Itron, Inc.
Q3 2018 Earnings Call Transcript

Published: 6 Nov 2018

[Operator:]

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.

[Kenneth Gianella:]

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.

[Philip Mezey:]

Thanks, Ken. Good afternoon, and thank you for joining us today. I'd like to start by discussing our third quarter results. Total revenue of $596 million and non-GAAP EPS of $1.13 reflect solid improvement over prior quarter and prior-year results. These results drove significant cash flow in Q3 that allowed us to pay down $90 million in debt. Networks is performing ahead of our expectations, and we have reached several key milestones in the integration process, including integrated back-office systems, merged operating teams and a combined go-to-market strategy. While these are all positive outcomes, we continue to experience supply chain-related headwinds in Q3 which will remain in Q4. We are working to mitigate these near-term challenges on both cost and customer deliveries while improving our internal production inefficiencies. Now let me provide an update on the issues we identified on last quarter's call. Previously, we estimated an impact of approximately $70 million in increased supply chain costs and internal production inefficiencies from our original full year guidance for 2018. This estimate has increased by approximately $20 million to $25 million, for a four total impact of approximately $90 million to $95 million. The supply chain challenges are not just impacting costs. The extended lead times and component shortages are now impacting our top line, contributing to lower updated revenue guidance for the full year. Our operating revenues are primarily comprised of two categories

[Joan Hooper:]

Thank you, Philip. As Philip just mentioned, the Q3 results were in line with our expectations. A summary of consolidated GAAP results is shown on Slide 7, and non-GAAP results are shown on Slide 8. Revenue of $596 million increased 22% versus last year driven by strong performance in the Gas segment and the addition of the Networks segment. As anticipated, third quarter gross margin of 33.1% was down slightly from last year due to supply chain headwinds and the release of a special warranty reserve in the prior year. We continue to see higher supply chain costs due to component constraints, longer lead times and internal production inefficiencies, which are impacting margins as well as revenue. Moving on to EPS. Our third quarter GAAP net income was $20 million or $0.50 per diluted share compared with $26 million or $0.65 last year. Regarding non-GAAP metrics, adjusted EBITDA of $81 million or 13.5% of revenue is higher year-over-year driven by increased gross profit on higher revenue from the Gas segment and the acquisition of the Networks segment. Also contributing to the improvement was lower variable compensation and cost savings from restructuring efforts. Non-GAAP net income for the quarter was $45 million or $1.13 per diluted share compared with $31 million or $0.77 per share in 2017. Free cash flow was $37 million in the third quarter versus $9 million last year. The increase in cash flow was driven by improved profitability and working capital management. Cash and equivalents at the end of the third quarter totaled $109 million, a decrease from the second quarter as cash was used to accelerate the pay down of debt in line with our stated strategy to delever. Now turning to Slide 9. Total debt decreased by $90 million in the quarter to $1.05 billion following payments on the revolving credit facility and the required principal payments on the term loan. The balance sheet remains flexible, with net leverage decreasing to 3.9x and continued strong cash flow generation from our operations. Despite the rising interest rate environment, our blended interest rate is 4.2% as we have over 70% of the debt hedged. Our liquidity remains robust with $450 million in undrawn revolver capacity. Now turning to the third quarter year-over-year revenue bridge on Slide 10. Total company revenue grew by 22%, or 25% on a constant currency basis. Excluding the Networks segment, revenue grew 4%. Electricity revenue was down 1% as reported and flat in constant currency. This reflects lower commercial and industrial shipments in the Asia Pacific and Latin America regions, offset by continued strength in North America and EMEA smart shipments. Gas revenue increased 19% or 21% in constant currency, driven by record North America module shipments and smart devices in EMEA. Water revenue was up 1% in constant currency due to deployments in Australia as well as continued demand in Latin America residential projects. Revenues for the Networks segment was $90 million in the quarter, up 22% sequentially, driven by the timing of customer projects and the ramping of new deployments. The non-GAAP year-over-year EPS bridge is shown on Slide 11. Non-GAAP EPS was $1.13 per diluted share this year compared with $0.77 in the prior year. The primary drivers of the $0.36 year-over-year improvement are

[Philip Mezey:]

Thank you, Joan. While the updated 2018 outlook is disappointing to us, our fundamental strategy and long-term financial model are intact. We continue to see operational improvements from our restructuring programs, and we are successfully integrating the networks acquisition. We are delivering new and innovative products to market and we're moving ahead on the execution of our strategy. A key element of our strategy was the acquisition of Silver Spring Networks earlier this year. To maximize the effectiveness of the acquisition, we are merging all of our network assets into one business unit. Another key strategic goal is to increase our services- and outcomes-based business solutions. To that end, as of October 1, 2018, we have realigned our internal organizational structure from Electricity, Gas, Water and Networks to Device Solutions, Networked Solutions and Outcomes, servicing the utility and smart city markets. Slide 18 and 19 give an overview of our new segments. Itron remains focused and committed to the unique needs of electric gas and water utilities, and recognizes the need to support these customers with an end-to-end solution and outcome-based approach. To achieve this, along with the announcement of our new segments, we have unified our go-to-market strategy with a single global sales force that will sell the full portfolio of Itron products and services. This will be supplemented by our existing channel partners around the globe. We will continue to manage our product development, service delivery and manufacturing operations on a worldwide basis to promote a global integrated perspective in our operations and to ensure consistency and interoperability among operating segments. With this change, we will now report under the three operating segments

[Operator:]

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

[Chip Moore:]

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?

[Philip Mezey:]

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.

[Chip Moore:]

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?

[Philip Mezey:]

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.

[Chip Moore:]

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?

[Thomas Deitrich:]

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.

[Chip Moore:]

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?

[Philip Mezey:]

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.

[Operator:]

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

[Noah Kaye:]

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?

[Thomas Deitrich:]

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.

[Noah Kaye:]

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?

[Philip Mezey:]

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.

[Noah Kaye:]

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?

[Joan Hooper:]

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.

[Noah Kaye:]

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?

[Joan Hooper:]

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.

[Operator:]

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

[Joseph Osha:]

Sorry about that management incentive comp.

[Philip Mezey:]

It's appropriate.

[Joseph Osha:]

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?

[Joan Hooper:]

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.

[Joseph Osha:]

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.

[Joan Hooper:]

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.

[Joseph Osha:]

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?

[Joan Hooper:]

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.

[Joseph Osha:]

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.

[Thomas Deitrich:]

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:]

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

[Pavel Molchanov:]

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?

[Philip Mezey:]

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.

[Pavel Molchanov:]

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?

[Joan Hooper:]

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.

[Operator:]

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

[Sean Hannan:]

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?

[Thomas Deitrich:]

So Tom here. I think that there's a number of different dynamics. Certainly, we've seen lots of component shortages, as you point out. In general, products that have shorter life cycles, so think more consumer goods, they tend to be pretty quick-moving. You have a new platform coming out, and they jump onto a newer technology sooner. Older products, industrial products, tend to be more lagging generation components. As new capacity comes onboard, with component suppliers, they generally build that capacity in the newer technologies, and the older ones stay constrained a little bit longer. So what happens from -- if you look at it through an industrial product kind of lens, you've got two choices

[Sean Hannan:]

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.

[Thomas Deitrich:]

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.

[Sean Hannan:]

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?

[Philip Mezey:]

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.

[Operator:]

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

[Philip Mezey:]

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.

[Operator:]

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.