Good day, everyone, and welcome to the Itron, Inc. Q2 2019 Earnings Conference Call. Today's call is being recorded. [Operator Instructions]. Now for opening remarks, I would like to turn the call over to Ken Gianella. Please go ahead.

Thank you, Operator. Good afternoon, and welcome to Itron's Second Quarter 2019 Earnings Conference Call. We issued a press release earlier today announcing our results. The press release includes replay information about today's call. A presentation to accompany our remarks on this call is also available through the webcast and on our corporate website under the Investor Relations tab. On the call today, we have Philip Mezey, Itron's President and Chief Executive Officer; Joan Hooper, Senior Vice President and Chief Financial Officer; and Tom Deitrich, Executive Vice President and Chief Operating Officer. Following our prepared remarks, we will open the call to take questions using the process the operator described. Before I turn the call over to Philip, let me please remind you of our non-GAAP financial presentation and our safe harbor statement. Our earnings release and financial presentation include non-GAAP financial information that we believe enhances the overall understanding of our current and future performance. Reconciliations of differences between GAAP and non-GAAP financial measures are available on our earnings release and on our Investor Relations website. 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 and the comments made during this conference call, in the Risk Factors section of our Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements. Now please turn to Page 4 in the presentation, and I'll turn the call over to our CEO, Philip Mezey.

Thank you, Ken. Good afternoon, everyone, and thanks for joining us. We are pleased to announce an exceptionally strong second quarter. With higher-than-anticipated customer demand in our network solutions segment, combined with improved operating performance, we are well positioned as we exit the first half of 2019. You'll hear the details from Joan in a moment, but to highlight our Q2 2019 performance, revenue was $635 million, adjusted EBITDA was $73 million, non-GAAP EPS of $0.87 and free cash flow of $38 million. These results capped off a strong first half performance. As a result, we are raising both our revenue and non-GAAP EPS guidance for 2019. Turning to Slide 5. I'd like to give some color on our sales performance in the second quarter. Our total backlog at the end of the quarter increased sequentially to $3.1 billion and our 12-month backlog was $1.4 billion. Our bookings in Q2 were $702 million, and we continue to see robust customer demand with a very strong pipeline. An example of this quarter's bookings is the recently announced signing of Liberty Utilities. This will be a multiyear project that will deploy over 800,000 endpoints of our OpenWay Riva Solution, spanning across their 40 utilities in 13 states. While bookings levels vary quarter-to-quarter, we are on track to achieve a book-to-bill ratio of approximately 1:1 for 2019. As discussed at our recent Investor Day, we've been making strong progress on our operational initiatives. Our supply chain optimization strategy is well underway, and our execution is improving as demonstrated by this quarter's results. While our component costs and inventory remain at elevated levels, we continue to see an easing in the supply chain constraints as the number of components with lead times over 6 months has decreased over 60% since its peak in 2018. We are making progress on several initiatives to reduce component costs, and the transformation of our manufacturing footprint is well underway. Our supply chain transformation, combined with improving external conditions, leave us well positioned to achieve our long-term gross margin targets and improve our ability to meet our customer commitments. The results of these efforts, combined with strong customer demand, contributed to the better-than-expected first half results. I'll now hand the call off to Joan to discuss full Q2 results and our revised 2019 guidance.

Thank you, Philip. We are very pleased with our second quarter and first half of 2019 performance. A summary of consolidated GAAP results is shown on Slide 6 and non-GAAP results are shown on Slide 7. Revenue of $635 million increased 8% versus last year driven by strength in our Networked Solutions and Outcomes segments in the North American market. Q2 gross margin was 30.1%, flat versus last year due to product mix, increased variable compensation, higher supply chain costs and other onetime charges. As a reminder, the second quarter of last year was when the global supply chain constraints began to negatively impact our financial results. In addition, we booked a onetime benefit from a decrease in variable compensation last year, both of which impacted year-over-year comparisons. Moving to earnings per share. GAAP net income was $19 million or $0.49 per share compared with net income of $3 million or $0.07 per share in the prior year. Regarding our non-GAAP metrics. Non-GAAP operating income was $63 million, up 43% from the prior year due to the higher revenue fall-through and lower operating expenses. Operating expenses were down year-over-year primarily due to the benefits from restructuring and delayed spending associated with the CEO leadership transition. Adjusted EBITDA was $73 million or 11.5% of revenue. Non-GAAP net income for the quarter was $35 million or $0.87 per diluted share compared with $21 million or $0.51 per share in 2018. Now turning to the second quarter year-over-year revenue bridge on Slide 8. Total company revenue grew 8% or 11% on a constant currency basis. Our improved performance was driven by both the Networked Solutions and Outcomes businesses performing ahead of our expectations, in part due to accelerated customer deployments. Their growth offset the expected decline in our Device Solutions segment, which was…

Thank you, Joan. As Joan mentioned, we're working hard to continue the momentum into the back half of the year. We are mindful of our near-term operational commitments, and we'll continue to consistently challenge ourselves to improve and accelerate value creation for all of our stakeholders. As we announced, I will be retiring from Itron as President and CEO effective tomorrow, August 6. There are no words to describe how extremely grateful I have been for my time with Itron and the support I have received from our customers, our employees and our shareholders over the years. It's been my privilege to work with so many talented people. My decision to move on is in no way a reflection of the immense opportunity that Itron has before it, as I truly believe that Itron's brightest and most innovative days are ahead. Itron is not about any one person, it's a company with a vision and a team dedicated to creating a more resourceful world. I'll look back with pride at the accomplishments we've achieved together, and I am excited about the future. Now it is my pleasure to congratulate and introduce Tom Deitrich on being named my successor as President and Chief Executive Officer.

Thank you, Philip. It has been a great journey and I've enjoyed working for you for these past 4 years. This is indeed Philip's last earnings call at Itron as CEO, and I would like to take a moment to thank him for all that he has done for almost 20 years for our industry and for our company, and most importantly, for our time together as my mentor. Philip has worked hard to build relationships with our employees, customers, analysts and investors with the utmost sincerity and integrity. I can only hope to build upon what you have started, Philip. It is my pleasure on behalf of over 8,000 employees and partners around the globe and our Board of Directors to thank Philip and wish him all the best in his future endeavors. Thank you, Philip. Before we move on to Q&A, I would like to share the progress in our journey, remind you of our priorities and highlight my initial focus areas as CEO. To start, I am honored to be leading our team of talented and hard-working employees here at Itron. During the past 4 years, we have been working to architect the company's innovation and product strategy, reoriented our company's go-to-market and manufacturing footprint and realigned our structure to better serve our customers through our solutions-oriented business units of Outcomes, Network Devices and Device Solutions. As we have discussed at our recent Investor Day, our company priorities are clear, and these priorities are unchanged with my appointment. We are working diligently with our customers to grow our business in 3 unique ways: first, to expand our footprint of connected devices; second, to expand our value by empowering our customers with solutions and software that allow them to achieve their desired outcome; and third, to expand our…

[Operator Instructions]. And our first question will come from Chip Moore with Canaccord Genuity.

Philip, I wanted to say thanks for all the help over the years, to start.

Thank you, Chip. Thanks.

I guess first, just your comment on customer demand in the pipeline. It sounded like you're seeing a bit of a pickup. Maybe you can expand on what you're seeing out there.

Sure, Chip. Tom here. I can take that one. What we see is a continuation of strong demand, robust flow of deal opportunities in North America. The types of deals that we see out there tend to be solution oriented. They tend to value higher-value applications from our point of view. So it's more than just an AMI application, but really starting to think about what more you might be able to do with the network and the solution that's out there. So North America, clearly, would be a big region for us and a strong deal flow. APAC is a bit smaller region for us, but we also see good and robust demand for Networked Solutions as well as device-oriented types of things. In Europe, it tends to be a bit of a mixed bag from country to country. It's a big region, but there's still good opportunities primarily in the Device Solutions space for us in Europe. So that being a quick march around the globe is really what we see on the part of the customers.

Got it. That's helpful. And maybe for you, Joan, when you talk about some of the acceleration in deployments, how should we think about, I guess, the magnitude of that sequential decline in Q4 from Q3? And then any more color you can give us on the segments.

Yes. I would say that the estimated range of -- and I would talk second half accelerating into first half is about $25 million to $30 million of revenues. So it's fairly sizable. The segments are primarily Networked Solutions and maybe a little bit of Outcomes. So decent margin as well. And so that really helps explain the EPS first half to second half trend as well.

Great. That's helpful. And maybe one last one. I think you mentioned that book-and-ship problems in Europe seem to have abated. Do you think those issues are behind you now?

I do, Chip. Tom here again. I think that we've seen a pretty consistent improvement in the supply chain environment over the last couple of quarters. That's reflected in the results that you've seen. We also -- you can also see it in our inventory numbers as we've built up a bit of inventory to make sure we're well positioned as things can ebb and flow and naturally will as we go forward in time. But we're feeling much better about it. From the peak of the lead time issues that we had last year where we were leaving some revenue on the table, it's improved substantially from that point. We're down probably 60% or more in terms of the components that have that really long lead time as the metric that we use to communicate the improvement, but we see a good supply chain environment for the back half of this year as well.

And certainly, that's part of when we're able to raise the revenue guidance, $75 million at the midpoint, is because of our increased execution on book-and-ship business.

Great. Okay. Congrats, Tom. And Philip, thank you and good luck.

Thanks, Chip. Thank you.

Thanks, Chip.

Our next question will come from Noah Kaye with Oppenheimer.

Philip, we wish you well on the next phase of your journey. It's been a pleasure. And, of course, Tom, congratulations on becoming CEO.

Thanks, Noah.

I would like to ask a couple of questions to start with around margins. Joan, I think you called out lower incentive comp year-over-year as a headwind. You also mentioned, obviously, the components costs. But you had some favorable trends in terms of higher Networks and Outcomes growth, and then you also called out the mix impact from maybe a little bit better Devices. So maybe it would just be helpful for us if we can kind of understand the main components and any bridging you can do on the gross margin line to basically understand how we get kind of flattish gross margin.

Yes. So let me clarify a little bit. So the variable comp comments I made actually is increased variable comp year-over-year, not declining variable comp. So that serves to put a little bit of pressure on the margins. The Device margins year-over-year are actually down. And so that is part of the issue. But I would say product mix -- tariffs are in the equation this year. So this time last year, it wouldn't have any tariffs. Tariffs run anywhere from $2 million to $3 million a quarter. So that's certainly one of the items as well. And again, there's going to be some natural ebbs and flows to the margins. The important point, I think, is that we remain confident that we'll hit the 32% exit rate in Q4.

Okay. And how much roughly was that variable comp as a headwind?

Yes. We haven't really given that number out, Noah. If you recall, last year, we talked about benefits of having a reverse in variable comps. So the year-over-year impact was somewhat exacerbated because we had actually negative last year and a positive this year. But it was all around our overall performance last year versus where we expect to be this year relative to variable comp.

Okay. And so looking forward here, this is the second quarter in a row you pointed to 32% margin as an exit rate, you said exit rate for 4Q. I mean as you look at the mix of what you're booking, the improving components situation and obviously some of the cost initiatives that you're putting in place, is that sustainable? Or can you improve on it in '20? Just at high level how to think about that because, obviously, you've laid out some longer-term targets here. We're just trying to understand, is this 32% kind of the right level to start building off of for 2020?

Yes, I think so. I mean as you said, we've reiterated the 32% now. This is probably the third call, and we still feel confident based on our backlog and what's coming into the quarters. And certainly, we expect to improve from there. So while we didn't give 2020 guidance at the Investor Day, we gave 2021 guidance, and we expect the margins to continue to improve from '19 to '20 to '21.

Okay. And just obviously, it's -- you called out tariffs. Is there any incremental tariff impact from what was announced via tweet this past Friday?

Yes. Very difficult to fully assess it, the policy by that level of details is difficult. What we see thus far without having full clarity into it is the things that seem to be coming in the September time frame are much more consumer goods, household goods, not related to our segment at all. So we don't expect it to be material in terms of our guidance for the rest of the year. Please remember that our attack surface, if you will, is relatively small here, the amount of business we do in China and any manufacturing we do in China tends to be for that region. We do buy components from China, which is where we have seen impacts, which was that $2 million to $3 million per quarter that Joan previously mentioned. So I don't expect that it gets much worse, but difficult to know based on the level of information available today. And as you're keenly aware, it's a very active negotiating environment between the U.S. and China. So it's something that we'll have to continue to watch and mitigate as we go forward.

Next we'll take a question from Joseph Osha from JMP Securities.

This is actually Hilary on for Joe Osha. Join the train in today, I wish you a very happy retirement, Philip.

Thank you.

So just, first, you kind of touched on it earlier about the supply chain optimization. I was just wondering if you could provide a little more detail for where we stand on some of the initiatives that are driving that improvement?

I'll start and pass it to Joan perhaps for another comment or 2. But when we started some of the activities back in 2016, we focused initially on reforming our supply chain in North America. That is essentially behind us now, and we're into some minor optimization around that. We still are in the midst of some of the initiatives that we announced in the 2018 plan, which affect more on our European side of the operation where we have some factories that are in transition over that period. So overall, in terms of optimizing our supply chain, I would say we're in the middle innings of that type of ballgame with more to go specifically on the European side, which we started with our 2018 plan.

Yes. I was going to say, if you look at the chart, we described as opportunity beyond 2021 at Investor Day, we gave you a little feel for kind of what inning we're in for the various initiatives. And as Tom said, kind of middle innings for rationalization of manufacturing service; overall supply chain, probably even earlier innings, so there's a lot of opportunity even beyond the 2021 estimates that we provided at Investor Day by continuing on these initiatives.

Okay. Great. And then when you're looking at the opportunity with the water meters, I was as wondering if there was any progress you could share, conversations you're having and when we might see that become a more meaningful opportunity.

Sure. The water meter that was referenced there in your question, I think, was a static water meter, which we have had in our European portfolio for several years now, and we'll continue to proliferate that into the marketplace with different sizes and in different market opportunities. We are in customer pilots and testing on the North American version of that meter. And depending on how that goes, I would expect that to really be part of our stronger offering as we look into the 2020 kind of time frame. So in testing consistent with what we've said before and ramping into a meaningful product in the 2020 kind of time frame.

Next we'll go to Robert McCarthy with Stephens Inc.

Well, congratulations, Philip, on a great career. First question is maybe you could just talk a little bit -- I think you did not want to give as the kind of GAAP reconciliation here, but what items within the GAAP reconciliation can you give? And where is the biggest variable? Was it around restructuring? Where are the biggest kind of puts and takes?

So our press release should be out on the wire. In the very last page of the press release is a reconciliation of GAAP to non-GAAP. But as you say, it's amortization, it's any restructuring type payments. Those are probably the big ones. And we didn't really have any new restructuring charges of any sort this quarter, so it's primarily the amortization.

Okay. And then in terms of your backlog, I mean is there anything you'd comment in terms of your existing backlog in terms of better mix, worst mix, how we should be thinking about that going forward? Clearly, obviously, you must be somewhat confident given the exit rate for gross margin in the back half, but I just wanted to get any kind of color around that.

Sure. So our total backlog runs $3.1 billion or so. So above $3 billion -- the amount that is in the next 12 months is roughly $1.4 billion. The makeup of that is roughly 2/3 to 1/3, 2/3 being the Network and the Outcomes segment of the business. Because of the way customers buy and the way our backlog system works, that's majority North American types of business. So as you know, our Outcomes and Networks business tends to have slightly higher gross margins or materially higher gross margins than the Device business, and that gives us visibility into the revenue as well as the margin mix that's coming ahead of us.

And finally, just for general edification, given the blackout we saw in New York and obviously in the headlines in the early part of July, is there any learnings or market opportunity or awareness for you that you withdraw from that incident?

Oh, oh, okay. There was some echo on the line. I had some trouble hearing you. So anything we learned from that? I would say that it only increases the market need for the types of solutions that we provide, the more evidence we see of other external factors out there, the importance of resiliency and reliability of the grid is higher, which is a lot of what we are focused on with our distribution, automation and other offerings is a way that we can help our customers solve some of those problems and be more robust in the face of those types of things. That doesn't mean the specific New York case was anything really target point on to our products or services, but more just a general market need. And we see acceleration in that segment of our business, and we're pleased to be able to help our customers with it.

Our next question will come from David Katter with Baird.

Mine might have been answered, but maybe 1 more on tariffs. I think you guys at the beginning of the year previously estimated a $0.15 impact year-over-year EPS from tariffs. I was just wondering how that has changed and what's embedded in kind of your revised guidance that you guys just provided.

Yes. I'll take that, David. And just so -- you're actually cutting up a little bit. So I think the question was how does our current view of tariffs in the current guidance compared to what we expected at the beginning, and I'd say it's basically the same.

Got it. That's perfect. And then one more on kind of the sequential progression in gross margin. Are you expecting improvement every quarter from here out? Or is that going to be kind of a step increase to get there at the end of the year in Q4 based on your backlog?

Well, again, we gave the expectation for Q4 exit rate of 32%. I would say that it's not the type of business that's going to be sequentially every quarter a little bit better. As you saw this quarter, you can have customer projects move based on customer needs. And so if a lot of projects in the Network to our Outcomes segment move, they tend to bring higher margins with it; or if they push out, the opposite effect. So we expect to continue to grow and improve gross margin every year. But quarter-to-quarter, there could be some variability.

Got it. And also congratulations, Philip.

Thank you, David.

Our next question will come from Jeff Osborne with Cowen and Company.

Best of luck, Philip. A couple of quick questions here. Maybe, Joan, starting with you. Can you just give us an update of where you are on the restructuring process and how much is left? I think last time, it was $70 million or $75 million to go and an equal split between COGS and OpEx, but I might have my figures wrong.

Yes. At Investor Day, there's actually a slide in the deck that we gave a more precise color, but you're right around the overall savings of about $140 million. Roughly half had been achieved entering this year and the remainder will be primarily in 2019 and 2020, so basically no different. I would say if anything's changed in the last quarter, it might be that the Silver Spring stuff is accelerating even more. So we hope to be done with most of Silver Spring by the end of this year.

Remind me, is the bulk of the Silver Spring side on the G&A or in COGS?

It's both. It's actually not just G&A. It could be in R&D side as well. It's across OpEx and COGS. I'd say most of Silver Spring was OpEx. And again, half of it was achieved in the 2018 P&L. So initially, we expect it -- some of it to trickle into 2020, and there might still be a little bit -- most will be complete by the end of '19.

Got it. That's helpful. And you gave a lot of detail about the leverage targets for '21 at the Analyst Day. But just given the down second half and '19 versus the first half, is there any comments or perspective you can offer in terms of the cash flow outlook for the second half? Any onetime items we should consider? Just general thoughts would be helpful.

No. And again, I would try to give a little color around the sequential first half to second half because it's really related to the timing of customer projects that got accelerated. So no issues at all on cash flow. As our EPS guidance went up a little bit, I'd expect our cash flow to actually be a little higher than this year than what we originally talked about.

Got it. And then for anyone there, can you just remind us what the typical book-and-ship business is for you folks? You mentioned that part of the upside was book and ship, I assume, for Networking, but maybe it was for Devices. Just put that in perspective would be helpful.

Go ahead, Tom. Go ahead.

We have book-and-ship business that shows up in both the Device business as well as on the Networked Solutions side of things. Book and ship is probably something in the order of about 40% of our total business, and that's across both of those PBUs. So in general, we did well on the book-and-ship side of things. No particular concerns with fulfilling the revenue based on the supply chain situation.

It's good to hear. Two other quick ones, if you don't mind. You mentioned that working margins were down year-over-year because of mix. Can you just give us an example of what some of the mix challenges are?

Yes. It's more of a customer mix issue just in terms of what deployments we may have had last year versus this year that's primarily the issue.

Got it. And then how should we think about your exposure to Brexit and the U.K. in particular? I think a quarter or two ago, you talked about a SMETS 2 meter being qualified. My assumption is it's a pretty small piece of total revenue, and you probably scrubbed that pretty hard for the updated guidance. But just wanted to put in perspective as you talked about -- I think if I heard you right, Europe was a little bit softer this quarter and North America was a strength. But what's the outlook for the U.K. in particular?

Indeed, the U.K. is a relatively small part of our business. And we've tried to contemplate what would happen with Brexit around the U.K., and that's contained within our guidance. But know that it's not a particularly material difference for us one way or the other. We tend to have a fair amount of recurring revenue types of business there that's contained within the U.K. There are some products in meters that are shipped in which, again, you could get caught up in a little bit of slowdown around the border depending on how that would work. But again, contained within our guidance and relatively small for us in the grand scheme of things.

Makes sense, Tom. And then was the softness in Europe this quarter more France-related? Or any perspective as to geography given the strength in North America? I'm just trying to put a -- get a better sense of the exposure to Europe and what's the underlying fundamentals are for you folks.

Sure. So if I put some color behind the EMEA region in general, the biggest portion of that is indeed the big economies in Western Europe. We have some pretty big exposure to France and Germany. We expected things to start to slow down there just because of where the deployments are in terms of their life cycle. And indeed, that is indeed what we saw happening. The broader base things that we do in more like the traditional water area of the market was actually quite strong and quite okay for us compared to our expectations. So I think of it as more smart spec meters in the large-scale Western European economies, France and Germany related.

And again, those were not unexpected. If you go back to our Q4 call when we talked about 2019 guidance, we specifically talked about the ending of some customer projects particularly in France.

Next we'll take a question from Pavel Molchanov with Raymond James.

In the cash, debt and liquidity slide, you specifically called out $500 million revolving credit facility, but of course, you're in the process of paying down debt rather than taking on more. So I'm curious, should we read that as a sign that you're open to additional M&A opportunities or anything along those lines?

No. Our capital allocation strategy is no different than what we talked about at Investor Day. It's to pay down the debt and delever. We just wanted to point out that obviously having that treasure chest there, if you had to go -- opportunity for cash leaves us in a good position.

Okay. Okay. Clear. And then it's kind of a minor housekeeping item, I suppose. But tax rate always bounces up and down, obviously, quarter-to-quarter. I know you've historically talked about something in the low 30s as the blended average for the company, kind of steady state. Is that still the case for the second half of the year?

Yes. Well, it will be a little bit higher in the second half since we're projecting the 31% for the full year. And so the first half was, particularly the second quarter, was a little bit lower than that. But for the full year, it's the same -- the 31% is the same one that we originally guided to back in February.

Okay. Well Q1 tax rate was over 100% on a GAAP basis.

On a GAAP basis, yes. I apologize, Pavel. The 31% is a non-GAAP rate and the 28.5% that I quoted is the non-GAAP.

That does conclude our question-and-answer session. At this time, I'll turn the conference back over to Tom Deitrich for closing remarks.

Great. Thank you, Melissa. Thank you, everyone, for joining the call today. We feel good about our start to the year. And what I think you should expect going forward is our strategy remains unchanged, our focus on our customers and improving our business remains unchanged as we step forward. And we look forward to updating you in the next quarter's call. Thank you very much.

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 1-719-457-0820 with the passcode of 7922157 or go to the company's website, www.itron.com. That does conclude our conference for today. Thank you for your participation.