benefits will continue to next year. Obviously, we will reset the management incentive plan based on whatever we agree with our board as our operating plan for 2019. So that would go the other way.

And again, not in a position to give you an exact OpEx guidance. We'll be able to do that in the next call..

Okay. And then as a follow-up, just looking at your full year revenue guide and the non-GAAP and then just dropping that down, it does year-to-date, your non-GAAP is $1.77, right? And you're guiding to $2.40, so it's just the math. And that suggested a pretty dramatic falloff in Q4.

Is that a lower gross margin? Or what's going on there exactly? Because I'm getting the $0.68 in Q4, which is a big decline sequentially..

Yes. We mentioned on the call, Q3 was really a record quarter for gas modules, which come with very, very high margin. And so that's probably the biggest bridge item from Q3 to Q4 as we would accept lower gross margins..

All right.

So you're really, you're going to kind of renormalize to this June, June-ish level -- June-ish, I like that word -- June-ish level as we think about Q4?.

Yes. The other thing I would mention, in our full year guidance, we provided an estimated tax rate of 27%, which would imply a higher Q4, obviously, than the 18% we had this quarter..

Okay. And then last one for me. I'm sorry to be tough, but I -- we cover other companies. It seems as if there are some unique challenges here in terms of the magnitude of the supply chain difficulties that you're having.

Is there anything unique that's going on here in terms of maybe the fact that you're in the middle of moving manufacturing and so forth? It just -- it seems like the pain level of Itron is high relative to similar enterprises..

Yes. Joe, Tom here. I have a hard time judging others. I can only look at it through our lens. We clearly have a very, very diverse product portfolio of products that some of them are older generation technologies, some of it is new stuff; and there are lots of factories in our supply chain itself, so it's a pretty diverse set of things.

That certainly adds a bit of complexity and challenge for us on top of the industrywide shortages that we see. Certainly, there's plenty of self-help that we continue to work through.

The supply chain consolidation and the restructuring activities that we've undertaken are absolutely designed to make us more robust as we gain momentum on those initiatives..

[Operator Instructions]. And we'll go next to Pavel Molchanov with Raymond James..

A lot of questions about margin. I actually want to ask about top line. Your stock had a pretty severe drop throughout October as macro chatter in the market kind of escalated about recession risk, economic slowdown, et cetera. I'd like you to just directly address kind of based on your track record, your experience with previous economic cycles.

How would Itron's order flow and revenue be impacted if we were to get into a recessionary scenario?.

Thanks. I think a great question.

First of all, our focus on the utility industry, which tend -- which typically plans its capital windows over 5, 10 and 15 year periods is -- holds up strongly in a recessionary environment where the utilities are providing critical electricity, gas and water to customers, and so demand does not typically fluctuate that quickly in the utility market.

And as I say, capital planning windows are over a longer period of time, so the utility market is a strong market in a recessionary environment.

The secondary effect, however, is that the supply chain challenges that we're currently facing have to do with a roaring economy that's creating outsized demand in relation to the supply of a number of these passive components and other specialty products.

Were demand to fall off in other industry is for a variety of economic reasons, we would expect the supply chain to somewhat snap back, which would strongly benefit us at this point..

Right. We'll be swimming in components at that point. A question on a slightly different subject. You're obviously starting to generate free cash flow.

Are you still targeting 2.5x debt-to-EBITDA by the end of '19? I think that had been kind of the original target from the Silver Spring announcements still on track to get there?.

Yes. What we have stated is actually getting down closer to 2x by the end of '20, so we haven't given an interim year. But the answer is yes, that we're still planning to get to that level..

We'll go next to Sean Hannan with Needham & Company..

Here's for me really quick. Coming back to the component topic -- because the other half of my coverage is IT supply chain. And so I've observed it's really only been a very specific few where we've had some improvements in terms of the component tightness. I've actually seen some extend recently.

And as a lot of players are trying to -- as they're getting pressure from OEMs and customers, a lot of them are trying to push back into, whether it's the EMS guys, and communicate through to navigate and graduate up to the next level component, the next generation, and thus, some redesign work.

Is some of that happening? Is there some redesign that's being pressured through coming through to you folks?.

You wait for the other guys to move and multisource person and fight out the battle on the current generation; or you do some selective redesigns to jump into a newer technology. We actually employ a bit of both.

Certainly, when we go and work with our supply base to secure components, it's almost a discussion as to what would be the best way to solve the problem. Sometimes it makes sense to jump in and redesign. Sometimes it makes sense to stick with the version that we have. So we employ both, is the answer, and it's very situational-dependent.

We generally do it in collaboration with the supplier. Sometimes they push to jump to a new technology, and sometimes, that makes sense; in others, it doesn't..

Right. Understood. And because that's the problem, right? Is that a lot of the component guys, well, they really don't want to put any money in to expand that capital. We're getting into, at this point, these are very common commoditized parts, and they don't want to get stuck holding the bag, right? And so it's kind of a little bit of a battle..

Agree, yes. And a lot of the discrete guys really got caught in the last time when we were in this type of situation, where they built a lot of new capacity and then were left holding the bag, were stranded with that.

I think they're being a little bit more reticent to jump to build new capacity anywhere, let alone in sort of lagging generation technologies. It's making the whole crunch, if you will, in terms of the supply chain last a little bit longer than probably anyone had anticipated when it started to happen..

Fully understood. But otherwise, if we didn't have this scenario in front of us right now, obviously, it's hitting the top line. It's hitting large, and there's probably going to be some pressures, whether it's your internal facilities or if it's -- even for your outsourced guy.

There's going to have to be some overtime running in order to get product out the door.

When we remove these elements, it sounds like -- as painful as they might be, it sounds like business is tracking, probably at least demand-wise, it's a little bit better than where your sentiments or viewpoints might have been a few months or quarters ago, or is that not accurate? Just want to get a general feel around that?.

I mean, Sean, I think it's an excellent point, that supply chain headwinds are masking not only underlying operating improvement as we're bringing more of these synergies and benefits of restructuring online, that there is both organic growth, and as we've said, really strong performance in the acquired Networks segment.

And you see, on a combined basis, this very strong backlog that, in fact, there is tremendous opportunity for us to both continue to improve internally on our execution issues, but also once we're leaving that -- some of the constraints that we have on the supply chain side, there's tremendous opportunity..

At this time, I would like to turn the call back over to Philip Mezey for any additional or closing comments..

Okay. Well, thank you, everyone. Of course, the supply chain conditions, as we discussed, have been very challenging. But at the same time, the Q3 results were very strong. The cash flow generation, in particular, debt, deleverage, and there are a number of ongoing activities internally within our control to offset our supply chain challenges.

We continue to be extremely pleased with the performance of the network segments.

Just one thing to point out, this Entergy announcement, to have such a strong distribution automation offering gives us optimism about cross-selling that DA solution across the legacy Itron installed base, and we continue to work very strongly on various revenue synergy opportunities for cross-selling as a result of the acquisition as well.

And overall, as we've said, very pleased about the level of market activity. So we look forward to providing an update for you in February on new reporting segments as well as our outlook for 2019, and we'll talk to all of you soon. Thank you..

There will be an audio replay of today's conference available this afternoon. You can access the audio replay by dialing 888-203-1112 or 719-457-0820, with the passcode of 5203944. Or go to the company's website, www.itron.com. This does concludes today's call. Thank you for your participation..