Itron Inc (ITRI) 2004 Q2 法說會逐字稿

Good day everyone and thank you for your patience. We'd like to welcome you to the Itron Inc. Q2 earnings conference call. As a reminder, today's call is being recorded. And now for opening remarks and introductions, I'd like to turn the conference over to Mima Scarpelli. Please go ahead.

Thank you. Good afternoon, everyone, and thanks for joining us today. With me here in Spokane is LeRoy Nosbaum, Itron's Chairman and CEO; Dave Remington, our Chief Financial Officer, and Rob Nielson, our President and Chief Operating Officer. Before we get into the details of today's call, I appreciate your patience as we review the Safe Harbor statement and pro forma disclosure.

Our earnings release includes predictions and estimates about future results. In addition on the call today, we will be providing additional details and information that is forward looking. The forward-looking information we're providing is based on our best judgments and expectations as to what the future holds and is subject to a number of risks and uncertainties. In particular, I would point out that the timing of large customer orders has in the past resulted in differences between actual and expected results. There are numerous other factors that can cause our actual results to differ from our expectations and you should review our form 10-K for the year ended December 31, 2003, and Form 10-Q for the quarter ended March 31, 2004, for a more complete disclosure of risk factors. Itron does not undertake any obligation to update or revise forward-looking statements, although we may do so from time to time.

Our earnings release also includes pro forma information and we will also be discussing pro forma net income and earnings-per-share today in the call. We believe our pro forma results provide useful information in terms of enhancing the overall understanding of our current and future performance. A schedule reconciling or GAAP, or reported net income to pro forma net income and EPS, is included as an attachment to our press release and is also available on our website.

I'm going to start the call today with a review of financial results for the quarter. LeRoy Nosbaum will follow that with some additional comments on our guidance for the second half of this year, and as well, some additional detail on the integration activities related to the Schlumberger Electricity Metering acquisition, or SEM, that we closed on July 1.

A couple of items to talk about in terms of the quarter and then we'll get into the details. First of all, as mentioned in our release, this is the first quarter that we're beginning to report segment results under the new organization structure that we began to implement earlier this year. We're reporting revenue and gross margin according to our two main operating groups -- hardware and software. This is in place of the previous segment reporting, which was by market. We believe many of you will find it easier to model and understand our business under the new segment reporting.

In putting together the new organization, we also made some changes regarding the classification of certain activities. For example, we had previously classified senior-level sales management as G&A. Those expenses are now being reflected in sales and marketing. So our financial statements today reflect any of those new classifications. Historical financial results have been restated to reflect the current classifications, as well as the current segment reporting. And in addition to the press release we issued today, we have also filed an 8-K that has historical amounts restated by quarter through 2003.

Let's now get into the detailed results for the second quarter. Revenues for the second quarter were 79.6 million, very similar to our revenues in the second quarter of last year and revenues were up nicely, roughly 21 percent, over our first quarter revenues this year. In terms of segments for both the quarter and year-to-date periods, hardware solutions revenues were lower, primarily due to fewer handheld meter reading systems sales, which are down roughly 10 million year-to-date. AMR revenues this year are slightly higher, both for the quarter and year-to-date period. Most of the increase comes from higher implementation and installation services related to AMR contracts as modules at shipments this year are comparable with where they were last year. We shipped 1.2 million AMR modules in the quarter; that's up slightly from 1.1 million in the second quarter of last year. Year-to-date, AMR module shipments of 2 million are level with 2003.

Software solutions revenues increased slightly in the second quarter of this year compared to last year, but are down slightly on a year-to-date basis. New order bookings were 66 million in the quarter; that is equal to new order bookings in the first quarter, but bookings are up quite nicely from the 41 million in second quarter bookings last year. Year-to-date, new order bookings total 132 million, which is 31 million more than what we booked in the first six months of last year. Backlog at quarter end of 153 million is comparable with last quarter, but down from 173 million a year ago. Twelve-month backlog was 76 million, which is very comparable with both last quarter, as well as the end of June last year.

Gross margin was approximately 46 percent for the quarter and year-to-date period in 2004, which is comparable with where gross margins were in the first quarter of this year, but it's down from 49 percent gross margin in both the second quarter and year-to-date periods in 2003. I think the best way to understand the factors driving the lower margins in 2004 is to review the change in segment gross margin. Margins in the hardware solutions segment declined from 51 percent in the second quarter last year to 46 percent in the second quarter this year. And on a year-to-date basis, they declined from 52 percent to 47 percent. The primary reason for the decline in hardware segment gross margin was the change in hardware product mix. 2003 revenue amounts included a higher percentage of gas AMR modules and handheld products. 2004 revenue amounts include a higher mix of electric and water AMR modules, as well as higher sales of the SmartSync system for commercial and industrial metering.

Margins in the software solutions segment increased from 28 percent in the second quarter last year to 40 percent this year. On a year-to-date basis, they improved from 30 percent to 34 percent, primarily driven by improved utilization and increases in maintenance revenue on a year-to-date basis, and as well, some additional software license revenue in the second quarter this year. Total operating expenses were fairly comparable in 2004 with 2003, both for the quarter and year-to-date. However, G&A expenses are roughly 2 million higher in the current quarter compared with the second quarter of last year, the largest increase being professional services for audit and tax fees, partially driven by Sarbanes-Oxley activities. There are also some increases for IT depreciation and other IT-related costs, some of which are nonrecurring. Headcount increases also drove higher G&A, and as well, some increased spending related to the SEM acquisition, which is not capitalized.

Net interest expense was 2.2 million for the quarter, of which 1.3 million related to the senior subordinated notes we issued to fund the acquisition of SEM. Those (technical difficulty) into escrow on May 10th and the results for the quarter reflect the net interest expense from that date through the end of June.

Other nonoperating expenses and income items netted to 1 million of expense, the majority of which relates to the write-off of our remaining minority investment in Landthorn Technologies. The tax rate for the quarter of 47 percent on a pro forma basis results from some adjustments to valuation allowances for future tax credits and is not reflective of the expected rate for the year, which we believe is closer to 38 percent.

Well all of this discussion so far brings us to our net income figures for the quarter. GAAP, or reported net income, was 818,000 for the quarter, 80,000 year-to-date, both of which are significantly lower than last year. Pro forma net income was 2.1 million for the quarter, or 10 cents per share. That compares with 6.1 million in a pro forma net income, or 28 cents per share in the second quarter of last year. Year-to-date, pro forma net income was 4.1 million, or 19 cents per share and that compares with 12.4 million, or 57 cents per share in the first six months of last year. Pro forma net income of 10 cents per share for the quarter is much lower than what we had indicated in early June and what the majority of analysts were projecting, which was roughly between 16 and 17 cents per share; obviously, a huge disappointment to us as well as to most of you. However, the difference is not in any one area, but rather comes from a number of factors.

Some of the differences in gross margin -- while revenues came in a little bit better than expected, the mix was different, resulting in slightly lower gross margin than planned. Some of the difference comes from expenses we had not considered. We had some unanticipated IT expenses in June. We also had expenses related to Schlumberger Electricity Metering acquisition in a number of areas during the month of June as well. And some of the difference results from nonoperating expense items. The rate of interest income on the subordinates noted came in a little lower than expected. We had some foreign exchange losses and a few other things that went through other expense during the quarter as well and the pro forma tax rate for the quarter of 42 percent, as I indicated earlier, higher than the 38 percent rate that we had expected. So all in all, we did miss what we had indicated in early June by quite a bit.

Turning to our balance sheet and cash flows, let's first look at significant changes in the balance sheet since the end of March. Accounts receivable increased 14.3 million since the end of March to 61.7 million at the end of June, largely due to the majority of sales for the quarter occurring in June. That resulted in use of cash in the second quarter, but will generate cash in the current quarter. Days sales outstanding, or DSOs, were 59 days, compared with 58 in the second quarter last year. DSOs in the first quarter of this year were 81 days. Inventories were up in the quarter by approximately 1 million and as we indicated last quarter, we expect that inventory levels will begin to decrease in the second half of the year.

We had 21 million outstanding on a line of credit at quarter end; that is up from 5 million at the end of March. In June, we made a principal and interest payment of approximately 5 million on our existing term debt, which drove some of that increase. We also used approximately 7 million in the last few days of the quarter to prefund various related items related to the SEM acquisition that closed July 1st. All of the 21 million in short-term borrowings under the revolver at June 30th, as well as the 29 million of remaining term debt under our previous credit agreement, were paid off on July 1st when we closed the SEM acquisition.

As mentioned on May 10th, we closed into escrow the proceeds for the senior subordinated debt offering that we had just completed and you will see that on our balance sheet at June 30th, we had 128 million of restricted cash and 124 million of debt related to the transaction, announced a 125 million in senior subnotes, less the discount of approximately 900,000. The restricted cash was used on July 1st, along with proceeds from our new senior credit facility for closing on the SEM acquisition.

As of today, our debt outstanding consists of the following -- 124 million of the senior subordinated notes, 185 million of term bank debt. We continue to have 4.3 million in project financing debt which did not change as a result of our refinancing and we have no borrowings outstanding on the revolver.

Let's now look at cash flow for the quarter. As mentioned earlier, the increase in accounts receivable of 14.3 million was a use of cash during the quarter and resulted in the negative cash flow from operations of 6.8 million. Depreciation and amortization addbacks to net income during the quarter were 4.4 million. Capital acquisitions were 2.5 million in the quarter, compared to 2.8 million in the second quarter last and year-to-date, capital acquisitions are 6.8 million, compared to 5.5 million in 2003. As we mentioned in our last call, cash interest expense for all of our debt is around 16 million on an annual basis with mandatory principal on our new debt of just under 3 million, again, on an annual basis.

In terms of the second half of the year with electricity metering operations in the mix, we look for a substantial improvement in both EBITDA and operating cash flow with an expectation of right around $45 million in EBITDA projected for the last half of this year. So clearly, more than sufficient cash flow generation to meet any debt service requirement and to pay down further on our term loan B.

That wraps up our financial discussion for the quarter. I'd like to now turn the call over to LeRoy Nosbaum, Itron's Chairman and CEO.

Thank you, Mima. Good afternoon everyone. My comments today will focus on our second half financial guidance and the integration activities of our new electricity metering business. We are projecting revenues in the second half of the year between $265 and $270 million. Within that range, we're looking for electricity metering revenues of a little less than $100 million, with the balance coming from Itron's other products and services. So, roughly $165 to $170 million in revenue for Itron traditional products in the last six months of the year, excluding electricity metering. That expectation, again, excluding electricity metering, reflects growth over our first-half revenues of approximately 15 percent and revenue growth over the second half of last year of a little less than 5 percent -- less than we had hoped for coming into the year, and as Mima has mentioned, even a quarter ago.

We've seen a nice increase in bookings in the first six months of this year over last year with bookings up 30 percent. While we're pleased with that, we're still not seeing the kind of movement, with large orders in particular, that we had been predicting. The reasons for the delays are utility-specific, as opposed to industry-specific and include such things as union contract issues, internal management reorganizations, new processes for RFPs and various other types of things.

For all of the large orders we're working, the business case remains strong. We're actively working with those customers and we expect that a few of them will close before the end of this year. The good news is we're not losing orders. The bad news is we have not been able to close some of the larger AMR orders we have been looking for.

On a combined basis with our new electricity metering business, the revenue numbers we are projecting reflect very strong growth. Our expectations for the second half revenues in 2004 reflect growth in the excess of 80 percent over the first half of the year and in excess of 60 percent over the second half of 2003, obviously a result of the acquisition. In terms of revenues split between Q3 and Q4, it's close to 50-50, but not quite. We do expect slightly higher revenues in the fourth quarter than the third.

We are projecting that our second half 2004 pro forma net income will be between $15.5 and $16.5 billion, which equates to somewhere between 70 and 75 cents per share. Included within that is roughly 20 cents per share of accretion in the second half for the acquisition of the electric metering business. In terms of the split between Q3 and Q4, earnings do not mirror the revenue split. From an earnings standpoint, the split is closer to one-third in Q3 and two-thirds in Q4 and is primarily driven by expectations for electricity metering gross margin in the third quarter. We expect that the total company gross margin in Q3 will be slightly less than 40 percent, primarily as a result of a purchase price accounting adjustment that will impact third quarter electricity metering gross margin. Purchase price accounting requires us to record the assets we're acquiring from Schlumberger at fair market value. In the case of finished goods inventory, this means recording the inventory on Itron's books at the date of acquisition at the expected sales value, less any related conditions. As a result, we expect that between $8 and $10 million of electricity metering third quarter revenues will have zero gross margin or profit contribution in that quarter. This is a non-cash issue. Gross margin in the fourth quarter for the combined operations should be in the low 40 percent range.

Our overall expectations for pro forma EPS of 70-75 cents reflect Itron's stand-alone numbers, lower than what we expected coming into the year, but as we reported a month ago, electricity metering numbers that are higher than we had expected, resulting strong earnings in EPS growth for the second half of the year.

Let me now spend a few minutes talking about electric metering integration activities since we announced FTC clearance on the 3rd of June. I'm going to focus on sales, manufacturing, development and international as those are all areas that we were precluded from addressing prior to FTC clearance. Funding for integration of G&A and general support activities had been accomplished well ahead of our receiving clearance and is now going quite smoothly.

On the sales front, we have approached integration with a mindset of minimal change in order to reduce any potential disruption. Accordingly, we've kept the entire metering sales organization intact, with the only change been who their national sales manager reports to within Itron's customer-facing groups. All of the salespeople will call on the same customers they called on before, report within the sales organization for metering as they did before and sell the same metering products they did before.

In like matter, there is no change to the Itron sales organization. What has changed is that senior sales management is coordinating our efforts, Itron's efforts, on AMR accounts where we have now a basket of solutions that is larger than before, including both retrofit and new meter AMR solutions. This is a very manageable effort the way we've structured it. It was agreed by both sales forces in a joint meeting with great acceptance and appreciation for the minimal change and we will continue to operate for the foreseeable future in this manner until we see a good and justifiable reason to change it.

Turning now to manufacturing, there will be minimal change here as well. Both factories will continue to operate as they have. They are both nicely loaded, running efficiently, but there are a couple of things to note. Our electric metering facility in Oconee, South Carolina has recently received accreditation from Canada which will allow the manufacture of meters in Oconee, South Carolina for shipment into Canada. We believe that is the first accreditation of that kind. As a result, we will be shutting down a separate manufacturing facility in Québec, Canada and moving those operations to Oconee, keeping open only a small distribution facility in Québec. That activity was -- taken place under Schlumberger, so the effect of that will occur within Schlumberger. The other item of note is that purchasing groups from both Wausheeka and Oconee have begun to work with each other to discuss supply chain opportunities where we believe there is real potential cost savings.

On the development front, both teams have met together and exchanged information on ongoing and future programs. There is great excitement regarding how well both teams' efforts fit together and how they combine their efforts on future product offerings. One of the reasons our metering group has been so successful in the solid-state meter market is the level of silicone integration in our Centron meter. That expertise of silicone integration can now be applied to both metering and AMR in a variety of ways to produce more feature-rich and cost-effective products in the future. As well, the two groups are discussing how to more efficiently share the workload across both organizations.

On the international front, several exciting developments are already taking place. With this acquisition, we now have a base of operations in Taiwan where we manufacture meters for sale to Taiwan Power. We will be expanding that base of operations to better serve the Asia-Pacific region. In Mexico, we now have a sales office to serve the Mexican and Central American region. In South America, our metering group has been nurturing relations in several countries that we believe can turn into real opportunities where Itron has previously had no presence. And in the Caribbean, our sales efforts complement each other nicely -- where they are strong, we are not, and vice versa. So all in all, good progress already on the international front.

From a high-level management standpoint, we are making one change that comes both from acquiring our electricity meter business and from the realignment of operating groups into hardware and software. With these two events, it was necessary to appoint group vice presidents of hardware and software who are responsible for development, product marketing, service and support, and in the case of hardware, manufacturing. For our hardware solutions group, that new group vice president is Malcolm Unsworth, who is the past President of Schlumberger Electricity Metering. Malcolm has a very long and successful history of managing all facets of hardware operations -- development, manufacturing, service, sales -- with a strong track record of managing these kinds of operations to very high levels of innovation and efficiencies. The appointment of Malcolm to this position, we further ensure integration and synergies that will flow from the combined hardware operation, both AMR and meters. Malcolm will be moved to Spokane.

The person managing our software solutions group has been and will continue to be Philip Macy. Philip came to Itron as part of our Silicon Energy acquisition where he was managing all software development. Here again, we have a seasoned professional that will carry Itron forward to being a world-class software provider. All in all, we are quite comfortable with integration to this point. The stage is now set for a good second half and a great 2005 and beyond.

As we look out across the next 18 months or so, the task is clear. We will continue to assimilate the acquisitions that we have made during the last two years. I would not expect any more for awhile. We begin to refocus on regaining maximum operational efficiencies that have been interrupted by the events of the last two years. As well, we will focus on honing the value proposition and vision that we have built, one that moves from creating data to gathering data to using that data in innovative software solutions that increased our utility customers' knowledge about how their delivery systems are running, or how better to use their resources. We will concentrate on the markets we are in and the products we have, or those they can be produced by combining our existing substantial offerings. In summary, we focus on earnings, cash flow and organic growth.

With that, we will open up for questions.

(Operator Instructions). Steve Sanders, Stephens, Inc.

Good afternoon.. A couple of questions. Does your second half guidance anticipate closing some of these large orders that I think have been pushed out for the last couple of quarters?

Steve, it does. In total, again, we've been talking about a handful of orders. We have adjusted our expectations to take some of those orders out of the last half of the year, but there are still several that we feel pretty good about, based on where we're at.

Regarding Schlumberger, the $100 million number in the second half, if you strip out the contract manufacturing, potentially a significant portion of the grid order in second half of '03, what does that business look like year-over-year, in terms of growth?

Steve, there's very little contract manufacturing revenues built into that 100 million. We're very rapidly transitioning that away. I don't know what it was in just the last half of last year. I can tell you, it was about $50 million for all of 2003.

Okay. I'm just trying to get a little better sense of whether you are expecting that business to be flattish in the second half. Any additional commentary there might be helpful. I think if you start '03 with 294, you back out 70 for the contract manufacturing and then another 30 or 40 for grid, you get kind of a baseline around 200. So I'm just looking for some more color on the second half of the year in the core SEM business. Any other comments?

Yes. I guess what I would say is, that if you look at their core meter business, that which is not AMR project dependent, it has continued to grow at a very nice stable rate. Just as our business has been impacted by a larger AMR orders, so has Schlumberger Electricity Metering. And so while they have completed the large order that they had with Niagara Mohawk, they have not added any new large AMR project orders. And so, clearly, the expectation for second half revenues as they are part of Itron does not have any large AMR project sales built in. Just as they are working or just as we're working on some other orders, so are they.

And then one final question. Your intangibles amortization has been running about 2 million a quarter. I know you provided some pretty good detail in the 8-K. Are those good numbers from the 8-K, in terms of projecting second half amortization of intangibles, or can you give us an update on what that should look like over the next couple of quarters?

Sure. Obviously, the intangible amortization in the 8-K was based on a preliminary evaluation of their assets, and we would expect there will be some tweaks to that as we now have final numbers and final negotiated agreements, but it's going to be pretty close. I would use a figure of somewhere around 6.5 million per quarter over the next couple of quarters for amortization of those intangibles.

Okay, thank you.

Alan Robinson, Delafield Hambrecht.

Thank you. Just to refer again to the expecting growth in the SEM business. It looks like the expectations are built in for a 2 to 5 percent growth in Itron business. Is at about the same level of growth for the core SEM business for your second half of '04 projection?

On a normalized basis, we think it's between the 3 and the 6 percent range, so I'd up you a percentage point on both ends of the range. But that is what it is going to run.

And that is not counting large AMR project orders.

Sure. Since the closing of the acquisition, has there been any change in the attitude of current customers to new orders, now that the SEM is actually under your wing?

Prior to the acquisition, we had some customers that were delaying moving forward with some projects because they wanted to deal with one entity for both AMR and meters. Those have started to move forward. We would hope that one or two of them will close this year as we move through Q3 and Q4. So I think in general, people are very glad that we have finally gotten the acquisition done and that we can put these companies together and move forward.

I would add to that, LeRoy, that there are a number of customers, a large combination electric and gas customers, that Itron has been talking to about some gas AMR business. A number of those have now come back. So it's been said with SEM in the mix, we want to expand our discussions and look at putting electric AMR in as well.

Very good, thank you.

Sanjay Shrestha, First Albany.

Great, a couple of quick questions here guys. First one, if we actually just excluding here the interest expense of 1.3 and 775,000 write-off of your Landthorn Technologies, that's about 6 cents to the bottom line, right?

Correct.

Okay, I wanted to verify that. And the second point -- can you give us an update, in terms of what you're seeing on your software side of the business?

In general, Sanjay, the software pipe continues to grow. We're building backlog in software which is nice, somewhat a result of the way revenue gets recognized these days. But we are encouraged. We're encouraged both domestically and internationally and we are encouraged by a couple of reasons. One is just pure license sales and the prospect for growing license sales. But as well, the tie between our software products and the ability to sell AMR systems and pulling those two projects or those two product lines together. So we're very pleased.

Okay, great. In terms of the average size of the deals that you're chasing out there, can you maybe talk a little bit more about that here?

Software deals or hardware deals or deals in general?

Deals in general?

They are all over the map. They range from deals that will be in excess of $20 million to deals that are tens of thousands of dollars. To a point Mima made, I certainly referred to it -- the issue has not been (multiple speakers) making the smaller deals. We're seeing a fine flood of small deals, we're seeing senior fine add-on order business. It is the very large orders that there will be maybe five of being considered in any given year that are just simply not moving forward. We think we're closing in on a couple of those yet this year. We certainly hope so.

That's great. And I just want to verify one thing. LeRoy, you mentioned in your prepared comments that one-third is going to be in Q3 and two-thirds of the EPS or the pro forma earnings is going to be in the Q4 2004 right now. You're talking about a complete number, not just accretion from the SEM side of the business, correct?

That is correct, Sanjay.

Okay, great. And also, looking out into 2005, some of the published numbers still actually are pretty broad range from a pro forma earnings standpoint. I understand that it's a little early, but I was hoping if you guys could at least qualitatively comment on that? And if you could also tie your comments along the lines of -- what are you seeing on the solid-state meter side, and now after the licensing to Hunt (ph) Technologies, do you actually see some of these larger AMR opportunities moving forward and how that might impact your 2005 outlook?

There's a lot of questions in there, Sanjay. Let me give you some commentary on what I think the market looks like in '05. It's probably not quite as specific as you want, but perhaps it will be some help.

In the AMR world, we still look to long-term growth rates in the 10-15 percent range. And those will be affected by large orders, such as we have seen in the market in the last couple of years, whether that be Niagara, Mohawk, or PEPCO or Pennsylvania Power and Light. And so if we get a couple of those next year, and I think there's very good chance that we will, we will certainly be on the up end of that scale. I will tell you, I do not think that a constant 20 percent growth rate in this business is likely to occur without loss of those very large orders. And I think it's overly optimistic to predict lots of them, but I think a couple of them could occur next year, which will put us at the top of the range.

On the software front, we continue to grow modestly. However here again, our proposal activity is increasing and has been all year long. And so we know that that translates into more orders and given utilities in general will continue to get healthy and we think they will get healthier as time goes on this year. We think next year should be better. We will wait-and-see a little bit, but we think software revenue goes up next year.

On the metering front, again, recall that '04 was a bit different because of the very large front end with Niagara Mohawk. On a normalized basis, we think '04 looks more like the $200 million plus -- let's call is 6-7 percent growth -- so call it 12 to 14 million on top of 200. And then there is some AMR upside on top of that. We had a couple of good AMR orders. We are still very far in the lead on solid-state meters. So I think more or less your last question, we maintained that lead, we're doing some very interesting things there. We are no longer trialing with utilities, which some of our competitors have to go through yet, so we look for solid-state business next year to be, if not all, certainly a large majority of the meter business we will be doing and growing.

Okay. So probably, then, this is kind of in summary, it is probably fair to say that a combined company probably will be looking at, if there's not a lot of AMR, probably like the mid-single digit kind of growth. And if there is some optic (ph) on the AMR side, then probably the high-single digit kind of growth and then one can essentially look at the margin profile and get to the pro forma numbers, correct?

That's a reasonable way to summarize things. Right.

That's great. I'll hop back into queue. Thanks, guys.

Paul Coster, J.P. Morgan.

A couple of quick questions. Mima, perhaps you could just give us some idea on, as we move forward, how backlog and orders are going to be reported for the newly acquired SEM business?

We're in the process of trying to work through that. Schlumberger Electricity Metering doesn't calculate orders and backlog quite the same way that we do. It's not unusual for them at the beginning of the year to have a customer say, well, over the next 12 months, here is a large P.O., we want this many meters. But they don't today track that as a booking or backlog per se. Obviously, it's at the customer's discretion that they could make some changes there. So I don't have an answer for you today. I will, obviously, a quarter from now when we've had a chance to work through some those issues.

Can you take a stab at what the sort of visibility is inside that business, relative to the traditional Itron business?

Paul, this is LeRoy. Let me give you a little color on why they look at backlog the way they do, which I think will help you. It's very typical, if they get a blanket order for a year or even two years, for some number of meters. Let's say, 20,000 meters. Whether or not they ship all of that or they ship more of that is largely dependent on how housing starts goes. Can be a little bit dependent on how capital budgets and operating budgets go at a particular utility, and in some extremes, even on weather, although not much of that.

So, typically, the visibility is exceptionally good, but there is some reluctance to just load in 100 percent of all of those orders, because there is no way to tell whether or not they will actually come through and what the exact schedule will be for those orders, is somewhat dependent on how workflow goes at utility.

So the first thing I would say is -- the visibility is every bit as good on that backlog as Itron's is, but there is a great deal of caution around how they actually load it into what they consider a hard backlog. Because in the case of Schlumberger, one of the things that happens when they start loading in backlog is they actually start ordering parts and building things. And so they are careful about that. That clearly from a reporting perspective out into the world is one of the things we're going to have to sort through. We understand why you guys want some visibility there and we will get that sorted through by the time we do our next earnings call.

So the macro environment -- are there any changes ahead? I'm thinking either regulatory or any effects from high energy prices that are likely to have positive or negative impacts in your business in the next 6-12 months?

In the six-month timeframe, I don't think so. We are beyond the time when we would expect an energy bill, so I don't think we will see one until after the election, and then I think we'll see a quiet period of time before energy looms to the front again.

How does high energy cost work for you, in terms of (multiple speakers)?

It depends a little bit on what it is. High gas prices in the gas utility industry can be some beneficial, they generate a bit more cash. However in the electric utility industry, because they are using so much natural gas these days for generation, gas prices is hurtful. And some saps the budget and the financial strength. One thing that does happen is when electric and gas prices both go up particularly at the same time and they spike in any given area, lots of people start saying, well, shouldn't we be doing more with conservation, shouldn't we be doing more with period pricing, times of use, if you will. And what you end up with is a lot of experimentation, a lot of investigation by public utility commissions. But so far, we just have not seen anybody really move forward as we were hoping an energy bill might produce for us with some tax incentives to move in some of those directions. Now, if energy prices stay high and that becomes either the bait in the national elections, or a crisis situation post or pre-election, then I think we might see some turning again to regulation. All is sort of between the first and second quarter of next year, which we would have minimal, if any, effect next year, but probably some in '06, so we will see where that does.

Thank you.

Jarett Carson, RBC.

Good afternoon. On G&A sequentially, the increase -- I know you touched on it -- are there some things there that won't be repeated an in the third and fourth quarter? Particularly, you maybe talked a little bit about -- I think you mentioned some IT stuff?

Yes, Jarett, there are. There's roughly right around -- call it roughly $400,000 of some nonrecurring IT expenses that happened during the quarter. Clearly, there are some expenses related to SEM. Tough to quantify them, but we have started. We had some consultants down in Oconee doing some Sarb-Ox consulting on their operations and their processes. We had a national sales meeting where we brought both sales teams together. We have had product developments and manufacturing people flying back and forth. So, tough to give you a figure on that, but yes, there is some amount in there that will not recur.

The tax rate? Do you think it will go back down into the 38 percent range?

Yes. The tax rate should be in the 38 percent range. We had a change in evaluation allowance. And obviously based on the minimum income, it just makes the rate look real goofy in the quarter.

And LeRoy, I don't want to beat a dead horse here too much, but what are the issues -- you mentioned specifically trying to close orders here, particularly because we continue to be a disappointment on the AMR side? And maybe relative to forecasting, are you taking out and just whittling down to the two or three or four that you believe do have a very high probability here? Can you give us a little more color?

We certainly have gotten more conservative on large orders as we have looked at the back half of the year. And unfortunately, we are probably more bullish than we should've been here before. It's an interesting set of circumstance we find, because I cannot say that in any given utility, it's an A, B or C problem. They are all over the map. In general, all of the business cases are good and we are being told by the senior-level people that this isn't a business case issue per se. It's either a -- something has disrupted our current organization and we have to turn to that for a little while. We still see utilities reorganizing. And I guess since we've just done it a little bit, I can't get too cranky about it.

We still see utilities that are having to deal with union issues. In fact, if anything, we're seeing just a tad bit more of that than we have been for the last couple of years. And so in a case or two, that has been bothersome. We still see a utility here and there that has got some financial difficulty. We see utilities in general saying -- we're trying to reduce the amount of we have, and so many of them are being careful about capital expenditures.

The good news is that we have solid business cases at a number of large investor-owned utilities, and they will move forward sooner or later. We have clearly, as you alluded to, gotten more conservative about which ones and when, relative to Q's 3 and 4, and we would look for a bit of that in Q3 and Q4 and a bit in '05. So we think '05 is going to be a nice year. But, we're more conservative than we were a quarter ago, and certainly coming into this year.

Finally, with regard to the purchase accounting issue, it sounds like that's impacting some of the earnings power, and that will be kind of a onetime item in the third quarter. So that's something that, on a go forward basis, we can build in?

That sounds right, Jarett. Obviously, the 70-75 cents is depressed because of that adjustment and would not be a recurring kind of thing.

Okay, thank you.

Bill Dezellem, Davidson Investment Advisers.

Thank you. I actually have a group of questions. First of all, relative to the last question, that 40 cents of accretion in the second half. And again, that assumes a zero percent margin on some of the revs in the Q3. If we were to look at the accretion from October 1, so really thinking about the fourth quarter, which sounds like will be the first clean quarter through the Q3 of the following year. So the first clean 12 months, presumably -- and this is the question -- the accretion would be greater than 40 cents per share, since in the second half of this year, it's 20 cents per share? That's my first question. Is that an accurate way to think?

Well, let me see if I can say back to you what I think I heard you say. You're talking about accretion over a six-month timeframe of 20 cents, so you're doubling that and saying 40 cents, assuming that revenues clearly in that piece of the business are not going to go down, there's not going to be anything funky going on with margins. Clearly, we think that is a good assumption. We expect actually margins to improve a bit there. So if that's what your question was, Bill, then your math worked.

That was the question. So, given that the first half of that six-month period that we were multiplying times two is lower than normal, then it's definitely more than a 40-cent number for the first clean 12 months?

That's right.

Let me shift to the second question. And it's related to the customers that I think on the last call or two, you all have alluded to the fact that you felt but did not know for sure since you weren't able to discuss this with the customers, that some of them were in fact waiting for the deal to close before they would move forward, not with the order, but probably to negotiate more aggressively with you, but yet on a bigger piece of business. Now that the deal has closed, what insights can you share relative to those past opinions or thoughts or maybe just feelings that you had before?

We are seeing that in two ways. One, we're clearly now actively in negotiation with one customer specifically that had us held off a bit. And so as we had thought, it did occur. Mima alluded to I think where more impact is actually being felt, and that is customers who are looking at doing business on the gas side of their operation, now saying, okay, now that you have electricity metering until, and in specific, solid-state electricity metering until (ph), we would like to expand a look at AMR from gas into gas and electricity. So we are seeing that, we are actively in those discussions. And as proof of that, I think it's fair to say that our market-facing people are telling us the action requests; in other words, having to deal with the customers' requests for either a proposal or a statement of warrant, have shot up here recently.

And so that, if all follows according to plan, should bode well for the future backlog, where I guess it's the existing pipeline of prospects?

I would certainly agree with that, although we are being a little bit cautious about Q3 and 4 here. I think that that extends not only into three and four, but in '05 as well.

Understood. And LeRoy, my last question actually does relate to this issue of the forecasting. I'm curious whether you believe that you are finding yourselves now with a situation of pent-up demand, or whether in fact, what you are experiencing, this really is what you really should have realized was normal. As I think about the sort of things that you had mentioned for reasons that utilities have delayed, sound like typical business or typical utility in a number of cases, just the sort of things that happened. So I guess I'm trying to get some color on whether we do have pent-up demand now that could break loose, or whether this is just really the way we ought to and you all ought to think about the business actually playing out over time, just these sort of delays take place.

I'm going to give you two or three answers there. One, I think utilities are utilities and maybe we got a bit aggressive. We're going to see delays for all of a myriad of reasons. And so I think we always all need to be cautious about that. That's why I refer to the growth rate here as being 10-15 percent. But know that to achieve the high end of that rate, you're going to have to have some of the big orders hit.

The second thing I would say, Bill, is I have been some, in my own thinking, mistaken about the financial health of utilities. They're still awfully cautious about capital budgets and I thought we would be out of that, at most utilities by now. But as I look at other sectors, not just metering or AMR and look at monies being spent, whether it be on software or hardware products, utilities and electric or electric gas combination utilities, have been very cautious this year about spending capital dollars. Some of that is because they're trying to pay down debt, some of it's just because I think they are a bit cautious yet as to where the future is going for them.

And then the third thing I would say to you is, at the level of AMR business that we're now producing, in general a $300 million level, to continue to make 10 to 15 percent growth rates on that, we're going to have to hit more large orders than we have before. And the minute I say that, somebody ought to warn me that those large orders are hard to predict when they're going to close because things get in the way of large orders. So I think looking backward, perhaps we should have been a bit wiser and looking forward, we hopefully will be.

Great thank you. And then final question is -- did I hear comments relative to EBITDA contribution from SEM, numbers that were greater than you had put out here just in the last month or two? So actually some upward guidance on that front?

No, Bill, you didn't. I talked about EBITDA in the second half of the year on a combined basis of about 45 million, and that's down just a bit from actually what we have been talking about, which was a little closer to 50 million.

Was a combined number, then Mima, not just an SEM number?

Correct.

Makes sense, thank you.

William Becklean, Oppenheimer.

Hi. I'd like to ask little higher level question maybe, and that is -- to what extent are you interested in the market for network metering systems that not only metered, but managed loads and other devices at the customer prem, similar to what is being done by Echelon with their network energy services and with the IBM (indiscernible) partnership?

We have current products in the market that, on a network basis, are capable of reading meters, and we have a high level of interest in that. We have an observational interest at this point in looking at the ability to control various loads and do other things on that very same network. We certainly have the communication capability. And as we look at generation improvements, we look at those kinds of abilities. But lots of people like about controlling loads and doing that kind of thing. In point of fact, very little activity actually takes place there. We were running two experiments on the Landthorn (ph) project, a company that recently has had to go out of business because there simply is not enough available business to sustain that kind of activity today, albeit, there is a lot of talking about it. And in some locations, and certainly Enel (ph) is one of them, some proposed large level of activity.

Let me answer that. While most people typically associate network meter reading with electric, we are in fact have seen a substantial increase in interest in network meter reading on the water side of our business. A couple of months ago, we announced a new product in that area. We just recently closed our first order for network water system and would look for a pickup in that piece of our business.

Are those primarily wireless?

Yes.

Yes, that's all we do is wireless.

You haven't tried the power line stuff?

We do no powerline interior work at this point in time.

So you think maybe those initiatives are a little bit ahead of the market's appetite?

I think in general, they are in some places. Clearly, there is demonstrations taking place. But generally, I think we're ahead at the market appetite to make money.

Thank you.

Patrick Forkin, Rockhouse Securities.

Good afternoon. The run rate for -- when you announced the SEM deal, the run rate for revenues for '02 was about 229 million. And I know it spiked in 2003. What was that number in 2003, the revenue number versus SEM?

194 million. But, you have an apples and oranges situation here in that a contract manufacturing repair and services business was embedded in both the 2002 and '03 numbers, which goes away almost immediately from our acquisition date. But you have to take out -- and then the other major adjustment, as I think you know, for 2003 and the first of this year, is a very large contract with one utility. So if you wanted to normalize, probably ought to take out 2003 altogether and go all the way back to 2002 and take out the third party manufacturing business. When you do that, and this gets back to an earlier question, the embedded revenue that stays that continues with us will grow on the order of 5 to 7 or so percent.

Okay. Dave, what was that number of that third party revenue in the 229 number that you guys--.

I don't have it exactly. It was, I want to say, 30 some-odd million, 35 million from memory, but that is not the exact number. I don't have it in front of me.

I'm sorry, I don't see that, Patrick. It is in the 8-K that we filed that has the pro forma financials. So it's readily available. I want to say that, is you go back to 2002, the core metering revenues for SEM were right around 160 million.

But to that, you have to add the third-party meter reading revenues.

I guess I'm still struggling sort of with how the SEM assets are doing. But how are they doing, with respect to the revenue rate that they ran in 2002, or your expectations when you announced the deal contrasts the guidance for around 100 million for the second half here? Are they about where you anticipated they would be?

Yes. They're comfortably in line. We have no disappointment with regards to how they are going to perform in the second half.

Okay. And there was some mention of handheld sales being down 10 million. Is that year to date?

Correct.

Is the margin on the handhelds a little bit higher than your typical hardware product?

They tend to be a little bit higher, Patrick, because typically, when you sell a handheld system, you also have a software upgrade that goes with that. So it tends to drive margins a little higher.

Is there any sense as to what is happening in that area? Is it competitive, or is the need for the technology just slowing down a little bit?

Patrick, it's a cycle thing. If you could drop back a year, you will find that our handheld sales were quite more stout and we're sort of in an off-cycle for handhelds.

Last question. The Hunt licensing agreement -- are they up and running now? And what kind of impact, if any, are you looking from that in the second half?

Two points. One, we're compliant with all of the licensing activities we have had to do. They are not yet quite literally shipping product to customers. But they would not have been scheduled to do that by now. I believe we will see minimal, if any, real impact from the second half. I would expect that to start showing up early next year.

Okay, thank you.

Alexi Koscaros, Bear Stearns.

Hi, just a couple of quick questions. Should we expect really sort of the elephant hunting, so to speak, to continue over the duration over the next couple of years in the sense that this large contract are going to be really tough to achieve, or are highly unpredictable? And if you could give us a sense as to really what needs to change in the utility business to see more of an upward trend in that respect? And then I just had a couple of specific questions on the sales function -- CapEx and working capital -- so if I could follow up. Thank you.

Alexi, let me start with the first half. I think, clearly, one of the things that I have thought about a lot lately is the fact, if you look at the old -- the entire AMR market, that we're in a period of time where that constant 10-15 percent growth rate demand that you are going to have, some amount of elephant hunting take place. And as long as that elephant hunting is successful on somewhat of a routine basis, I think the market and Itron, because we're so much of it, has a fairly steady growth rate. What we have seen here is for reasons that we have talked about, that we have had no large contracts awarded this year. And so backlog is down, as everybody has noticed. And then the revenue line gets a little bit lumpy, and it's harder to predict what the future's going to look like.

I am hopeful that we come through the rest of this year and next and we get a couple of those elephants not only hunted, but brought to ground. And backlog will bump back up and we will be a little more predictable. But I do think that your fundamental question is an appropriate one and something to be mindful of. At these kind of levels of AMR activity, if we do not succeed in closing some of the large orders on a routine basis, we're going to get lumpy in that part of our business. Now the good news there is, I believe we will see that the Schlumberger stuff is less lumpy. And as a whole, we should be a little bit more predictable. We're hoping for that.

How to fix that with utilities -- I don't think we will. Utilities are utilities are utilities and these big orders are large enough for an electric or an electric and gas combination utility to have things impend upon them, whether it's organizational or structural things or financial things. So I think we're so with that relative to the revenue picture.

Thank you. In terms of the sales force, I just wanted to see whether I understood this correctly. You have effectively two sales forces, both on your side and the former SEM side. And I was just wondering, in terms of -- are they calling on the same purchasing managers? Could we get a better sense as to -- is there is any opportunity for symmetry there? I'm not sure if I understood correctly some of your earlier comments. And then, Mima, if you could maybe just tell us what the working capital picture will look like for the second half of the year and CapEx? Thank you.

Alexi, you called it on the sales force correctly. We fundamentally have two sales forces that are not operating independently of each of other. They're quite well aware, they talk to each other daily. But we have two people calling on the same purchasing managers, maybe not the lower-level people and not perhaps all of the same operating people. But, we certainly have two people calling it Southern California Edison or ConEd New York or all of the large IOUs. We also have some overlap in the resale area, in the public power area as well. Interestingly enough, we have our Itron traditional salespeople, if you will. Their bag is so full, not only of AMR, but of software product, they have little other time. And so this is a model that we think actually works well. They complement each other. I think we will have some synergy over time perhaps as we redescribe territories. But I suspect just as we do now that any given large IOU, we will have a team selling approach where we will have metering experts, software experts, AMR experts, all calling on that customer.

Thank you. And Mima, if you have a second, if you could maybe tell us about the working capital and capital expenditure picture for the balance of the year?

This is Dave. Let me view that by tying together two numbers that Mima mentioned. She mentioned EBITDA of 45 million, and also cash flow from operations of 45 million, and one of them is before interest expense and one of them is after interest expense. Interest expense is $8 million approximately for the half-year, which means that the net of working capital and all other items is $8 million going the other way. So if you wanted to compute what our cash flow coverage is on the basis of cash flow from operations minus CapEx, you would take 45 million minus around 10 million for the second half of the year for what is available to service debt, plus $8 million for interest expense if you're working from cash flow from operations. With regards to our financial covenants, which are stated differently in terms of EBITDA, we expect that in the second half of the year, our coverage ratio is going to be in excess of five times EBITDA to interest expense.

Thank you very much, Dave.

John Quealy, Adams, Harkness & Hill.

Hi, good afternoon. A couple of quick questions. First off, as we look at some of these onetime items, whether it's the $8 million expected in Q3 with zero margin or the 2 million in interest in Landthorn charges this quarter, can you talk about a little bit about the back half of '04 visibility about these non-recurring charges? Should we expect to see these in the next couple of quarters as you integrate Schlumberger?

Clearly, in terms of the Landthorn write-off, we are essentially at a point where we have no other minority investments. So I certainly wouldn't expect any more write-offs there. The 1.2 million or 1.3 million in interest for the quarter obviously came from prefunding that debt prior to the acquisition closing. Factored into our second half guidance is full-up interest expense for the two companies on a combined basis. So certainly nothing unusual there. And the purchase price adjustments on the inventory, again, is a onetime situation we find ourselves in with the acquisition closing on July 1st and having to take that inventory and value it at market.

And the closure of the Québec manufacturing facility -- should we see a onetime in the back half of '04 for that?

No, John, most of that expense should be absorbed by Schlumberger prior to the acquisition.

Second question I had -- you mentioned in the quarter AMR services seem to outperform module shipments in terms of volume. Would you expect that trend to continue as we enter the back half of '04?

Not necessarily. And again, that will be somewhat dependent on these large contracts. Typically, most of the larger utilities do a lot of the installation work themselves. And so where we find ourselves now with a fair amount of smaller orders, and particularly on the water side, we happen to have installation services that are a little bit higher than maybe the hardware. But it will really be dependent on how those large contracts go, whether they want to do the installation or whether we do it for them.

Okay, great. My last question with regards to SEM and the percentage of their business that you expect to be solid-state. I think from previous calls, you mentioned in '03, about 80 percent of their business was solid-state. Do you expect that number to go up markedly, up to the 90-95 percent, or what should we look for that?

I think in '04, John, you're going to see that kind of a number. In '05, it'll climb even farther.

Great, thank you very much.

Amin Benali (ph), John Hancock Advisers.

Thanks guys. A lot of my questions have actually been answered. I have one last one. Perhaps you could tell us or give us a rough estimate of the size of the typical large contract that you're after. You would just sort of give me a better understanding of the contract that you are phasing out of the picture?

Obviously, the size of the utilities we're dealing with I guess for starters is substantially larger than the size of some of the contracts we're hoping to book and start shipping again. Typically, when we talk about a large order, we're talking about an order in excess of $10 million over a twelve-month kind of timeframe. But it's tough to answer your question directly because, again, the utilities we're working with, and in case the ones that have just come back to us and said now we want to expand the purchase decision to include electric as well as AMR -- the size of the order, again, will very substantially -- but again, when we talk about a large order for purposes of what we are including in our mix of business, we're typically looking for an order that will generate somewhere between $10 and $20 million over a twelve-month timeframe. I hope that helps.

That is helpful. And there have been a lot of questions that were answered, so I'm all set.

Great.

At this time, we have no further the questions in our queue. Ms. Scarpelli, I'll turn the conference back over to you for any additional or closing remarks.

Great. Thank you again everyone again for joining us today. Our call went a little longer than normal. I appreciate your patience. Any of you that have further questions certainly can call myself, Dave Remington or LeRoy and we'll be happy to get those answers for you. Thank you very much.

That concludes today's conference call. Thank you everyone for your participation.