Itron Inc (ITRI) 2010 Q2 法說會逐字稿

Ladies and gentlemen, thank you very much for standing by. Welcome to the Itron, Inc. Second Quarter 2010 Earnings Conference Call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Ranny Dwiggins, Vice President Investor Relations. Please go ahead.

Good afternoon, everyone and thank you for joining us. On the call today we have Malcolm Unsworth, our President and CEO, and Steve Helmbrecht, our Chief Financial Officer. Steve will begin by giving us a financial overview of the quarter, and then Malcolm will provide a business update. After that we'll take your questions. Our earnings release includes non-GAAP financial information that we believe enhances your overall understanding of our current and future performance. We also have a supplemental slide deck that is intended to augment our prepared remarks as well as provide a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today.

You can find the supplemental information on our corporate website under the Investor Relations tab. We will be making statements during this call that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially from these expectations because of factors discussed in today's earnings release, in the comments made during this conference call and in the risk factor section of our Form 10-K, Form 10-Q and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that I'd like to turn the call over to Steve Helmbrecht, Itron's CFO.

Thank you Ranny and good afternoon. We had an excellent quarter. Let me give you a quick financial snapshot. Record quarterly and six-month revenue of $569 million and $1.1 billion. Quarterly and six-month non-GAAP diluted earnings per share of $0.98 and $1.99. Quarterly and six-month adjusted EBITDA of $84 million and $150 million. Quarterly and six-month bookings of $806 million and $1.3 billion. Record 12-month backlog of $1 billion and total backlog of $1.7 billion. Our North America business is growing rapidly. Our International business is stable. The impact of foreign exchange fluctuations has been modest. Our financial position keeps getting better with increased liquidity and improved credit ratios. Back to Q2 financial performance, Itron's revenue of $569 million was up $155 million or 38% from Q2 2009 and up 14% sequentially from Q1 2010. Our revenue growth was driven primarily by record revenue of $303 million in Itron North America, an increase of 112% from the second quarter of 2009.

OpenWay lead the way. We shipped approximately 1.2 million OpenWay units during the quarter. With OpenWay revenue contributing approximately 47% of total Itron North America revenue. International revenue was $266 million down about 2% from the second quarter of 2009. Revenue grew about 0.5% on a constant dollar basis. Gross margin for the quarter was 31% down from 32.2% in the second quarter of 2009. Itron North America gross margin was 34% up sequentially from 32.9% in the first quarter. The sequential improvement in Itron North America gross margin was driven by higher volumes. Itron International gross margin was 27.5% for the quarter down from 30.7% in the second quarter of 2009. The decrease in margin was due almost entirely to increased warranty expense of about $9.7 million. The warranty accruals of $9.7 million impacted Itron International gross margin by about 3.6 percentage points. Impacted overall gross margin by 1.7 percentage points. Impacted non-GAAP diluted earnings per share by about $0.16. The increase in these accruals relates to two arbitrations in Sweden. I'll provide some background. They involve claims that certain of our meters are affected by high frequency pollution from third party devices in the home environment which were not anticipated at the time of the meter design.

We believe that we have corrected the problem and satisfied our customer's concerns. While we have ongoing warranty claims and will make ongoing adjustments as required. We do not expect adjustments of this magnitude to occur on an ongoing basis. Let's address operating expenses. Excluding amortization of intangible assets, total operating expenses were $107 million. An increase of about $10 million due mostly to increased compensation expense resulting from the reinstatement of bonus and profit sharing plans. As a percentage of revenue, operating expenses excluding amortization and tangibles were 18.8% in the quarter compared to 23.5% in the second quarter of 2009. Higher revenue coupled with lower growth in operating expenses drove improved operating margins. Non-GAAP operating margin was 12.1%, up from 8.7% in the second quarter of 2009. Adjusted EBITDA was $83.6 million compared with $47 million in the second quarter of 2009 an increase of 78%. Adjusted EBITDA margin was 14.7% compared with 11.4% in the second quarter of 2009. Cash flow from operations for the quarter was $51 million.

Capital expenditures were $12 million, resulting in free cash flow of approximately $40 million. Moving to income taxes, our non-GAAP effective tax rate was 31% for the quarter and 17% for the first six-months. The increase in our second quarter tax rate reflects improved performance and an improved outlook in high tax jurisdictions. With that in mind we expect our non-GAAP effective tax rate to be in the high 20s for the next two quarters. And our non-GAAP effective tax rate for the full year to be in the low to mid-20s excluding any additional discreet items. New order bookings in the quarter were $806 million for a book-to-bill ratio of 1.4 to 1. We booked $339 million related to our OpenWay contract with Detroit Edison. This means we had $470 million of other new order bookings to a wide variety of electricity, gas and water customers in the US and International. Indicative strong order flow and a balanced business. Total backlog was $1.7 billion at June 30, compared with $1.6 billion a year-ago. Our 12-month backlog was a record $1 billion at June 30.

As I noted earlier Itron's financial position continues to improve, particularly our debt metrics. At June 30, we had $684 million in non-GAAP total debt at a blended interest rate of 5.2%. During the quarter we made $21 million in debt payments and our cash balance at June 30 was $137 million. Our debt to total capitalization ratio at June 30 was 33%. Our debt to EBITDA ratio was 2.6 times well below the maximum covenant of 4.0 times. On the liquidity front during the quarter we expanded our revolving line of credit from $115 million to $240 million. At June 30, there were no borrowings outstanding and about $30 million was utilized by outstanding letters of credit. This expanded facility provides Itron with the increased in -- flexibility in liquidity for general corporate purposes. I will wrap up with a few comments about our earnings guidance policy, which was included in our supplemental slide deck. In response to concerns raised by you, we have reviewed our guidance policy. Here's what we plan do starting today. We will provide full year guidance in our February earnings release and update guidance for the year in our July release. We will provide guidance on revenue growth, gross margin, non-GAAP operating margin, FX rate assumptions, tax rates and share count. With that, I will now turn the call over to Malcolm.

Thank you, Steve. Good afternoon everyone. If there is one core message today here it is. This was Itron's best quarter ever, with record revenue, a backlog at record levels, and near record earnings. Our success was due to OpenWay project implementation which are on track. Very strong performance in our gas and water businesses in North America and steady International activity with a continued high level of interest in smart metering. Overall, we had an improved outlook for 2010. Now, let's jump in deeper. First, a couple of comments on our OpenWay contracts. We recently surpassed the three millionth endpoint shipment milestone of OpenWay units. Installations continue to ramp. Our execution and deployment on these contracts is going well and continues to be a top priority. Southern California Edison recently celebrated the insulation of their one millionth SmartConnect meter. As you know our OpenWay solution is the foundation. We are on schedule with our next release of OpenWay CENTRON smart meter. We booked the contract with Detroit Edison during the quarter which made a very nice contribution to our backlog.

Second, I want to talk about our strong performance in our gas and water businesses in North America. The demand for our new gas Choice Connects smart metering solution is very strong. Contributing nicely to our revenue growth for the quarter. Units for our gas Choice Connect system grew by more than 40% over the first quarter. We also released a new water smart metering solution using similar technology as gas. Our customers are really excited about these new offerings. They include the ability to migrate from mobile AMR to a fully functional two-way smart metering solution with many added benefits for gas and water utilities. We are seeing a convergence of AMR and AMI technologies. Our Choice Connect system is an integral part of this conversion, giving it a tremendous competitive advantage as was highlighted today with our press release for New Mexico gas. Third, I was delighted to see the improvement in North America gross margin, from 33% in Q1 to 34% in Q2. We continue to focus on reducing costs and improving margins. While 2010 overall is going extremely well, recently we have had some competitive disappointments in North America. All of us at Itron are very upset about it.

Itron has always been customer centric and highly sensitive to the needs and wants of the marketplace. We have built our market leadership on these principals. Accordingly we are actively engaged in doing what we need do to maintain and augment our market leadership position on a global basis. I want to emphasize that the smart grid is a new market. The rules for success are still being written. This is a marathon not a sprint. We are committed to winning. Now, let's turn to International, which includes 85% of the world's meters where the transition to smart metering is in its infancy. Despite the fact that the economy in Europe continues to struggle, our International backlog has grown 38% since year end. Smart metering projects are gaining momentum. Here are a few examples. We recently announced that we had been selected by Iberdrola in Spain to participate in their 100,000 point smart grid pilot and they also selected our meter data management software IEE. Gaz de France has awarded Itron a 5000 point smart gas meter contract for their smart meter pilot . Our contract to smart payment gas meters in Azerbaijan has the potential to reach one million end users. I'd like to stress the importance of this innovation. It is the first of its kind and will be a key reference for Itron in developing countries.

Our AMR projects with Yorkshire Water in the UK is on track. It is the largest project of its type in the UK. It position us as a leader in water automation. Remember, there are 16 million homes that are not metered in the UK. Our large water AMR project in Mumbai is moving forward as planned. Now in Q2 we have added a gas AMR project in New Delhi using similar technology. This project has a potential to reach over 500,000 homes. We see continued progress with ERDF in France on their electric AMI pilot. We are on schedule to complete the de-employment of 100,000 points before year end. Lastly here's our guidance for the full year of 2010. Our total Company revenue growth rate in the mid-20s. Our gross margin percent in the low 30s. Operating expenses as a percent of revenue in the low 20s. Excluding amortization of intangibles. A Non-GAAP operating margin percent in the low double-digit. We are very excited about 2010. We are seeing great returns from our strategic investment. The way we manage the world's energy and water will shape this century. Itron is dedicated to providing end to end smart grid and smart distribution solutions to electric, gas and water utilities that will enable all of us to better manage these vital resources across the globe. With that I'd like to open up for questions.

Thank you very much. (Operator Instructions) I'll take our first question from Stuart Bush with RBC Capital Markets.

Yes, good afternoon guys, great quarter.

Thank you Stuart.

I was hoping you could give us some additional color on what your efforts to augment and create your competitiveness in the smart grid market might be. Is the focus R&D, some target acquisition? If you could just put some frame work about how that strategy might evolve?

Absolutely Stuart. One of the things that we have been doing for quite some time is developing our smart grid solutions for OpenWay. I promised over the past several meetings that we've had with investors that we will being having a second generation of smart OpenWay meter that will be released in the second half of 2010. Well , we are here in 2010 in the second half now. I'm glad to say that we have the smart meters in the hands of our customers and they're doing testing. This is the platform for our next generation of complete open interoperability of IP. This is the platform we are going to use. It is higher speed. It's got higher memory capability. And it is the platform for IP. Obviously, as we've thought through it before, it has an ACIS which reduces the number of components and in turn improves the quality. So there are significant amounts of effort that we have been doing in increasing our footprint in the smart grid.

When I take that a little bit further and go to smart gas solutions, we have launched our gas AMI solution in the second quarter. And also launched our gas -- sorry our water AMI solution. They use the same architecture and it is called Choice Connect. There are some significant opportunities that we have got to augment our opportunities in North America. In addition Stuart, we are also looking at partnering with -- we have a many number of partners and alliances. So that's just the North American side. Internationally, as I said before we're focusing on many of the developing countries. As I said regarding AMI solutions both in France, and Spain and the UK, I mentioned all those, that's what we're going to do to increase our level.

Okay, great. Can you give any commentary on the pricing momentum in the quarter? It looked like North America was stronger overall. Is that because of mix or have you seen some improvement in the market on price taking?

We face competition all the time, Stuart. And obviously we have a different mix of products today. We get a higher price for our OpenWay solution. And we get a higher price for our gas products. So we are seeing a higher price. The higher price gives us more gross profit to work with. That's what we're seeing. There is always competition. Remember we booked $1 billion, $1.3 billion for the first six-months of this year. That was all competitively bid.

All right, thank you. Moving on, we'll now take a question from Steve Sanders with Stephens Inc.

Hi guys, good afternoon. Good quarter.

Hi Steve.

Maybe a follow up on the warranty issue in Sweden, is this something that could potentially be an issue in other regions? Or do you think it's confined to the architecture in Sweden and the situation there?

This is Steve. We do think it's confined. As the meters were confined to that area. And the issue itself is really confined to that region in particular.

Okay. Then the follow up is kind of a two part. Malcolm, you expressed some of your frustration about a few of the deals that have been awarded recently. First, in North America, can you give us a sense of how many large projects are still out there? And draw the line where ever you want. $75 million. $100 million. How many large projects are still out there? Are active in the RFP stage and could be awarded over the next six to 12 months. The second part is on the International side. Just comment generally about your share. And based on some of the things you are seeing Internationally, are we getting pretty close to a point that we should look for the International business to grow in constant currency? Or is it a little early for that?

Let me just answer your first question, first of all. When it comes to RFPs in the US we are actively working on many proposals. There is a significant number of proposals that we are working on both across all water, gas and electric. So, yes, we are actively participating. Can I give you a number? Off the top of my head it is large. That's all I'm going to say. Let me give you something about International. Our International market shares, it's spread between Europe, South America and Asia. European market shares that we have are very good. I'm not going to go into all the -- I think we have the detail on our last investor presentation. But we have very good market shares. What we are finding is that the utilities that are moving forward with some of their AMI and smart metering projects are seeking out help in looking and working with them in developing solutions for their smart grid applications. We see that's going to continue to grow. There is no question that will grow across the globe. We are seeing the same in South America.

Obviously with Europe it is based on legislation and we feel that's going to take off as we talked about many times with a number of pilots that we have. In South America it is similar. It is not quite by legislation but it is similar. It is primarily similar because of what we call non-regulatory -- sorry non-technical losses. They have a significant amount of theft that goes on in South America, in particular in Brazil. So we're uniquely positioned to take full advantage of that because we have done similar projects in South Africa and also in the UK when it comes to smart payment systems. We are well positioned to take advantage of that complete International growth that we see over the next few years.

Moving on we'll take a question now from Sanjay Shrestha with Lazard.

Good afternoon guys. Congratulations on a great quarter. Just two questions, first up on this Baltimore gas and electric issue, have you guys seen that sort of impact some of the other utilities that have received the funding under [ARAA] and having gone back on the drawing board potentially delaying some of the other AMI projects? Can you comment on that a little bit as to --

Absolutely. We see this as something that we've had experience with before. We've got a long history of working with regulators around the world. Both obviously here in the US and obviously these things take time. We help our utilities with business cases. We foot that forward with them. Obviously one of the things we've (inaudible) is going to be about the consumer. So, we are providing solutions to help utilities put more information into the hands of the consumer. So, is this going to be a trend? I'm not really certain. I have a good idea with regards to the issues associated with it. But I think what they are looking for, what the commissioners are look for is to give more information to the consumer at a reasonable cost to the consumer.

If you take a look at Texas they negotiated with the three IOUs in Texas and they've got 15 minute interval data going to each one of the people who signed up for it. They managed to negotiate a clear, definition about what they need to do and what they need to do moving forward. It is mixed, Sanjay. There's 50 Public Service Commissions in the United States. Many regulatory bodies throughout the world. It is a mixed opinion.

My next question then is Malcolm, you talked about sort of some disappointments here and then working on technology, having the availability of that. You guys have always had a huge traction in North America, at least on the electric metering and the AMI side. It sounds to me like you guys are getting a bit more aggressive and we should expect to hear a lot more about your win also on the natural gas and the water side complimenting what looks like a pretty fantastic growth opportunity for the next several years to come.

Obviously, Sanjay with the recent announcement that's gone on with ESCO about Southern California gas we are obviously disappointed in that. But think about what the situation is there. We provide the needed data management system to the utility. And there is also 2.4 million gas points that we are staying connected with Southern California gas. Yes, that's a disappointment. If you start looking at some of the electric utilities and some of the other opportunities, if you take a look at what we have done over this year and over the last -- this quarter, about 25% of our global revenue comes from products that were designed in the last three years. They didn't exist three years ago.

So, technology changes. We have been moving constantly. We are on our -- I don't know what generation of our electric CENTRON meter and the generation of our gas product. We are always changing technology to advance it for the future. That's what we are doing. We are innovative. We make sure that we are moving ahead. And we are sticking to what the utility and what the customers want. Yes, maybe it is a short-term issue or a short-term situation. But remember, this is a long-term play that we are in. We are in it for the long haul and it is a marathon.

Moving on, we'll take a question now from Elaine [Kwei] with Jefferies & Co.

Hi everyone. Thanks so much for taking the questions. Outside of OpenWay could you talk a little bit about how much of the strength you saw came from AMR versus conventional metering in both North America and International?

Yes, what we are finding now is if you take a look at the global offerings, and I said earlier, if you look at the technology that we've developed, in particular North America, you said outside of OpenWay, we have traditionally had an AMR solution in the past. Most of our install base is AMR. I talked about the convergence of going from AMR to AMI. So, what we are finding now is if you take a look at the announcement that we made today with New Mexico gas, there were 345,000 gas meters or gas modules. Those gas modules are all two-way communicating meters or two-way communicating modules. There is a convergence of AMR to AMI. All of the products that we're now selling-- not all, that's not true, many of the products that we are now selling in North America and many over seas are two-way communicating devices. They are going from AMR and automatically now having AMI embedded.

Great. Could you talk a little bit more about the prepaid market that you are seeing ? And how large that could potentially be and who some of the other competitors would be in that area?

Pre-payment metering is something that's mostly been in developing countries. We have 5.5 million. We manage 5.5 million prepayment meters in South Africa. By the installation of putting what we call smart payment solutions in there, they saved -- the utility saves 40% of their non-technical losses. They reduced. There's a huge business case to drive for pre-payment or smart payment. If you look at what they do in the UK , it is significant what they do the UK because we've got a smart tee that goes in there. Now, If you look at the -- other areas of the world we've got a significant spend in places like Indonesia, also in South Africa. Now we are pushing that solution to some of the developing countries in South America.

So, we have a significant, broad depth of innovation, the smart payment systems and in particular the one in Azerbaijan uses the innovation of a smart -- like an ATM credit card. You go and buy your product. You go and buy your gas at an ATM machine. You load it into your debit card. You take the debit card to your meter and you then -- you download the credit into the meter. Once you run out of credits, basically you have to go and top it up. It is called top-up. This is really starting to be big in some of these developing countries. Because the utilities -- there's many countries that they don't have homes, don't have street addresses but they have electricity. Yes Elain, it is a big market for us.

Thank you. Moving on, we'll take our next question from Paul Coster with JPMorgan.

Yes, thanks. If you don't mind, I'll also build upon this theme of the future. Can you hazard to guess what penetration level we now stand at in North America and Europe for water, gas, electric in terms of the smart meters? And where you think we ultimately will get? Will we get to 100% penetration, Malcolm?

I said this -- spend this with you quite a few times Paul. There are 2.6 billion meters throughout the world, okay, we've said this before. There are so many, 1.7 billion, I think the number is. For electric at 1.2 billion and for gas and for water. Nearly all of that automation is in North America. Okay, we have a very significant market share. You think about how many millions and billions of meters there are to be positioned for smart metering. What's that sort of time frame? In Europe it's dictated by 10 years. Between now and 2020 they have to do, there's about 510 million water, gas, and electric meters. Now, water is not mandated. But it's becoming very scarce in certain areas. The AMR technology is being used now. As I indicated with a couple of technologies there are contracts that we won in the UK.

So, I see this over a period of time. Third party companies showed in our investor conference that we had with, I think the Company is [IMS], that the compounded annual growth rate of some of these opportunities outside North America is 50% over the next five years. Those are not my numbers. If you take China out I think it is in the neighborhood of 35%. Paul, it's huge. The opportunities are enormous.

There's sort of a sensible aspect to this question, which is a couple of investors have expressed to me concerns that your backlog is going to peak soon. It really feels like there is still a lot of growth to be had in the backlog, a lot in North America. But then Europe should kick in 2011, 2012. Do you concur that Europe is a year or so out in terms of the ramp. Are there any specific catalyst for when Europe gets going?

Yes, there are catalysts. I'll just talk about Europe first of all. If you take a look at the announcement that I put in my prepared remarks, GDRF are moving forward. That's Gaz de France. We just got a pilot with those guy for 5,000. They have the put in, I think the number is 11 million gas meters and replace them all by about the same time in 2020. If you look at Spain with our Iberdrola account, that's about 10 million points that are going to be deployed over a period of time. If you look at the UK , there is 47 million. There is 16 million water meters that are unmetered. Yes, I think that backlog outside of North America is going to start growing. As you said earlier, will the backlog peak in the US? Well, think about the amount of revenue and the amount of bookings that we have had. There are now that are not OpenWay, there are other products, they are still significant. We booked $1 billion, almost $1 billion in the first six-months without the Detroit Edison order. It is significant, Paul.

And moving on we have a question now from Michael Horwitz with Baird.

Great, thank you very much for taking my question. Just quickly a couple questions about Detroit Edison. Much of this is in public filings but just to clarify with you on your call. As a reminder, when did you actually win the contract? Now you are able to put it into backlog. As I understand in some of my reading, please correct me if I'm wrong there are really two tranches. There will be an initial deployment up to about 600,000 units. Then you'll need to go back to the Commission to approve the final deployment. So you are able to book all of that now? Or am I reading that wrong?

Maybe -- there is a lot of requirements that we have when we go into booking large contracts. I'm going to give this to Steve. Maybe you can answer that, Steve.

We received a notice to proceed from Detroit Edison during the quarter. We are very excited about their decision to proceed now with the project and the receipt of funding and budgetary approval. The contract in the original discussion was about a year ago. Of course it wasn't booked before this quarter for that reason. We've received the notice to proceed. They do have a budgetary process they'll be going through over time. But we booked that in the quarter for the amount that's in the contract and are very excited about working with them as they roll out the OpenWay project going forward. The bookings methodology is very consistent with what we have done and what we do with our other large bookings.

Michael, you did say the first 600,000 for the next two years. That is correct. The balance is after that.

Right, then there is a reapproval or at least another conversation that you will have with the commission before the subsequent deployment, is that correct?

I can't comment for the Detroit Edison, actually.

All right, thank you. Moving on we'll take a question now from Carter Shoop with Deutsche Bank.

Good afternoon.

Hi Carter, how are you?

Well, thanks. One story that we haven't heard a whole lot about is the bookings over the past four quarters in North America excluding AMI. You've had a positive book-to-bill there for five quarters in a row. The first question is how sustainable is that strength in the non-AMI business or non -- business? And then under clarification, can you tell me if the New Mexico gas was booked in the second quarter?

New Mexico gas was booked in the second quarter.

Yes.

It was booked in the second quarter, I believe. Okay. Maybe we'll get back to you on that one. I do believe it's booked in the second quarter. The non-AMI business -- that's a big conversation by a lot of you. We have now launched our Choice Connect solution for, as I said on my prepared remarks for water and for gas. We are seeing significant interest in those opportunities. We did launch this at DistribuTek for gas. We've also launched it at AWWA for water. There are customers up showing significant interest. Obviously, will that sustain? Yes, I do believe there is significant opportunities there if you look at the install base of what we've got and you take that off and you say how many are available for new opportunities for water and gas? It is still a huge number.

This is Steve. I want to confirm that New Mexico gas was booked in the second quarter.

Okay. Regards to margin performance on the operating line there for North America, that was very strong. Can you let us know if there is any one-time items that positively benefited the North America business in 2Q or should we assume that these types of margins are sustainable going forward?

This is Steve. No there were not any unique one-time items. As I mentioned in my prepared remarks, we are seeing the benefit on the gross margin line from increased volumes. We are seeing the benefit in the operating margin line from our management of sales and marketing R&D and G&A. But I do want to emphasize Malcolm's point that we're continuing to vest heavily in R&D. We continue do so. That's reflected in those numbers as well.

So the margin continues that -- I think, we believe we have 34% margin in North America. That is without the next generation of OpenWay meters.

Moving on we'll take a question now from Craig Irwin with Wedbush Securities.

Thank you for taking my question. First, congratulations on the solid performance in the quarter.

Thank you.

I wanted to continue along the seam of gross margins for Itron North America. Obviously you are seeing some pretty nice improvement there. Everybody was expecting headwinds over the last couple years as you ramped up your AMI shipments. Obviously the gross margins there improved quite nicely over the last couple of quarters. I was hoping you might be able to give us a little more color on the relative contribution of recovering volumes within the core Itron products in North America versus the improvements in AMI profitability so the overall gross margin improvement that we have seen over the last couple of quarters?

I'm not really certain of your question regarding recovering margins. We did have some lower margins. Now they are getting significantly better. With regards to the new products, the new products that we've always had on the legacy side, we have -- as I said earlier to Elaine, we have migrated those over to AMI. There is a differences between a one-way communicating meter or device and a two-way communicating device. Because you have more components on a two-way communicating device. We're seeing that we've done a significant job in R&D to make sure that we can keep the cost down. From a stand point of our gas and water solutions we are seeing continued improvement all the time. When it comes to product mix we also have different solutions. Different solutions mean with different product you get higher selling prices like we got with OpenWay with a larger product mix. With OpenWay we have got the next generation coming out. Those are all opportunities for margin improvements. Higher selling price and better margins going forward.

Excellent. You just touched on one thing I wanted to ask specifically. Can you quantify for us or maybe give us some directional color on the potential for gross margin improvement from your next generation OpenWay product? This sounds like it's a pretty attractive opportunity from a financial performance standpoint.

That's fairly competitive information. I don't really give that out. I've said it all before, what we do is we take components off a -- we've got it on our register board. We take the components off there and put it onto silicon, on an application-specific integrated circuit. That takes components off. It improves the cost or decreases the cost and improves the quality levels. So, as far as how much is that? I haven't really given that number. I just know that it is -- it takes a significant number of components and consolidate that into silicon.

Moving on, we'll take a question from Sean Hannan with Needham & Company.

Yes, good afternoon.

Hi Sean.

Malcolm, you had touched on a comment a little bit earlier in one of your responses to the questions. It got at how some of the regulators view the economics of some of these deployments. I was hoping what we could do, if we could step back and I could get your perspective around whether you view pricing at some point potentially likely to become or used a little bit more as a weapon in terms of winning RFPs given the scrutiny that some of the utilities may get from the regulators and their AMI plans whether deserved or not on the economics of these deployments in the US?

That's a great question, Sean. Just remember that if you look at the projects that have been approved by commissions, approximately 50% of the cost of one of these implementations is hardware and solutions. The other 50% is what they get for implementation with system integrators and also with consolidation and putting it all together. We only are responsible for basically half of the total cost of the business case that goes forward to the Public Service Commission. So there is room across all of this breadth of the IBMs of the world. The other guys -- and all the guys that help put this together to benefit the utility and the consumer. It is a total cost of these installation. It is not just us. We are competitively positioned. As I said before we develop new products with a market leader in everything we do. We have got a significant amount of R&D. If there is pricing pressure we have the room in there to do things. And to help the utilities approving it through their public service commission we have always been competitive.

That's helpful. Actually as a follow up also in looking at the RFP process . Are there any changes that you are seeing in terms of preferences on the technology merits of all the different AMI offerings out there in the industry? Whether the focus is on the merits of durability, feature rich functionality or an established track record? Instead of comp sensing whether, that all of these are factors there perhaps a way, if you could provide a little color around what tends to be the dominating tipping point for utility decision today or how might some of this be changing, if at all?

One thing that we do belief in, we first of all developed a solution which we called our electric solution OpenWay. We called it OpenWay because it is opened. It is an open standard. We are now developing our next generation, which is basically as I said earlier, the platform for the hardware is basically done. Or is done and is in the hands of our customers. The next generation is going to be interoperable, what we call interoperable native IP. Which means that it is similar to what we did before. Only now it is completely interoperable IP rather than propriety IP. We are getting ourselves set up for the smart grid. The smart grid of the future will make sure that all of these devices that are in the field are completely and totally interoperable. That's what we believe is driving the future. We are very well prepared for it.

Moving on, we'll take a question now from John Quealy with Canaccord.

Hi, good afternoon guys, great quarter.

Hi John. Thank you, John.

Two quick ones. One on the cash flow, $90 million in first half free cash. Steve, I think you were hesitant in previous calls about what that number could be. Can you talk about what we should be looking for in next couple of quarters here with this visibility?

What you should look for is our continued focus on working capital and managing it. We use our high quality customers. You have seen some build up in inventory and receivables commensurate with top line. But our overall working capital metrics have improved. We don't expect to see anything significant on the CapEx line. In fact it was about 2% of revenue in the second quarter, I've said it's 3%. Generally over the course of the year there could be some movement in and out. We don't see other significant factors that would really move free cash flow. In fact, our free cash flow yield overall is highly correlated to our earnings growth, as well. We'll continue focus on driving that. I won't give a specific number for the second half but we'll say that we're going to continue to focus on very strong cash generation and using that to pay down debt.

Okay. Then my second one for Malcolm. When you are talking about enhancing the competitive position. I know you talked a little bit about internal product developments in the new ASIC and things like that. Can you talk about where you think your competitive position was deficient with some of these wins? Then also can you talk about the potential for M&A now that balance sheet is really going to the cash side pretty quickly?

Competitive position, if you think about where we are across and I'm assuming John, you are really meaning North America and you are really talking about electric or are you talking electric and gas? Because I'll give you both answers. Competitively positioned, we're always looking at opportunities to reduce costs. So, I don't believe cost and projects that we've got for R&D improving the functionality is an issue for Itron. We have done this. This is what we do for a living. The competitive position though with regarding to functionality, this is something that we do believe that this is going to drive the industry over the next few years. It is a long-term marathon as we've said before. You have to have the right competitive position and the right functionality within your whole solution. That's why we also have partners and alliances that we utilize. We don't believe, we can do it all. We partner with other companies and it enhances our competitive position.

John, the second part of the question was M&A. You've seen obviously historically selected acquisitions have been part of our strategic plan generally funded by organic growth or funded after the fact by organic growth and cash flow. In the near-term, we're continuing to focus on strengthening the balance sheet, reducing debt, that remains our priority. We will continue to consider tuck in and opportunistic acquisitions where appropriate going forward.

Moving on we have a question from Collin Rusch with Thinkequity.

Hi, this is [Brandon Malara] for Collin Rusch. Thanks for taking my question. So, I was actually wondering for North America, if you guys might be able to talk a little bit about just what you are seeing in terms of the municipal market. On one side just how much of the market or how much of your market potential will you see coming from municipal utilities? Then also just what you might be seeing in terms of the condition of the municipal market right now.

Sure. Not a problem, Brandon. If you remember with municipal markets. Many of the municipal markets have got two solutions. Sorry, we have two solutions to offer. They're mostly public power. There is public power market and municipality market. We've got a breadth of products particularly in the water and electric space. We just announced a couple of -- I think we just announced one today regarding the solution that we had for a municipality in the city for water and for electric. There are many of those in the United States. So, we have this broad portfolio with products and we have them all with a complete solution, which is what utilities are looking for, for an end-to-end offering both for installations and all the way to meter data management systems. We offer all of that. Municipality markets are a very important piece of our business. We take it very seriously. We have a sales force across all of the United States both selling through distribution and selling through direct sales force. We see this as very important. We've got all the product breadth of our solutions and our offerings to address that market.

All right. Thanks. Then just as a follow up question. I know you were speaking about making OpenWay a part of the smart grid and everything like that as time is going on. But, as far as -- have you seen any increase in requests for kind of distribution automation specific kind of products?

DA has always been part of our offering. We offer that in our solutions. We manage DA. Today, the DAs part of our solution. We communicate to these DA devices and we've got all of the various hardware and software solutions embedded in complete suite of offerings. Yes, we see DA as a big part of the whole smart grid scenario.

Moving on we'll take a question from Ben Schuman with Pacific Crest Securities.

Hi, guys. Looking at your guidance for revenue growth assuming the midpoint of 25%, that would imply a sequential down tick in revenue in Q3 and Q4. Is that indicative of some lumpy shipments on the AMI side with the $1.2 million this quarter. What' s driving that potential down tick?

This is Steve. We provided a range in the mid 20% and believe that to be reasonable. Obviously that is a range. There is a lot of the year left to go. We are in the ramping process right now with the projects. We're very pleased with how we've done in the second quarter. There can be some variation overall. With that said we are not seeing overall slow down in the business.

Okay. Great. Just to expand on some of the earlier questions about technology and partnerships, multi-tier networking is something that you guys talked about maybe back a year ago, at your Analyst's Day down in South Carolina. Is that something that you are seeing a lot in RFPs and in competitive wins and stuff right now?

Yes, we do partner with a number of mid-tier network companies. That's part of our strategy today, yes.

Great, thanks.

Thank you.

(Operator Instructions) Moving on, we'll take a question from Steve Milunovich with Merrill Lynch.

Good afternoon. Just a couple housekeeping questions on the numbers. Share count 41.5 million was in the guidance. Was that a year-end number or is that what you expect to be average shares for the year?

Average shares for the year.

Okay, that assumes a fairly decent tick up from where you are in the first half?

Some of that just takes into account some activity that went on last year that, it's been fully reflected over the course of this year over time in the share count.

Okay. Steve, could you repeat what you said about DTE? How much was that in orders and backlog this quarter?

The booking itself was $339 million of the total bookings. The other $470 million relates to non-OpenWay projects globally.

Moving on we'll now take a question from Jeff Osborne with Stifel Nicolaus.

Great, thank you. I just have two questions. One, around the new ASIC. I was wondering if you felt more confident that the install base, your existing three customers would be likely to update that in 2011 or if it was more of a design for new customers moving forward?

It's both. It's completely backward compatible.

Okay. I've got you. I was just wondering then, if you could just -- I've never heard the term proprietary IP before. How does one manage a propriety IP, and a native IP network in the same architecture, do you have to have a software patch or download to the existing install base? Can you walk me through that?

One of things that we've managed do, is we brought in some experts. We have four major IP experts that have looked at our solution. They are very happy with what we are proposing.

Moving on we'll take a question from Michael Coleman with Stern Agree.

Good afternoon. I wanted to go back to the base orders. Non-AMI business, so if we back out the contract and you look at your orders, they're fairly stable quarter-to-quarter. North America is up 10% sequentially. My question is in terms of that base business, at least in North America is there a seasonal pattern to that as well as Europe? How do we think about base orders on a seasonal basis in the back half of the year?

This is Steve. We view it less as seasonal as lumpy. In that some of these orders can come in and out. We have just a mix of business that can come in at different times in North America. I would describe it as just based on order flow, there can be some fluctuation, but it's less seasonal. Although there can be some year-end spending, you do see in utility capital budgets in the fourth quarter overall. In International, we talked about this in the past. There can be a bit of seasonality in our businesses, I think in particular in the gas business where we do see some first quarter spending the way utilities are driven some in Europe. Again, overall we don't see major seasonality within the International utility base, either.

Okay. One follow up question on the New Mexico gas contract. Since it's in the backlog, you've obviously have been working on it for a while. You are going to complete that in three quarters. While it is less than 0.5 million units, is that one of the benefits as you look at this Choice Connect offering in terms of the time that it takes to actually deploy as a feature? Could that actually accelerate making this base business much -- just enhance that base business?

I mean these projects don't happen in five minutes. Let's make that very clear. Once the gas company decides they are going to go with these solution or the water company they want go with them very quickly because they want to benefit from all the savings that they will generate. In our particular case now they are going from a mobile application with this solution, install it then use the features of this afterwards for all the features of two-way communication. So, deploy it very quickly. Add it and install it on a gas meter. Do it by what we call by route. You're getting the savings initially from that particular route. Then overlaying it later with a network, if they so choose. So, what we're really saying is that this is a very good opportunity to get these in the ground very quickly. We're all ready to go, all ready to do it. The product is finished. It is two-way communication and it's completely backward compatible with AMR.

(Operator Instructions) We'll take a follow up from Steve Sanders with Stephens.

Thanks for taking the question. A couple of things on the next generation system, or the new ASIC that it sound like is being tested by some of your customers now. Do you have a better sense now of that testing process and period when they may actually accept those products? Then kind of a related question. Are your customers doing or I'm sure you are, doing significant testing of this remote firmware upgrade capability? If so how is that going?

All that I can say of our customers is I wish they were all the same speed, the way they do their testing. Some are faster than others. They are all very thorough. But some take longer than others. So they are all working at their pace. With regards to remote firmware, we have already done this. We have downloaded a significant number and upgraded the firmware all the way down to a meter and changing the meter firmware and also through the communication that we have. We've already done two-way communication firmware downloads. The next generation that we have will just speed that up as well. The version that we have now is faster. The next version is even faster.

Okay. Then the last question, everybody is obviously aware of the big utilities around the country. This is more about North America than anything else. Historically you guys have done a great job on the electric meter side with the middle market. But in an AMI project that's much more complicated sale. So, I'm curious, are you making significant incremental sales and marketing investments to reach the middle market on the AMI side? Do the existing channels take care of that? How should we think about that?

We've actually reorganized our sales organization in North America, focusing on the public power markets and all the municipalities. We have taken steps, Steve to address this market. We understand, it is a lot different than selling a meter sale. Yes, we have reorganized our sales and marketing group.

Could I ask you how many calls we have in the queue?

We have two questions left in the queue.

We'll take those two and let's bring it to a closure then.

All right, great. Moving on, we'll take a question from Paul Coster with JPMorgan.

Thanks very much. In Europe the smart meter solutions will be largely power line based we believe. What does that do to the average selling price per meter? Malcolm, I may have misunderstood what you said about Southern California gas. You've still got a piece of that business. Can you just elaborate? I think it was a bit unclear from your opening statement.

Okay, will do, Paul. First of all let me address the PLC market in Europe. As you know, they have been using power line carrier communication probably in GDRF for the past -- I'm not certain, maybe it's the past 15 years. And that solution has been working very well. The average selling price of those products, when you add more functionality you increase the selling price. There is no question. The product that we have today is different than the power line carrier solution that we have had in the past when it's just communicating energy. So there is a difference between the two, functionality usually means a higher selling price.

-- North America average selling price per meter? Is it higher, lower, the same?

Well the average selling price in North America for a full blown AMI offering with communication into the home as we've said is an average of about $100. It is not that high over there. So, it is not that. If you go to Southern California gas, to elaborate more on that, we provide Southern California gas, they selected our meter data management system. We also are connected with them because we are a gas meter provider. They apparently -- they will be in their filing replacing 2.4 million gas meters. They will take their ESCO communicating device and attach it to the gas meter -- to new meters. We do have a very large market share with one other or a couple of other manufacturers of gas meters. We have a factory in Kentucky. And we are participating in that business. We will expect to get a share of the 2.4 million gas meters, as I say, in Southern California gas. I hope that answers your question, Paul.

Our final question will come from Michael Horwitz with Baird.

Just along those lines with regards to gas. Gas is obviously a good business and a great business for a couple of your other competitors, as well. In many instances, better margin. One thing I struggle with though going forward with AMI and any opportunity there is the business case for gas AMI a lot easier to be told to the PUCs around electric. Can you just give me your thoughts there? Thank you.

Absolutely. Our business case for AMI, if you take a look at an AMR business case first of all. We have -- the business case has been mostly for operational efficiency. When it comes to AMI, I agree with you, on gas it is not as easy to give you all of the benefits that the consumer is going to have. However, if you take a look at the operation improvements now with an AMI solution it gives you all of the information basically that a two-way communication device gives you for electric. And we have developed a new product called a safety valve or a shutoff valve that attaches to our meter that is embedded in our meter and also uses our Choice Connect solution to do two-way communication to shut the gas off. If you smell gas or if you -- should I say in the Northeast, many of these homes are -- or actually, many of these gas meters are indoors. If people, as an opportunity, if people have a problem with payment or they smell gas they can actually shut off the gas without having to visit the home and deal with it automatically. So we have improved the business case opportunities for gas AMI. In addition, we've also got the telecommunications that we've done with other devices around the AMI gas distribution system.

Okay. Thank you everyone for joining us today. As always if you have any questions or need any further information feel free to give me a call or [Marty Filcher]. Thank you.

Thank you very much ladies and gentlemen. That does conclude today's conference. There will be an audio replay of today's conference available this afternoon. You can access the audio replay by dialing 1-888-203-1112 or 719-457-0820 with the passcode of 6492029. Or go to the Company's website www.Itron.com. Thank you very much. Have a good day.