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July 24, 2000
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Q2, ad nauseum
Okay, this turned out to be long. Sorry. Skimming is your friend. Come to think of it, the Next button may be your friend. Instead of reading all of this, I recommend you just listen to the call [direct RealAudio download of Echelon Q2 conference call].
The Q2 numbers looked slightly worse than I expected. Excluding the $400K in ENEL negotiation/moving expenses, EPS was basically on target at (0.00). I'm not a big fan of excluding one time charges, and I would actually prefer that blockbuster contract negotiations become a recurring expense, but I want to stress that a cent or two a share at this stage is really immaterial. The market, in all its efficiency, can react interestingly, but a few hundred thousand dollars in net income has little impact on a the present value of future cash flows. Don't be a sucker for the consensus game (in fact, I congratulate Echelon on not segregating the ENEL expenses on the income statement).
Revenue growth was a bit lower than I'd hoped for, though in line with company guidance. I suspect that early i.Lon sales haven't blown away expectations, but have still be successful (I admit, I held out a bit of hope for the former). Gross margins were excellent, while R&D jumped a bit. Inventory turns, in line with previous guidance, continue their descent, down to 3.3. On the call, Chris said that turns should stabilize around current levels. Enough about the 3 month P&L and balance sheet...
The conference call, which unlike last quarter was hosted by Ken Oshman, is absolutely required listening for would be investors. I had to cringe a few times at some of the questions, but Oshman more than suffered them gladly. He cleared up a lot of confusion about Echelon's position in the control networks industry; basically, he taught class. There was no RS analyst on the call (or none asked questions), but John Todd from Thomas Weisel was on.
Chris gave some serious guidance going forward. Q3 revenue estimate is $12.4 million +/- $900K (how often does company guidance include estimation risk?), with flat operating expenses sans the non-recurring charges. Small net profit expected for Q3, but that includes expected interest income from the ENEL investment (deal should close in August - HSR filings this month). Judging from this guidance, I think it's possible that operating income is negative in Q3, which would be below my previous expectations. Echelon also expects a small profit in Q4, but that will be mitigated by a 6-8% in operating expenses stemming from ENEL ramp up, including a move to reduce long term product development costs for ENEL inventory.
Further down the road, Echelon expects to see $40 million +/- $10 million of ENEL revenues in 2001, with the bulk of it coming in the second half. 2001 will also see continued increased operating spending, including sales and marketing costs. Still, the company expects to be profitable in every quarter of 2001, with most of the benefit of the ENEL deal emerging in 2002. The worst news delivered in the CC, in my opinion, was that ENEL gross margins are going to be substantially lower than the base business, and 2001 gross margins should decline 7-10%. Although I'm not through with my model, I think $110 million might be reasonable benchmark for 2001 revenue at this point. No for the good stuff from Dr. Oshman.
Enel will install Lonworks network is basically every home (27 million) in Italy. Initially, the network will allow Enel to (1) Read meters remotely (2) Remotely turn power on and off at will (3) Do a limited amount of demand side management (usage rationing and control). They'll manage it all from five locations throughout Italy, and expects to earn back its investment in three years. The next step, should ENEL take it, would be to offer additional device networking functionality to customers (after adding a gateway). Those additional, potential services include (1) Remote diagnostics and upgrades for connected devices (2) Network management to home automation (3) Security management.
What will Echelon sell to Enel?
Echelon power-line transceivers will provide network connectivity in each meter in each home, Echelon concentrators will then collect information from 75-100 homes that share a distribution transformer and transmit it to Enel's headend, where Echelon's LNS software will manage the network. Oshman pointed out the LNS was maybe the biggest factor in securing the contract for Echelon, allowing an interface for controlling an entire network which can scale to 27 million houses. No other solution, according to Oshman, offers anything similar. Finally, Echelon may eventually sell a gateway from the meter to other devices in the home, if Enel wants to become the master of the home network. Though he didn't elaborate on that gateway, it's fair to say that IP connectivity would involve an i.Lon server, and that inter-medium connectivity could involve Echelon routers.
Two side benefits of the Enel Contract
Outside of the direct revenue benefits, Oshman (really) emphasized the increased market opportunity that this major contract may incite, in two ways. First, device makers - like the refrigerator, lamp, alarm, toaster, and washing machine type manufacturers - suddenly have an economic justification for making Lon-enabled products. This is particularly important for converting low margin, low risk manufacturers who have historically been reluctant to undertake the switching costs of new technology. ELON can then turn around and sell hardware and software to the manufacturers. This is a prototypical example of application driven network effects, where increased customer penetration increases the value in making applications for the standard, and the resultant increased application availability feed back to create more value for customers.
The second peripheral benefit from the Enel deal is that it provides visibility for not only other power providers, but for telcos, cable and service providers for the idea that Lonworks can be implemented on a massive and provide cost savings and functionality right now. An aside to this, which Oshman didn't mention, is the implication that any one of the aforementioned service providers can become a first mover in this space and take control of the home device network, so even the monopolies might want to move quickly. This benefit is also part of what I would see as Oshman's ongoing open letter to AOL, requesting politely that they get with the program.
More Contracts: Information and Insinuation
Oshman gave some straightforward information about business developments, claiming that they are "very busy" with "a lot of interest from a wide variety of companies." Both Echelon and Enel are talking to a number of electric utilities (note here, that ENEL really seems to be working to exploit its real options from being an earlier adopter. Taking equity, a board spot, and now looking to expand its role in Lonworks implementation to other electric companies are sure signs). Echelon has also stepped up talks with a number of telcos because, supposedly, they now know it's doable. With regard to the North American market, Oshman said they were "working NDA (non disclosure agreement) with a very large partner" and that "it will happen in North America." He also pointed out that recent brown outs could have been avoided with Lonworks networks in place, and that the players all know it. Now for the hints.
-Someone asked whether anything was brewing with IBM, and Oshman said there was "nothing further publicly I could say about relationship with IBM." That's a bit different that simply "no comment." We want Home Director, baby.
-Someone said they'd heard that AT&T left Lonworks for emWare (which is wrong, T joined EMIT, but is also a Lonworld gold sponsor, the Gorillas play all their cards simultaneously in this space) and in correcting him, Oshman blurted out that ELON's recent press release about T clearly shows that� what's that? We didn't issue that release yet? Oh. Forget it.
-Asked about AOL: "We don't comment on anything that we don't announce."
Oshman on the Competition
Oshman explained in depth how Bluetooth differs from Echelon, in that Lonworks is a control application, while Bluetooth is a communication network (primarily for the data network), and not an application at all. Echelon uses IP as its communications medium, but could easily use Bluetooth, also. Oshman forgot that ELON was on the Bluetooth consortium.
He basically dismissed Microsoft's SCP initiative, acknowledging that it appears competitive and that it was wise to be paranoid, but called CEBus "listless" and seemed more worried about marketplace confusion than actual competition. The problem, he implied, is that companies like Microsoft who are not direct control networking players are more than happy to try and set up a free standard (sound like Internet Explorer?) on which they can leverage their own interest (UPnP), but that control networks aren't merely about standards, but about end to end application solutions.
Conclusions and Comments
The numbers, including the Q3 and Q4 and 2001 guidance, were all a bit below my optimistic expectations. Inventory management may become a challenge as turns dropped a bit more than I expected, and Enel gross margins will not be what I expected. The business, on the other hand, took a major step this quarter along the technology adoption life cycle, with a massive roll out of product. Oshman sounded genuinely enthusiastic - actually, festive - about business developments and future prospects. Echelon will have to manage significant revenue growth in the next few years while continuing to pound the pavement for increased adoption, but I think they feel like they've finally gained some momentum in the stubborn control and device market. As Oshman said, "I haven't sold a share."
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