Itron Inc (ITRI) 2006 Q3 法說會逐字稿

Good day, everyone, and welcome to the Itron Q3 2006 Earnings Conference. Today's call is being recorded.

For opening remarks, I'd like to turn the conference over to Ms. Deloris Duquette. Please go ahead.

Good afternoon, everyone, and thank you for joining us today. I have with me in Spokane, LeRoy Nosbaum, our Chairman and CEO, and Steve Helmbrecht, our Chief Financial Officer.

The earnings release that we issued today includes an updated outlook for revenue and earnings for the remainder of 2006 and preliminary high-level expectations for 2007. Today's call also includes discussions that are forward-looking in nature. The business outlook and other forward-looking information we are providing is based on what we know today and is subject to a number of risks and uncertainties.

I would like to encourage you to read the forward-looking disclosure in our press release, which alerts you to a number of factors that can cause a difference between our expectations and our actual results. You should also refer to our 2005 Form 10-K for a more complete disclosure of specific risks and uncertainties related to our business. 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 non-GAAP financial measures that we believe enhance your overall understanding of our current and future performance. Schedules reconciling GAAP to non-GAAP financial information are included with our press release and are also available on Itron's external website.

Steve's going to start the call today with a discussion of financial highlights for the quarter, and after that, LeRoy will offer some additional insights and comments. We will hold a question-and-answer period after our prepared remarks.

Now, I'd like to turn the call over to Steve Helmbrecht, Itron's CFO, for the financial highlights discussion.

Thank you, Deloris, and good afternoon, everyone.

Before I get into the financial details, I want to touch on a couple of important points for the quarter that have been top of mind -- revenue and bookings. We had total revenues of $164.7 million, a new quarterly record. Revenues were higher this quarter than the last quarter despite the expected decrease in revenues coming from our contract with Progress Energy.

As you know, in the third quarter of 2005, we booked and ordered to implement 2.7 million Itron meters with AMR. We are very pleased with how the Progress Energy implementation has rolled out. Approximately 2.4 million Itron meters were installed in under 15 months, making Progress among the largest and most rapid AMR implementations of its kind.

Progress accounted for 11% of total revenues in the third quarter compared with 19% of total revenues in the second quarter. We are continuing to execute well in the marketplace, and as this quarter shows, we have been successful in replacing Progress with other business.

New order bookings for the quarter of $128 million show an increasing trend of book and ship business. You may have noticed during the quarter that there were few new order announcements, yet the overall level of bookings was healthy. For the first nine months, our new order bookings were $441 million. This is only $65 million lower than the bookings for the first nine months of 2005, even though 2005 included the $118 million booking for Progress.

Now, I'll expand on our financial results. Revenues of nearly $165 million for the quarter were 17% higher than the third quarter last year. Year-to-date revenues of $484 million were 23% higher than year-to-date revenues in 2005. Increased revenues in electricity metering for the quarter and year were driven primarily by the Progress Energy project.

Meter data collection revenues for the year were higher than last year, despite a planned shift from selling electric retrofit AMR modules to selling electricity meters with embedded AMR, which we include in metering revenues. The increased meter data collection revenues were driven by a 62% increase in gas module shipments.

Software revenues for the year were 15% higher than last year, primarily due to increased licenses and services.

As I mentioned, new order bookings for the quarter were $128 million, which is up more than $20 million from the second quarter, and reflects an 84% book-to-bill ratio for the quarter and almost 1:1 year-to-date. In our second quarter earnings call, we talked about the potential of a book-to-bill ratio of 1:1 for the second half of the year. While the timing of orders and bookings fluctuates as part of the normal selling process, we believe that a 1:1 book-to-bill ratio for the second half of the year is still possible.

Total backlog was $325 million, of which $14 million was related to Progress Energy. The total backlog was $325 million a year ago, of which $118 million related to Progress Energy. We have backfilled $104 million of Progress into total backlog. Twelve-month backlog was $194 million at the end of the quarter, of which $14 million related to Progress Energy. Twelve-month backlog was $198 million a year ago, of which $77 million related to Progress energy. Here again evidence that we have backfilled Progress.

In a year's time, we have replaced much of the Progress Energy backlog with backlog from other orders. Total company gross margins for the quarter and year-to-date periods were 41% and 42% respectively, which is less than the 43% in both periods in 2005, primarily due to a larger portion of installation revenue in 2006, which tends to be lower margin.

We continued to focus on improving our operating margins. Pro forma operating margin was 16.1% for the quarter, which was lower than a margin of 16.9% in the third quarter of 2005. However, pro forma operating margin for the first nine months of 2006 of 16.9% reflects a nice improvement over 15.2% for the same period last year. Year-to-date operating margin improvement is due to efforts to control operating expense growth.

We continue to invest in software solutions, and the results reflect the loss at the operating income level. However, revenues continued to grow, and operating margins for the first nine months of 2006 were affected by a one-time expense of $800,000 related to the relocation of operations in Vancouver, B.C.

Pro forma net income for the quarter was $16.6 million, or $0.63 per diluted share, up from $12.6 million, or $0.49 per diluted share in the third quarter of last year. Year-to-date pro forma net income of $48.2 million was 59% than the $30.3 million in the first nine months of last year. Operating cash flow was $30 million for the quarter and $87 million year-to-date, compared to $50 million in the first nine months of last year.

Capital expenditures of $25.9 million year-to-date were higher than the $10.3 million in capital spend in the first nine months of last year. The increase in 2006 was related to planned capital improvements for our new headquarters facility, which we moved into during September, and for an ERP system upgrade, which is in progress.

Adjusted EBITDA, which excludes the effect of stock option compensation, was $92 million year-to-date versus $69 million for the first nine months of last year.

During the quarter, we issued $345 million of convertible senior subordinated notes with a 2.5% coupon rate and a 40% conversion premium over the closing price, which equated to a conversion price of $65.16 per share.

We secured financing during the quarter based on positive market conditions. We raised a targeted amount of capital in the form of convertible notes, which we expect to utilize for strategic acquisitions to strengthen our business and drive growth. The convertible notes contain an important feature called net share settlement, which basically means that the principal amount is repaid in cash and treated as debt, and the only portion that could be potential diluted will be any increase in stock price over the 40% premium, but we retain the option of paying the spread in cash.

The net proceeds of the transaction have been invested in secure, high grade, short-term investments and cash equivalents that we expect to put to work by the end of 2007. We ended the quarter with about $234 million of cash and $172 million in short-term investments.

Looking to the rest of 2006, we expect revenues for the year to be between $638 million and $642 million, which is up from the guidance we provided in our second quarter call of $625 million to $ 635 million. We expect pro forma diluted EPS of $2.35 to $2.40 per share, up from the guidance we provided in our second quarter call of pro forma diluted EPS of $2.25 to $2.30 per share.

Our pro forma diluted EPS expectations for 2006 exclude any tax benefits associated with the federal research credit, which has expired and has not been renewed by Congress. We make significant investments in R&D. If the research credit is passed and retroactive for all of 2006, we estimate it would reduce our pro forma tax rate by approximately two percentage points, which we estimate would increase pro forma diluted EPS by approximately $0.07 to $0.09 per share. Also, our guidance for 2006 includes the effect of interest accretion from the issuance of our convertible notes.

In a moment, LeRoy will talk about our preliminary expectations for 2007. However, for those of you who are developing models for 2007, I do want to point out a couple of things. The preliminary guidance we issued in our earnings release for pro forma EPS continues to exclude the impact of stock option expense since we excluded the expense in 2006. However, we are in the process of determining whether or not to continue excluding that expense from our calculation of pro forma EPS going forward. If we do change our calculation for pro forma EPS next year, we will publish statements restating our quarterly 2006 pro forma results, so you will have comparable amounts to analyze.

As stated in the press release, we also included the positive impact of interest accretion from our convertible note offering and now preliminary pro forma EPS guidance for 2007.

In closing, we continue to be pleased with our financial and operating results for the quarter and the year and look forward to talking about our results and opportunities going forward. Now, I would like to turn the call over to LeRoy Nosbaum, Itron's Chairman and CEO, for some additional comments.

Steve, thank you, and thanks for all of you joining us today on the call. I'll be relatively brief and try to leave a lot of time for the questions at the end.

The quarter was another good one. Revenue, earnings, cash flow, all in good shape. Operating margins at 16.1% were down a bit from Q2 and Q1 one of this year. Some of that is gross margin mix. Some of it is increased spending in research and development on OpenWay, Itron's AMI offering. I'm very comfortable with that increase in R&D. As I will talk about later, it will continue into 2007, as we invest for the future.

New order bookings at $128 million, a good number, if it were not for the tough comp from Q3 of last year when we received the Progress Energy order. As you have heard us say repeatedly, this is a somewhat lumpy business. The good news, as Steve outlined, is that if we compare Q3 from last year to this, we're just $4 million short of last year's 12-month backlog level, even though we've shipped nearly all of Progress.

As I said on our last earnings call, we have a fair chance of a 1:1 book-to-bill ratio in the second half of this year. I still believe that's in reach. No, we don't have another Progress-type order forecast for Q4, but business is good, and we're booking numerous smaller orders.

Steve talked about guidance for the rest of the year -- revenue in the mid range at $640 million, up $10 million from last quarter; pro forma EPS of $2.35 to $2.40, again, up $0.10 from last quarter. All good progress as we've moved throughout the year.

As we look to 2007, we're partway through our budgeting process. What we're giving you is accordingly somewhat preliminary, but we feel good about it. We see '07 revenue growth of about 8% over our current expectations for 2006, with a potential swing of plus or minus 3%. On the minus side, while there's very strong activity in the market on AMI, RFPs, pilots, lots of interest. These are large and complex projects that have many interested parties. They tend to drag out, as we've seen in Ontario and elsewhere.

The momentum is great. The opportunity is extraordinarily encouraging. However, large and complex, almost always go slower than expected. As well, for many utilities, this is a time of consideration of AMI, even though in the end, more traditional forms of AMR, mobile or fixed network will be purchased. Here again, the potential for some orders at some utilities to be delayed somewhat.

On the plus side, the book of business is good -- $325 million in backlog. RFP levels for traditionally products and for OpenWay remain high. Our pending acquisition of FullMetrics will produce upside potential in the water market, and business in South America is growing nicely. If we can close a few pilots for AMI and get them moving in '07, and continue to improved results in other areas, 8% might, in fact, be conservative, so an upside of 3% is not unlikely. We should know better when we report earnings for Q4.

In a similar manner, we're handicapping earnings growth at slightly less than two times the rate of revenue growth. All the same factors apply, with one additional. We are going to continue to spend at an increased level on research and development for OpenWay, which is tamping down earnings a bit, but providing great opportunity for the future.

Let me now turn to several industry conferences that were held in the last several weeks. In mid-October, we had this year's Itron's Users Conference -- 813 customers, from 324 utilities, from 14 countries around the world, 158 sessions about Itron products, including OpenWay. By any measure, a great success.

Two weeks later, Itron, along with number of you, attended AMRA in Nashville. My own reaction, as I was there, a lot of interest in AMI, including OpenWay, a level of seriousness about demand-side management that I have never seen in this industry ever. And while the competition remains high, and there are a lot of companies out there with interesting products, I didn't see anything that surprised us. A good conference for Itron, as usual.

Moving on -- I hope that most of you were able to get a look at the other press release we issued today. The announcement of a 10,000-point OpenWay trial with CenterPoint Energy, as part of their intelligent grid implementation. As many of you know, CenterPoint is an electric and gas utility, headquartered in Houston with over 2.2 million electric and 1.2 million gas customers. CenterPoint operates in a deregulated environment that allows customers choice of energy suppliers.

Key features to be piloted include meter reading, remote disconnect and reconnect, outage detection, load management, and voltage monitoring, all with the backbone of broadband over power line. Deployment begins later this year and will extend into next year. CenterPoint is a great example of a utility that wants more from an AMI solution. OpenWay provides the features and the functionality required. Itron is delighted to be working, not only with CenterPoint on this fine project, but IBM as well. Along with Manitoba Hydro, we begin to build a solid base of AMI customers for future expansion.

Let me close with a few words about potential acquisitions. I know that all of you want to know what we're going to do with the $345 million that Steve talked about. As I've said before, we have been and continue to look at several interesting acquisition candidates, both domestically and around the world. We look in the same space we are in -- electric, gas, water utilities. We look at what we do today and think about how to extend that internationally and within the U.S. We also look at the great success of acquiring an electric meter company, and we think about water and gas.

While we're having discussions with a number of companies, we are neither far enough along, nor ready to announce anything.

Okay, with that, let's open the call to questions.

[OPERATOR INSTRUCTIONS]

And our first question will come from Steve Sanders with Stephens.

Good afternoon.

Hi.

Hi, Steve.

Good quarter.

Thank you.

A quick question on the book-to-bill -- I think the words I heard were possible and fair chance. Would you characterize that as needing one mid-size order, you know, $30 to $50 million to hit that? Or can you give us any more color there?

Yes, Steve, that would do it nicely. If it doesn't happen, we've got a lot of other bit smaller orders that could come to fruition, and likely we're going to see a little bit of year-end money spent, as well. So at this point we feel pretty good about it.

Okay, and then on just broadly AMR AMI technology trends -- the players look relatively stable, but there seem to be more options out there. You know, the RF mesh getting a little more buzz. You guys are out there pushing OpenWay. ELC continues to make some progress. There are more third party networks out there. Do customers and utility commissions see sort of the declining cost and more flexible systems as an inflection point for AMR AMI, or is this just sort of the steady progress that we've seen over the past four or five years?

And where I'm going with this is sort of along the lines of your comment earlier. Is this creating a wait and see sales cycle challenge for you and everybody else?

Yes, I think there's some good points in all of the various questions you raise. Let me tick through them. First of all, I think there is an inflection in some regard, because there's a lot of new technology showing up and a lot of new features showing up. I think for some of the various competitors, that the change is incremental. For others -- I would put OpenWay in this category -- it truly is not incremental, but it is a real transformation.

I do think that one of the things that our customers are looking at -- more options, more companies, more functions, more features. All of that, I think, has the potential to not stop orders from happening, but the potential to retard the speed at which orders are actually placed. So as we talked about '07 guidance, yes, I'm allowing for a little bit of slowing down while people are looking at what are, in some cases, extraordinarily complex offerings from all of us.

Okay, and then another question on the large deals -- obviously quite a few out there, where utilities are talking pretty aggressively here. It's pretty easy to count eight to 10 big deals that are brewing. What's your level of confidence that we'll see two or three of these fall over the next 12 months?

Oh, absolutely.

No question.

Over the next 12 months, two or three will fall, but let's define fall. I mean, I think what you're going to see is people doing pilots, as we've just announced with CenterPoint. If we perform well, if the business case turns out to be as favorable as they think, that's going to go forward. I think you'll see a couple of those. I think it's far more unusual that somebody will just come out and say, 'Okay, here's an order for 1 or 2 million points.' I just don't think you're going to see too much of that happen.

But I do think you'll see some direction set, and if the vendor performs well and the business case proves out, I certainly think by the end of 12 months from now, we're going to have a much different view of the lay of the land and a much easier call in '08.

Okay. Thank you very much.

You bet.

Thanks, Steve.

Next question will come from Stuart Bush with RBC Capital.

Good afternoon, guys. Congrats on a great quarter.

Thanks, Stuart.

Can you give us some color on pricing trends you were seeing across the AMR module -- stuff for gas, electric, and water, and what factors are driving those?

Yes, sure. We still have not seen any trend downwards. It continues to be about the same as it's been. As we said before, the trends we did see were primarily volume-driven, rather than competitive. Now, AMI is a brand new product, so we really don't see any trends to that yet.

Right, right -- I was referring to AMR. Okay, good. So as you reference, you guys have done a great job of integrating and finding synergies with the electricity meters and AMR module. If you were to look at the gas and water markets and were to, by chance, pursue the same type of strategy there, how would the challenges differ in finding the same level of synergies in those markets?

Well, it's a little bit less electronics than a gas meter or a water meter. Although some of the registers that you start to see on gas meters and water meters have some electronics in it, so it's probably not as big a bang. On the other hand, you get synergies in distribution channel. You get synergies and go-to-market strategies, so some of it's there but clearly not quite as much.

Okay, thanks a lot.

Sure.

Thanks.

From the line of Paul Coster with JPMorgan.

Yes, a few quick questions -- the guidance that you've issued for the fourth quarter, essentially I think you're calling for a sequentially down quarter. I think that's the first time in three years on the revenue side. Is that because of the Progress roll off? Or is this year-end different from others in some way?

Yes, Paul. We talked about this year-end would likely be a little bit different than others. We knew that Progress would front load us. We actually expected it front load the first half of the year a little bit more than we did. We came in with another great Q3, so that trend has been pushed. But yes, you could infer from our guidance that it's a down quarter from the trend we've had this year -- not expected to be the same next year. We expect a return to more quarterly trends that we [inaudible].

Okay, in retrospect -- so I mean, you've just absolutely blown away the numbers versus consensus and your own expectations for the last five quarters, I believe. Is it because Progress simply stepped on the accelerator each quarter? Or are you being too conservative?

Well, we don't think we're being too conservative. Obviously, Progress installed a little bit faster than we originally expected. So that was an issue. But frankly, we've continued to book meter business as we go along, so our book and ship business has increased as well.

Okay, are there any catalysts in the near term, LeRoy, that might catalyze the adoption of AMI? Or is this really a process, a long kind of buying process, as you've described it?

Paul, I think you guys all should look for two catalysts, and I don't think you'll see them for a while. One, if we can get a serious deployment of AMI in oh, in my own mind, I'd say 20- or 30,000 units, that a utility can look at a strong business case and start publishing results. I think that will cause both public utility commissions and other utilities to take note. Is the 10,000 units we're going to install at CenterPoint big enough? It's close, but it's -- for some utilities, they'll look at that, and they'll say, 'I would have liked to have seen two or three times that many customers involved.'

I think the other catalyst that everybody will be watching for is if we can get some good progress at PG&E in California and a couple of other utilities, more utilities in general, and utility commissions will feel good about moving ahead with a little less risk because some of their brethren have done it. So I think those two things, and I don't think you're going to see either one of them until toward the end of next year.

Okay, my last question is, is the AMR product depicted as compatible with AMI? Or is there a risk here that your clients feel like they're getting stranded on obsolete technology here?

Yes, great question, because we have ruminated on that one ourselves. So far, we have had people ask about backward compatibility, which it is not in the main. And when we've talked about -- the reason it's not backwardly compatible is you wanted so much more function, so much more -- so many more features, you just couldn't get there. We have had far less, what I would call adverse reaction to that, than I would have expected. In general, customers said, 'Got it. Understand -- was hopeful, but understand why that's not the case.'

From my own perspective, if you're going to switch to a different vendor, they aren't backward compatible to us either. It's technology moves on. If you want it to go twice as fast and do twice as much stuff, you're just going to have to get off the older model.

Got it. Thank you.

Thank you.

We'll now take a question from David Smith with Citigroup.

Hi, guys. Nice quarter.

David, thank you.

Thanks, David.

Just you've talked about why margins went down on the electric meter side. Can you just give us a hint as to why you saw them going up on the meter data management side? Did it have to do with a mix in the contracts in the quarter or volume? What was the explanation there?

The MDC side, David -- is that what you're talking about?

Yes.

Yes, it was a mix of gas modules in the quarter. It was predominantly gas. We had such a large increase.

Okay, so and it did the highest margin?

They tend to be a better margin, yes.

Okay. Just coming back to -- you've talked about Ontario a couple times, and maybe a Manitoba -- LeRoy, does it look like the Ontario deal has any visibility as to when it's going to get booked? Or could it kind of go to like an OpenWay type of a pilot? Or where are we with that?

Yes, David. I think you're going to see a lot of Ontario action as we go through November and December. We started to see some awards or hints of awards up there. I think the unfortunate truth of the matter is that we were a little late to the Ontario party with OpenWay. I haven't lost all hope, but I don't think we are probably going to participate with OpenWay in Ontario as much as we would have liked to.

That's the bad news. The good news is Ontario in total, en masse, is not all that large. Now, that having been said, I still hope to get some meter business out of the Ontario with some other people's communication products sitting in our electric meters. But I do think that here in the next 45 days, you're going to see a bunch of stuff coming out of Ontario, because they seem to be ready to start issuing some orders.

Okay, got it. Coming back to the U.S., any further talk of any federal credits or accelerated depreciation that could entice the market a little?

Well, I'll tell you what. I was actually with two of our senators this past weekend, and I asked that very question of both of them. They actually think after the election we are likely to see some more energy legislation, and one of them, at least, promised to faithfully try to push some tax incentives in the form of accelerated depreciation. So I think there is, in fact, and to the earlier question on catalyst, that one might provide some catalytic action as well. So it could happen after election.

Okay, great. Thank you.

Yes.

Next question will come from Sanjay Shrestha with First Albany.

Great, thank you. Good afternoon, guys. Once again, good quarter. Just a quick question here, LeRoy, on the book-to-bill side. For you guys to get to that at least one book-to-bill for Q4, you know, I mean a lot of the small orders is probably all we kind of need to see, and for you to get to that book-to-bill of one for the second half is probably when you're going to need somewhat of a large size order. Is that the right way to think about it?

I think we're going to have to see a good mix -- I'll get it out -- a good mix of book-to-bill, as well Sanjay, as a couple of medium size orders or one nice one, all of it which is possible. One of the things we're starting to track is our book-to-bill level of business. And while we're not ready to give you guys some statistics on it, it has grown, and it's grown nicely. And so one of the things that I think we're going to have to help you with, perhaps, coming out of our fourth quarter release is a better idea of how much book-to-bill we're actually -- or book and ship we're actually getting, because it is becoming substantial.

That was kind of where I was going with that, because with the sort of the backlog trend, but the kind of like book and burn type of stuff increasing as a percentage of revenue in the outer years, that I guess is another factor that gives you a level of confidence, even if, let's say, it's a lumpy business, and bookings were to be somewhat light, again, in Q4. But at 3% plus or minus on that 8% is where you're coming from, right?

If I can add one more thing, Sanjay. We are also not able to announce or did not necessarily announce all the orders we did receive in Q3. So you have to remember there's a combination of book and ship business, as LeRoy mentioned. There are also sometimes when we can't announce some orders that we have, or they could have been follow orders from other customers that we already have that we just don't announce follow-on orders.

Precisely, precisely. Got that -- great. Great. One other clarification, if I could -- now, in terms of the preliminary '07 guidance here, I guess the way we're looking at it is we've got the cash from the convert, and there's clearly a spread. And when you were talking about the guidance for next year, since we do not have a live acquisition candidate at this point in time, we're sort of assuming that there is that incremental interest income that is going to contribute to the EPS number. And if we do end up closing an acquisition, let's say some time in the middle of the year, at that point in time, you guys would be updating that. That's the right way to think about it, right?

That's exactly right.

Okay, got it. Got it. Just wanted to confirm that as well. Now another thing, LeRoy, with starting to sort of this whole solar movement in California following the California solar initiative and some of that being based on the performance needing for the utility meter and stuff like that. Is that a potential market that you might start to look at, as well, as an incremental opportunity for you guys? What's your view on that? How do you see that as an incremental opportunity for you guys? Or you don't think that's an area you're that interested in?

Certainly we're not interested in the solar opportunity in and of itself. But if you're going to start doing solar things on residentials, then you got to have net metering. We're right there with product already. It could actually turn out to be an interesting up tick on business, but beyond that, no, I don't want to be in the solar business.

No, no -- I understand that. That's exactly my point, you know, because of the net metering and one of the key things, that is needing for the two meters is what I guess the latest talk right now.

No, you don't need two meters. You need one good meter.

Got it, got it, got it. So then that kind of brings me to my next point -- is there anything incremental as it relates to the meter business with the PG&E portion of the business, anything additional there?

Unhappily, I can comment on that. PG&E has stated definitively they are going to buy mechanical meters. We don't make mechanical meters anymore, so it looks like they are going that direction -- good advice to the contrary.

Got it, got it. One last question then, LeRoy, you guys said that you do plan to make an acquisition by the end of '07, and obviously you're evaluating a lot of different option, is there anything more you can talk about that in terms of the market, from the geographic standpoint, sort of expansion of any particular segment of the business? What else can you talk about as it relates to that acquisition at this point in time, other than what you said in your prepared comments?

Yes, great question, and Sanjay, I'm just not going to say any more about it. We're pressing in a couple of directions. We like them all. Everything's expensive, unfortunately, but we can deal with that. The one thing I would say is that as we look at acquisitions, we continue to hold to our fundamental beliefs that things need to be either accretive immediately or nearly so. And we need to be able to provide long-term value by leveraging the technology or the market position we have as we combine with something that we might acquire.

But -- and I know you guys all want to know more detail on what we're looking at. I'm just not going to do that yet.

All right, I can understand that. That's fine. Thanks a lot, guys.

Yes, thank you.

Thanks.

And next we'll hear from John Quealy with Canaccord Adams.

Hey, good afternoon. Great quarter.

Thanks, John.

John.

First, on OpenWay and AMI and this sort of thing, more of a big picture question -- you're in a unique position because you do have such a -- at this point, such a stronghold over the solid-state meter market. And OpenWay is part and parcel an extension of that strategy. LeRoy, can you comment a little bit about if we look at these, whether they're AMR contracts or AMI contracts in the next year or so, or potential in the next year, can you comment about your strategy vis-à-vis competitors stripping out the technology side -- and I've asked you this before, in terms of does the meter lead, does the meter give you what you think is a competitive advantage or not when people are looking at wholly revamping their metering infrastructure--

John, we try to lead, frankly, with both products. We like our sales guys to go in and to press either our fixed network technology or OpenWay or mobile or all three, but we also like them to press ahead in the meter shop on our CENTRON electric meter. The other thing we do, and it's critical, and we do it very carefully, is the guys that run the meter business covet meter business with our attachments and our technology, but they also covet meter business with our competitor's attachments and technology, and so we try to maintain, even though we compete, whether it's with ESCO or CellNet or any of the other guys, a real open relationship, so that we can offer them a product in our CENTRON meter that allows them to be competitive, allows them to be more competitive with our meter than our competitor's meter, and if we can do that, we think we continue to get the lion's share of the business.

So we have really focused on thinking about the meter opportunity somewhat separately from the AMR or AMI opportunity, in making sure that the guys who are really heavily involved with our meter business think about it in that manner.

And just sort of keeping with the solid-state side of things -- you've had, historically, very strong market share in that space. Your competitors are pretty aggressive there, and have been aggressive lately. Do you have a ballpark range, longer-term, two or three years what you think that market share can stabilize at? Or how do you think about it, because you had such a great head start on that trend?

Well, let me start with how I think about it. I'm not sure I can answer the other question very definitively. I think about it knowing full well that for a while we were at over 90% of the market share of solid-state meters. That's come down a bit, and it's expected. The good news is, as it's come down, the pie, if you will, for solid state meters has gotten bigger, because the other guys are selling less and less mechanical meters. And so our market shares are going to shrink in solid-state electric meters. As more people buy solid state, the other guys stop shipping as many mechanicals.

The good news is we have so dominated the market place with solid-state meters that a whole lot of meter shops, a whole lot of utilities, have become very used to our product. It's very well entrenched, if you will, in our utility customers. So we're doing really good.

Now, if you go three years down the road, what's out market share in electric meters going to be? I don't know. I really don't know. We're going to fight like the daylights to every percentage point we've got. We do that in a couple of ways. We think we've got a great sales force, but we also think we have a great meter, that we've got really bright engineers working on it every day to do two things -- take costs out of it and increase its functionality. And if we can keep doing that, I think we can continue to have extraordinarily good market shares in solid-state residential meters.

Just two more qualitative questions -- on some of the larger installations that you have, Progress was done early. Piedmont, on the gas side, sounds like it's getting done early. There seems to be an acceleration in customer expectations for how quickly this hardware gets deployed and how quickly they can start reaping some of the ROI benefits. Can you comment on if you've got the logistics, and it sounds like you've got the logistics to handle it, but does it alter the competing structure when you go out to bid a new project, in terms of here's what I'm bidding for in terms of deployment, but I really want it 20% earlier because I want to get some of these benefits before my rate case is up. Can you comment about that thought?

Yes, John, we have really seen the utility executives say, 'This is such a great move for us. We want it in as fast as you can get it in.' No question about that. We haven't seen that add to our competitive quiver, if you will, in terms of winning business versus not winning business. What we have been able to do, I think, is to reduce our costs to do those installations. We are extraordinarily good at it. That may give us a competitive basis when we, in fact, have to bid against other people who are not as good at it as we are.

One of the things we have turned to doing in a couple of places lately is we're actually doing all of the labor work ourselves and managing that, which so far is turning out really, really well.

And I'm sorry, my last two -- on AMI, it looks like you've got two pilots going with, my guess would be, preliminary results back in that sort of Q1 timeframe, Q2 timeframe. What's a reasonable expectation, given that these are complex potential deployments en masse of a sizeable order coming out of AMI in your view? Is this sort of a 12-month sort of expectation? Or how do you view that?

I think as long as in the AMI market in general we don't see any big hiccups from us or anybody else, I don't think it takes quite that long. I think you could see some nice orders showing up at the end of next year -- between the middle and the end of next year. Now if we see some hiccups, for one reason or another, whether it's our stuff or somebody else's stuff, either the business case doesn't prove out or we're seeing an installation problem or the technology doesn't work as people thought it would be, then I think you'll see utilities take a little longer look, because the people that ask the questions, whether it's management or public utility commissions, they're going to ask just more questions. And so everybody gets a little cautious.

And my last one, quantitatively -- Steve, I don't know if you talked about cash flow expectations for the full year '06, as well as what you think back of the envelop '07 is?

John, we haven't talked about '07 yet, but we expect operating cash flow for full year 2006 to be somewhere in the $100 to $105 million and free cash flow somewhere in the $65 to $70 million range for the year.

Steve, are there any, in terms of working capital usages, looking into '07, that we should be aware of, aside from this sort of Progress capability that just passed us?

No, not overall. I think we're comfortable, and as we look longer-term at CapEx, we talked -- I talked a bit about that in my prepared remarks, but we would expect that to trend more closely next year to a 3 or 4% of revenue range, that we had some bigger projects this year that will be through. But to answer your question, no, we don't see any significant change in terms of our working capital expectations.

Great. Thanks, guys.

Thanks.

Yes.

You'll now hear from [Dick Hughmore] with [Soundpost].

Hi, guys. Good quarter.

Thank you.

I have a question on margin. It seems -- could you give a little bit more color on the margin compression this quarter? Have you seen additional competitive pressures from GE and et cetera? And then it looks like from your guidance for the rest of the year you're expecting margin compression to continue. You've raised your revenue guidance, but EBITDA seems flat. So could you give some color on that as well?

Sure. We -- the biggest effect on the margin this quarter was the fact that installation revenue, especially associated with Progress, was a higher component of our total revenue. And that tends to have a much lower margin than our product business. So that did decrease the margins, especially in electricity metering this quarter, as well in the software, we had a little bit of a compression because of the timing of some projects we're working on right now.

So you're right, we see margins in the fourth quarter trending a little bit higher than what they are this quarter, but not substantially higher, and that's because we'll also have installation revenue with Progress again next quarter. And also, remember we're still continuing to invest in AMI, as we already discussed.

And the higher R&D associated with that.

Yes.

What was the last thing?

Higher R&D associated with the investment in AMI, so --

All right.

-- effect there on operating margin, of course, not gross margin.

Right. And then next year, for your guidance for next year, it seems you're not expecting that margin compression to continue. It looks like your earnings growth expectations are a good amount higher than revenue. Is that -- am I reading that correctly? Is that the right expectation to have? Or -- and could you give some color on that margin?

Sure, and again we're still real high level at this point in time. We think margins will continue next year about what they are this year. Thusly, one of the things that might move the needle on that is the amount of AMI business that actually comes through. The initial shipments that go out with amount will be at a higher cost, because we're not at any volumes yet, so that could affect gross margins one way or another. And we think we'll continue to get some operating margin leverage, but as LeRoy stated before, that's tamped down just a bit, because we're going to continue to invest in R&D, especially with the AMI product.

So do you -- so the -- sorry, the high level expectations for next year, are you expecting margins to be around this quarter or just levels --

About what they are for the year this year.

Okay, about what they are for the year, which is a bit higher this specific quarter.

That's right.

Okay, that was it.

Thanks.

Thanks

Thanks so much.

We'll now take a question from Patrick Forkin with Tejas Securities.

Good afternoon, and congratulations on a good quarter.

Hi, Patrick. Thanks.

Thanks, Patrick.

With respect to OpenWay at CenterPoint, LeRoy, I just want to make sure I've got this straight. If everything went well in the pilot there, do you think they would be looking at commencing a full deployment towards the end of '07?

Pat, I certainly think they will. I think our gear has to do what they think it will do, and I think the business case, in terms of grid automation and doing intelligent grid stuff, has to work reasonably, as they think it will. And I have a lot of confidence that both of those things are going to happen, so I'm favorably disposed that if things go well, back half of next year, we ought to see some continued business there.

Okay, and then with respect to you comments on backward compatibility, if you will. Is it still possible that a utility like Progress, who's just gone through a mobile deployment, that they could or would upgrade to a fixed network too?

Oh, absolutely. We, in fact, look at a small handful of customers that we're in conversations with about moving to a fixed network 2.0, because it's all they need. That allows them to read meters pretty much as often as the want to; allows them to do outage notification, which is great; allows them to deal with move-in and move-outs, which is a big expense for some utilities. So the benefits continue to accrue. What you can't do is talk two-way to the meter or two-way into the home over that same network. There are other ways to talk two-way into the home that, frankly, are not beyond the realm of possibility.

Okay, so is it fair to say that you guys still have some fixed network 2.0 pilots in place at fairly significant utilities?

Absolutely, yes, and still sell the product, because it is sort of midway between the cost of mobile and the cost of AMI. And so for some utilities it's the right economic alternative.

Okay, and then with respect to moving OpenWay forward -- it looks like you're product development spend's about $15 million a quarter. And how much of that is related to OpenWay? And will that be increasing because of OpenWay or be staying about the same?

I'll partly answer that question that a good deal of it's related to OpenWay. We won't parse the R&D budget for you, but what I will say is as we look at '07, we will continue to have a very healthy, somewhat abnormally healthy R&D budget, and a good deal of that is because of OpenWay.

Okay, and then last point -- when you talked about things that could slow down AMI deployments, one of the things you mentioned is somebody goes to their PUC without a good business case. And we same some of the briefs being filed at San Diego over the last week or so, and it looks like they've got a pretty good gap in their business case, i.e., depending on like 40% of the cost to be covered by demand response. Any comments on sort of what's going on in California and how that impacts your thoughts on AMI?

Well, if we hearken back to PG&E, there was a bit of the same kind of give and take. First go around on that, they have a whole lot more cost recovery from demand response than they did in their final filing. I have not read the latest stuff, which apparently came out this week. So I don't know exactly what it says, but I think you're going to see some give and take there. And that's a matter of how much the utility wants to give back to the rate base, as opposed to any benefit to their investors. And so I think some of that going back and forth is a normal thing.

But it all plays into what I said. When these things get to be big and complex, they get to be slower than you think they were going to be, because there's too many cooks in the kitchen, if you will. And there's lots of people commenting. There's lots of staff work, and the big salvo in California was from the Department of Ratepayer Advocates, who are always aggressive in their approach, as they're supposed to be. And so I think that will settle out. San Diego will get that. Meanwhile, Edison's learning from PG&E and learning from San Diego. Maybe they'll have a better time of it.

Right. Okay, very good. Thank you.

You bet. Thanks, Pat.

We'll take a question from Chris Summers with Greenlight Capital.

Hey, guys -- a couple quick questions.

Hi, Chris.

How are you guys doing?

Good.

Great. Noticed that you guys are now getting about a $0.04 to $0.05 per quarter benefit from the convertible note offering, is that $0.16 to $0.20 included in the '07 earnings guidance or --?

Yes. Yes, it is, Chris.

Got it. And then secondly, at the beginning of the year you guys had talked about getting software to breakeven profitability. I guess that's going to be, I guess, difficult for '06. Is that now an '07 goal? Or is there a different strategy there right now as you guys roll out?

That's a great question, actually. One of the things that we see with AMI, whether it's our hardware product or others, is the necessity for great meter data management and great interface work to other utility systems is really coming to the forefront. I think if we can see a couple of these land, and AMI continue to go forward, that we will have our software group in a position to clearly be in a making money mode.

All of that aside, I would hate to be in the AMI business without the software prowess that we have gathered about us today, because I think you have a tough time competing. You have only to look at a couple of my competitors and see what they're trying to build to see that they agree with that wisdom. So I don't get overly sudsed about whether or not software's making money. The problem is we report it as a separate operating group, and so we have to sort of comment on it.

Yes, the software chief's disappointed he's not going to be breakeven by the end of this year on a run rate. I'm not, and I'm damn happy to have all those guys with us.

Got it. Great, guys. Thanks a lot.

Thanks.

You bet.

We'll now hear from [Ben Lee] with Royal Capital.

Hey, guys -- a quick question for you.

Sure.

Just to clarify, there's nothing left to bid for PG&E, right?

Well, that's a good question, actually. PG&E tentatively has identified ESCO and Hexagram as the suppliers of electric and gas AMI product respectively, both now belonging to ESCO. What they haven't done is given orders for all 8-plus million points, and I think over the years, there's going to be some other opportunities to bid, both on AMI product for electric and for gas, and we're certainly talking to them about OpenWay. We've done it very aggressively, both to PG&E and to the California Commission.

But I also think that sooner or later the idea of buying mechanical meters is going to fall on a different ear set at PG&E, and we potentially have the opportunity to sell some of our CENTRON meters there. Along with that, I still think there's some upside potential in the software area. While they did not pick us as a meter data management group, that's far from being played out. And then lastly, where we have been doing tremendous business at PG&E is in the consulting business on energy efficiency and the real effect that conservation can have in California. We're getting some very nice contracts in that area with PG&E.

Got it. Okay, thanks. And one more question as it relates to your guidance for next year. What are you assuming that you're earning on your cash? I guess, trying to back into what the operating profit improvement's going to be in '07 versus '06?

We would estimate -- we'd talked about a $0.05 per quarter, $0.20 for the year, so based on today's rates. And then that's about a 5.2% investment rate on the cash.

Got it. And what was the accretion in this quarter due the converse --?

It was about $0.03.

Got it, thanks. And final question is I noticed that in this quarter, the electric meters that were provided with a third party AMR seemed to be unusually high. Is there a reason for that?

Probably just the timing of orders. We do have some orders from one of our competitors that they had started a project. It could be driven by that, but really it's dependant on the orders that some of our competitors are rolling out.

Okay. All right, thank you.

You bet.

And there appear to be no further questions at this time.

Well, let me make a few remarks before Deloris closes. A great quarter. Even if it wasn't clear, we acknowledge that many of you had asked about whether or not we were going to be able to backfill Progress. We actually think we've done a really good job of doing that. I'm very pleased with the sales guys being able to go out and book business.

The other thing that I think bears repeating is we do seem to have a growing level of book and ship business being driven fundamentally from two things, near as we can tell. One is the meter business. We expected that to happen. People buy meters every day. The other one is we have such a large deployment of mobile AMR out there that when new houses are built, territories are acquired, all of that is really generating just plain old book and ship business. We get it every day. It comes across the transom. It's wonderful.

The other thing I would say is Steve made comments and we put some notes in the press release to try and help you guys model. If you have some questions around that, certainly Deloris or Steve can address them. We're coming through a time when there's accounting changes and some other things going on that are going to have to be sorted out as we model '07, so trying to help you there as best we can with that.

Deloris, anything else you might have?

That's everything. Thank you guys for your participation, and if you have any follow-on questions, feel free to give me a call. Thanks.

And again, that does conclude today's conference call.