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Edited Transcript of ITRI earnings conference call or presentation 27-Feb-19 10:00pm GMT

Q4 2018 Itron Inc Earnings Call

LIBERTY LAKE Mar 4, 2019 (Thomson StreetEvents) -- Edited Transcript of Itron Inc earnings conference call or presentation Wednesday, February 27, 2019 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joan S. Hooper

Itron, Inc. - Senior VP & CFO

* Kenneth P. Gianella

Itron, Inc. - VP of IR

* Philip C. Mezey

Itron, Inc. - President, CEO & Director

* Thomas L. Deitrich

Itron, Inc. - Executive VP & COO

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Conference Call Participants

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* Chip Moore

Canaccord Genuity Limited, Research Division - Senior Associate

* David Francis Katter

Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst

* Jeffrey David Osborne

Cowen and Company, LLC, Research Division - MD & Senior Research Analyst

* Joseph Amil Osha

JMP Securities LLC, Research Division - MD & Senior Research Analyst

* Noah Duke Kaye

Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst

* Pavel S. Molchanov

Raymond James & Associates, Inc., Research Division - Energy Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Itron, Inc. Year-end and Q4 2018 Earnings Conference Call. Today's call is being recorded. For opening remarks and introductions, I would like to hand things over to Mr. Ken Gianella. Please go ahead, sir.

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Kenneth P. Gianella, Itron, Inc. - VP of IR [2]

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Thank you, operator. Good afternoon, and welcome to Itron's Fourth Quarter 2018 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 our 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, please let me 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 in 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, the comments made during this conference call and 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.

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [3]

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Thank you, Ken. Good afternoon, and thank you for joining us. We have a lot to cover today, so let's get started.

We ended 2018 with Q4 performance as expected while also operating our first full quarter under our new segments of Device Solutions, Networked Solutions and Outcomes. You will hear details from Joan in a moment. But to highlight our Q4 2018 performance, revenue was $587 million; adjusted EBITDA was $59 million; adjusted non-GAAP EPS at $0.88 was above our guidance due to onetime favorable tax items; and we had another strong quarter of free cash flow performance of $25 million. Customer pipeline continues to be healthy with a Q4 book-to-bill ratio of just over 1.3:1. We ended 2018 with a book-to-bill ratio of greater than 1:1.

Our total backlog at the end of the year was a record $3.17 billion, and our 12-month backlog was $1.35 billion.

As I reflect on this past year, while we made tremendous progress in many areas of the business, we also had mixed financial results. We encountered unexpected headwinds both internal and external in our supply chain, which resulted in lower revenue and profitability than we expected.

In terms of strategy execution, we gained strong market momentum, which will lead to long-term value for our customers and our investors.

First, we strengthened our position as the industrial Internet of Things leader in the smart energy and smart city space with the acquisition of Silver Spring Networks. This acquisition allowed us to extend our software and services capability, deeper end solutions such as distribution automation and smart street lighting. By expanding our product portfolio, this allows us to offer our customers end-to-end support in navigating the evolving complexity of their business environment.

As a combined company, we have delivered over 200 million 1- and 2-way communicating endpoints with over 60 million under our active management. We are one of the largest providers of connected streetlights and have some of the largest cellular deployments for advanced metering, making us one of the largest industrial IoT companies in the world.

To strengthen our leadership position long term, we introduced the technology road map that merges 2 world-class networks and leaves no customer behind. Our customers will have the ability to securely and efficiently manage the proliferation of devices, sensors and intelligent endpoints, all on our platform.

We worked with partners to increase our reach through network standards like Wi-SUN, NB-IoT, 5G and other transport technologies to ensure seamless operational capabilities for our customers.

We continue to prioritize organic investments that will drive higher margin software and services deeper into our footprint of connected devices. These efforts will enable our customers to successfully manage their operations, information and consumer engagement needs for decades to come.

Finally, we are laser-focused on our commitment to expanding gross margins and executing on our operational cost improvements. We made tremendous strides on our committed restructuring and integration plans by achieving over $70 million in cumulative savings through the end of 2018. And we expect to deliver the full $140 million in cumulative savings by 2020. We are pleased with the progress on our strategy and look forward to the year ahead.

I will now hand off to Joan to discuss the full Q4 results and our 2019 guidance.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [4]

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Thank you, Philip. Before I discuss our fourth quarter results, let me remind you that this is our first quarter reporting under the realigned business segments of Device Solutions, Networked Solutions and Outcomes. We held an informational call on February 21 to review historical results for these new segments. As Philip mentioned, fourth quarter results were in line with our expectations. A summary of consolidated GAAP results is shown on Slide 7 and non-GAAP results are shown on Slide 8.

Revenue of $587 million increased 7% versus last year, driven by strong performance in the Networked Solutions segment and the acquisition of Silver Spring Networks. Fourth quarter gross margin of 30.1% was lower than last year, primarily due to a special -- higher special warranty costs in 2018.

Moving to earnings per share. Fourth quarter GAAP net income was $24 million or $0.60 per diluted share compared with $2 million or $0.05 last year. You may recall Q4 2017 results included a onetime tax charge related to the newly enacted U.S. tax reform legislation. Regarding non-GAAP metrics, adjusted EBITDA was $59 million or 10% of revenue. Non-GAAP net income for the quarter was $35 million or $0.88 per diluted share compared with $40 million or $1.01 per share in 2017. A lower 2018 effective tax rate contributed a $0.22 per share year-over-year EPS increase.

Free cash flow was $25 million in the fourth quarter, lower than the prior year primarily due to the timing of working capital as well as restructuring and acquisition-related outflows. Cash equivalents and restricted cash at the end of the fourth quarter was $122 million, up $11 million from Q3.

Turning to Slide 9. Total debt decreased slightly from Q3 to just over $1 billion, following further payments on the revolving credit facility and the required principal payments on the term loan. The balance sheet remains flexible with net leverage of 3.9x and our operations continue to generate positive free cash flow.

Now turning to the fourth quarter year-over-year revenue bridge on Slide 10. Total company revenue grew by 7% or 9% on a constant currency basis. Device Solutions revenue was down 5% as reported and flat in constant currency. Networked Solutions revenue grew 21% in constant currency, driven by continued strength in North America on smart energy deployments. Outcomes revenue was down 6% in constant currency due to lower EMEA business and the completion of onetime software deployments in the prior year.

The non-GAAP year-over-year EPS bridge is on Slide 11. Q4 non-GAAP EPS was $0.88 per diluted share compared with $1.01 in the prior year. Net operational improvement contributed to a $0.04 per share year-over-year increase after normalizing for higher special warranty expense, which had a negative $0.22 per share impact year-over-year.

Higher interest expense from debt used to finance the acquisition of Silver Spring Networks decreased EPS by $0.17 versus last year.

Partially offsetting these expenses was a lower 2018 non-GAAP tax rate, which benefited EPS by $0.22 year-over-year. The lower rate was driven by onetime favorable discrete tax items booked in Q4. We do not expect these discrete tax benefits to continue in future quarters.

Slides 12 through 14 show results by business segment for the fourth quarter. Device Solutions revenue was $228 million on gross margin of 16.9% and operating margin of 11.1%. The lower 2018 margin was driven by higher special warranty expense as well as higher component costs, supply chain inefficiencies and product mix.

Networked Solutions revenue was $305 million on gross margin of 40.3%, down slightly year-over-year due to lower OpenWay shipments partially offset by a higher mix of software. Operating margin was 31.1%, down 160 basis points due to lower gross margin and higher product development expense as we invest in the technology road map following the Silver Spring Networks acquisition.

Outcomes revenue was $54 million on gross margin of 28.5%, up 300 basis points year-on-year. The increase was driven by improved scale and the continued integration of Silver Spring Networks. Operating margin improved 590 basis points to 12.3% on the higher gross margin combined with lower operating expenses.

Now before we move on to 2019 guidance, I'd like to normalize our 2018 results to provide a more meaningful comparison to 2019. Turning to Slide 15. We have prepared a bridge that normalizes 2018 revenue and non-GAAP EPS for current FX rates and onetime tax benefits booked in 2018. The FX rate normalization allows us to focus on the operational performance drivers versus year-over-year currency fluctuations. In 2018, our revenue would have been approximately $40 million lower at today's exchange rates, primarily due to the movement in the euro to USD rates. For 2019, we are forecasting a euro to U.S. dollar rate of $1.14 versus the $1.18 realized in 2018. This 2019 forecasted rate is very close to the [27] actual rate for comparison.

On this chart, we also normalized 2018 non-GAAP EPS for onetime discrete tax items. This normalization brings the 2018 effective tax rate to 30% versus the booked rate of 22%. This tax normalization equates to $0.28 per share. So after adjusting 2018 revenue and non-GAAP EPS for the normalized tax rate and forecasted FX rates, revenue reduces to $2.34 billion from $2.38 billion on an FX-adjusted basis, and non-GAAP EPS on an FX and tax adjusted basis is $2.33 per share versus the actual of $2.65. This normalization is important to understand the operational performance embedded in our 2019 guidance.

Now moving on to the 2019 guidance on Slide 16. We anticipate full year revenue to be in the range of $2.35 billion to $2.45 billion and non-GAAP EPS between $2.35 to $2.75 per share. The 2019 revenue guidance is a range of 1% to 5% growth on a constant currency basis or approximately 3% at the midpoint. The revenue guidance assumes nearly double-digit growth in the Networked Solutions and Outcomes segment, partially offset by a high single-digit reduction in the Device Solutions segment. The decline in the Device Solutions segment is attributable to lower EMEA business following a very strong 2018.

The non-GAAP EPS guidance range represents 1% to 18% year-on-year improvement over normalized 2018 performance. At the midpoint, the non-GAAP EPS guidance is 9% normalized year-over-year growth.

Other guidance assumptions are the euro to U.S. dollar foreign currency exchange rate of $1.14 that I just mentioned; average non-GAAP effective tax rate of 31%; total interest expense of approximately $50 million; and average shares outstanding for the full year of 40.65 million.

Turning to Slide 17. We bridged from the normalized 2018 non-GAAP EPS of $2.33 to the midpoint of our 2019 guidance of $2.55 and highlight the key drivers year-over-year. We expect net operational performance to increase year-over-year EPS by $0.46 per share. This category includes the flow-through of the revenue increase I just discussed as well as additional year-over-year benefits from ongoing restructuring programs and acquisition synergies. Partially offsetting this is the addition of variable compensation versus the prior year. We have also assumed an improving supply chain environment in the second half of the year.

To add some color to the gross margin profile over 2019, we expect gross margin in the first half of the year to be in line with our Q4 2018 exit rate of approximately 30%. Looking to the second half of 2019, we anticipate gross margins will improve by 150 to 200 basis points versus the first half from easing of the supply chain constraints and our operational initiatives. All combined, we expect net operational performance improvement of $0.46 per share over our normalized 2018 results.

Moving on to other factors in our guidance. We anticipate a significant increase in projected tariffs in 2019 over 2018 levels. While we are working on our supply chain strategy to reduce the tariff charges, we currently anticipate approximately $0.15 per share of negative year-on-year EPS impact. We will continue to monitor this global situation.

Other key assumptions are the tax rate of 31% in 2019 versus the normalized rate of 30% in 2018 and a year-over-year increase in share count. Combined, these decreased EPS by $0.09 per share year-over-year. The expected 2019 tax rate is slightly higher than 2018 due to jurisdictional mix of income.

We are encouraged by the strong revenue growth in our Networked Solutions and Outcomes segments. And throughout 2019, we will update you on our restructuring progress and margin improvement outlook.

Before I turn the call back to Philip, I'd also like to announce we will be holding an Investor Day on Thursday, June 27 at the NASDAQ Investor Center in New York City. We plan to provide updates on our strategy and market outlook, details on our long-term operating model as well as outlook for each of our realigned business segments, updates in our technology road map and our restructuring efforts. More information on the event will be posted in the coming weeks.

Now I'll turn the call back to Philip.

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [5]

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Thank you, Joan. As Joan discussed, while our Device Solutions business is facing a softer European market, we are very pleased with our bookings momentum in North America where we expect Networked Solutions and the Outcome business units will continue to grow at significant rates in 2019. This will be supported by our record backlog and strong pipeline of upsell and book-and-ship business.

In our guidance, we do see a slight easing in supply chain lead times. Last quarter, we reported over 550 parts with lead times over 6 months, that has now decreased by approximately 14%. While this decrease is promising, we still have a ways to go and are not standing still on our gross margin improvement efforts. We continue to introduce selective price increases, are aggressively targeting lower manufacturing costs and will continue to rotate our business to solutions with higher profit margins.

As Joan mentioned, we have an upcoming Investor Day where we will go deeper into our strategy and outlook for both the company and our new segments. Before we turn it over to Q&A, I wanted to give some insight into our segment realignment strategy and our planned execution for 2019.

Starting with the Device Solutions business, the meters and sensors that we manufacture are a critical part of our customers' infrastructure. Safety and quality continue to be our top priority in delivering products to our customers. With factory optimization and the impact of supply chain headwinds in 2018, we are focused on meeting our customers' demand with improved quality and the prompt delivery of product in 2019.

We will continue to expand the Device Solutions product portfolio with the introduction of new products across our regions, including the release of a new Intelis static meters for our gas and water market, a next-generation prepayment solution for gas and a new electricity meter platform that will serve as the basis for all future development in IEC electric markets globally.

Moving to Networked Solutions. We're excited about the continued growth in our Networked Solutions business in 2019. Combined with our technology road map and planned investments, we will reaffirm our strategy of being the industrial IoT leader in the energy and smart city space. We look to expand product and partnerships, allowing us to support an even greater selection of network devices for sensing, metrology and control. As the demand for smart infrastructure continues to grow, our investment in Riva6, the converged platform of OpenWay Riva and our GEN 5 networks, will position our customers to manage and analyze the proliferation of devices and data for decades to come.

And finally, our Outcomes segment. Outcomes was created from 3 strong assets within the company: Itron's existing solutions, the Distributed Energy Management assets from the former Comverge acquisition and the former Silver Spring Networks Managed Services and Outcomes business.

We are focused on delivering value add services, software and products that organize, analyze and interpret data. With a portfolio of turnkey solutions that range from endpoint management to data analytics, we're excited about the opportunities that lay ahead for our Outcomes business unit.

Over time, we expect Outcomes to be the fastest growing of all of our segments and are still working through efficiencies of scale. We are balancing growth and margin improvement with our customers' experience during the integration of the Comverge and Silver Spring Networks portfolios. We are investing ahead of the growth curve in Outcomes. On future products with higher margins, security and data analytic offerings. This will increase the capabilities for our customers and improve our operating margins for our Outcomes business. By combining our segment strategy with near-term execution on gross margin expansion and free cash flow, we will deliver long-term value for our customers and shareholders.

Thank you. Operator, please open the call to take some questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We'll take the first question today from Chip Moore, Canaccord.

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Chip Moore, Canaccord Genuity Limited, Research Division - Senior Associate [2]

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I appreciate the color you gave on guidance -- on margins in the first half versus the back half, Joan. Maybe -- is there a way to talk about margin progression with the new reporting structure? How should we think about that by segment?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [3]

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Yes, we're not going to provide a specific segment guidance. But I mean, you can get a feel based on looking at historical segment margins, relative contribution. But again, the first half versus second half is more a function of the easing of supply chain as well as some of the restructuring things that we're doing kicking in.

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Chip Moore, Canaccord Genuity Limited, Research Division - Senior Associate [4]

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Got it. And just a follow-up on margin, the special warranty in the quarter, what was going on there? And anything lingering from that to think about into the current quarter?

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [5]

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Chip, this is Tom. I'll take that one. What was behind that was an error that we had made in a product transfer as part of our manufacturing restructuring that was going on. We moved a product from location X to location Y and had some problems in the bring-up. The product that was affected there was time-bound, meaning it was manufactured during a certain period. Since then, we've understood the problem, corrected it and made sure we learned from the mistake going forward. So no overhang expected into 2019.

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Operator [6]

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The next question is Noah Kaye, Oppenheimer.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [7]

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Maybe we can start with the top line. Your comments around Devices being down high single digits and you pointed to EMEA. Is high single-digit decline year-over-year your view of where the market is going to be?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [8]

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No. I'll start and then Tom may want to answer. I would say, no. The market, though, for devices is probably anywhere from 0 to 3% growth, but we had a very strong 2018 with our Linky program in France and some of our other programs. So it's more a function of projects that really ramped up in 2018 and they won't continue into 2019. Tom?

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [9]

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No, I think Joan nailed it. It is more a function of specific project transitions and country-specific rollouts and timing. I don't know that I would reference a full trend based on that.

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [10]

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Noah, the way I would think about that is we -- sorry, Noah, the way we thought about that is in the past, we've talked about the migration from standard meters to smart meters. This is a similar kind of a transition that's occurring over time. It's now just expressed between what we're calling devices and networks.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [11]

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Yes, that makes sense. I guess just a related question for the avoidance of doubt, I mean, last quarter you talked about just not being able to fill some of that book-and-ship business because of the supply constraints. Is that embedded in your guidance? Or is that no longer an issue in your view for '19?

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [12]

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So Noah, Tom here. What we do see is the supply chain environment starting to improve. The thaw is actually happening. It takes a little while to work through. We think the supply chain environment will continue to improve during 2019 and that's reflected in the guidance. So that the revenue overhang, I guess, that we saw back in the back half of last year continues on, although probably at a lower rate in this year but should improve throughout 2019.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [13]

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Okay. And then I guess just turning to -- thinking about the profitability profile of the business. You had a nice, strong bookings number in networks. The backlog looks good exiting the year. Really where you're losing revenue is in that lower-margin Devices business and you're going to see, you said, close to double digits on the other side. And I'm not sure if I'm doing my math right but just taking the midpoint of your guidance or working backwards from the assumptions, I'm coming out to around, call it, $250 million-type EBITDA number implied in the guidance, which is healthy but about a 40 bps margin expansion year-over-year. And I guess I just wanted to understand, you called out tariffs but are there any other considerations that we should be really thinking about as kind of a headwind to profitability in '19? It seems like a little bit slower than we might have looked for.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [14]

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Well, again, if you went to the Slide 17 in the deck that I talked to, the net operational improvement of $0.46 per share has a lot of puts and takes in it. So it has higher revenue and, again, the higher revenue is really going to be coming from Networked Solutions and Outcomes and obviously lower in Devices, had benefit of restructuring in there, but there are some offsets in there. So if you recall, we zeroed out variable comp in 2018, and so we have restored some variable comp in 2019. So that would all be netted out in there as well. As well as just the deal with Silver Spring Business, in particular, there are some general lumpiness when you have projects and software deployments that come in and out. So that's all factored in. We're looking at our backlog, which is quite healthy as you indicated, and we know the profile of the backlog that's going to roll off in 2019, and that's reflected in our guidance as well.

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Noah Duke Kaye, Oppenheimer & Co. Inc., Research Division - Executive Director and Senior Analyst [15]

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That's very helpful. And if I could just squeeze one more in. Just for my own comprehension, I think the tariffs, the incremental headwind. Where are you really expecting that to come from? Is that List 3 China? Can you just give us a little bit of color because I think previously we had sort of seen this as more manageable. So I just wanted to understand how it's playing out for you this year.

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [16]

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Right. It is generally an East-West, not a North-South kind of phenomenon, meaning China-based or Asia-based goods tend to be more affected. The types of commodities that are generally in focus there are metals, so casting types of products as well as cables and connectors. Those are some of the types of things that are in play. Obviously, the environment is pretty fluid, ongoing global discussions probably even as we speak. So it's tough to call but we wanted to make sure we were as transparent as we could be. Clearly, our objective is to mitigate as much of that as possible by working within the rules but finding better ways that we can develop our supply chain to sidestep some of those things. So that's our ongoing mission, but at least I wanted to point out what we saw today.

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Operator [17]

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Next question will come from Jeff Osborne, Cowen and Company.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [18]

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A couple of questions on my end. I was just curious on the philosophy or how you sat down and came up with the guidance. Is any approach, in terms of your top line assumptions, different than years past, more conservative, more aggressive? I'm just curious as you look at backlog, what the philosophy was and if there's any change versus prior years.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [19]

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No. I would say it's a similar process. Obviously, there's new segments so -- this time last year, we would have been integrating Silver Spring when we had our old electric, gas and water in, so there are new segments, so we had to go through the process of recasting history, which we shared last week. But it's the same process. We look at the backlog, we look at the sales models. We obviously talked with the business leaders and come up with what we think is a reasonable range.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [20]

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Got it. And then, Joan, I don't know if you can remind me but when you came up with the 2018 guidance, were some of those nonrecurring tax benefits, were those included and called out? I forget from a year ago.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [21]

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No, but most of the tax benefits that occurred in 2018, most of them occurred in Q4. So if you looked at our Q4 2018 non-GAAP tax rate, it's actually negative 2%. So we had several large settlements of different countries, multiyear tax returns that settled as well as we had some statute of limitations expirations that rolled off at the end of the year. So it was really a Q4 phenomena.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [22]

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Got it. And then is there any way that we can peel back the onion on Slide 17, of the $0.46 in terms of what the benefit is on an absolute dollar basis of restructuring in '19 and '20, in particular '19, I guess, as you have your $140 million program? And then you called out variable comp and how people weren't paid last year but want to be paid this year. What are those 2 numbers in particular, would be helpful.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [23]

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Yes, I'm not going to give you the variable comp. That's a pretty sensitive number. But we have talked about restructuring so I can give you that one. So as Philip mentioned in his opening comments, we've laid out 3 restructuring programs, the 2016, the 2018 and Silver Spring, which totaled about $140 million. We're a little over $70 million, through '18, of that. So there's -- think about it as roughly another $70 million to come, split equally between '19 and '20. And if I look at '19, think about it as equally between above the line and below the line. So roughly $17 million, $18 million in gross margin and $17 million, $18 million in OpEx. And those are embedded in our guidance.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [24]

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And is it safe to say that the variable comp would be the next -- you said there are multiple puts and takes, is restructuring the largest and variable comp the second largest, if you're not wanting to break it out?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [25]

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So no, I mean, the revenue fall-through is quite large as well, right. So we have revenue growth embedded in here as well. So revenue, again, there's lots of different numbers but revenue fall-through is a sizable number, the variable comp add back. You've got mix. You've got all kinds of different things that go -- even merit that was happened late in '18, you get the run rate effect into '19, so there's all kinds of things we have to factor in.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [26]

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And the last one I had was just on the supply chain constraints. Can you talk about specifically what you're doing to mitigate that and give investors comfort for the second half of '19? Has that improved or are you putting cash deposits on future supply or developing or qualifying new suppliers? What -- anything you can give us that is anecdotal or specific would be helpful.

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [27]

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Sure, I can take that one. What we have been doing is a number of activities and you mentioned some of the bigger ones. It is multi-sourcing components to make sure that we can have the best diversity of supply as products roll in. We have been working hard on making sure we have forecast accuracy. We have buffered inventory, so bought more when it was available, and you can see that in our balance sheet today, to try to be prepared. The part of our business that's most exposed here is the book-and-ship business and making sure that we could do our best job to anticipate that and give us diversity of supply. So it's multi-sourcing, it's inventory buffering. It is building ahead on selected products that we had, are really the best medicine and that's what we are indeed seeing and finding a way to better manage the situation. We do see lead times starting to come down. While Philip quoted the number of components that are still more than a 6-month lead time are many hundreds, but it's improved by about 15% quarter-over-quarter in terms of -- and using that as your measure of the health of the supply chain. We do anticipate that it'll take a couple of more quarters for this to fully work its way through but do see steady improvement and better environment for the second half of the year based on the visibility we have today.

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [28]

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And then, Jeff, maybe just a structural comment that says this is an identified plan, many line items and owners that it is administered and reported on very, very regularly. There's quite a lot of structure around the achievement of these improvements.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [29]

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Makes sense. Maybe just a follow-up on that, if you don't mind. So is there a way to potentially -- maybe it wasn't an issue, but some of your competitors have indicated that there was lost revenue in '18. Did you lose any revenue in '18? Or is there anything in the guidance as it relates to losing revenue in '19, as it relates to component issues?

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [30]

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Yes, I mean, we did, on a recent call, actually bring the revenue number down by $70 million and talked about the effect of -- on our -- specifically on our purchase order business, which is sort of shorter cycle within the quarter business, which is what led to providing that number of the 550 parts that are over 6 months to sort of give a feeling for the challenge of capturing some of that business. And through both inventory buffering and the initiative that Thomas talked about, we feel that we've accurately captured in the revenue and margin guidance -- or EPS guidance that we've captured the effects of the supply chain constraints in the numbers provided.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [31]

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Yes, and as Tom indicated, there's still some hangover effect, if you will, on net revenue, probably more so in the first half of the year than the second.

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Jeffrey David Osborne, Cowen and Company, LLC, Research Division - MD & Senior Research Analyst [32]

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And I apologize for squeezing in one last one, if you don't mind. But Joan, the tax benefit that you had in the fourth quarter, that was unforeseen as it relates to the original guidance. So if some of those jurisdictions hadn't showed up, obviously the numbers would have been worse. But I'm just trying to get a sense of, did you have that in the plan but you just weren't sure if they would come in? Or how do we think about the $0.30 headwind that you flagged on Slide 17 -- or the $0.28? I'm just trying to reconcile all the moving pieces on tax and what you do when and....

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [33]

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Yes, if you go back to our last call, we guided to an EPS range, and that had probably about $5 million or $6 million of a discrete tax benefit embedded in the range. So that was basically about half of what we got. So the rest of it was settlements that came in that we weren't expecting to come in or a statute of limitation expiration. So you might have lots of different jurisdictions, where the statute expires on 12/31. You really don't know whether or not you're going to have an issue with that particular jurisdiction until it expires, and so we don't typically bake that in the forecast. But I would say about half of it was baked in the EPS guidance that we provided you.

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Operator [34]

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From JMP Securities, Joseph Osha has the next question.

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Joseph Amil Osha, JMP Securities LLC, Research Division - MD & Senior Research Analyst [35]

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A couple of things. First, back to this issue of the warranty charges in Q4. The fact that those aren't going to recur, Joan, from your comments, when combined with the margin guidance suggests that there might maybe be some other headwinds in the first part of the year given the fact that the gross margin is flattish. Or am I missing something?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [36]

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No. It's primarily going to be the timing of software-related deployments. So if you have a lot of software in Q4 that doesn't reoccur in Q1, you're going to have a natural dip in gross margin from that. The special warranty not reoccurring in Q1 will go the opposite way, so it's puts and takes of a lot of different things. But I would say software is the biggest one that goes the other way.

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Joseph Amil Osha, JMP Securities LLC, Research Division - MD & Senior Research Analyst [37]

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Okay. And the idea of being then that those don't recur in the second half?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [38]

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Well, again, our software deployment is very project-based. So with particular customers, they're not -- they don't necessarily go every single quarter. So in the fourth quarter, we did have some large projects that concluded that allowed us to recognize the software revenue and that tends to be very high-margin business.

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Joseph Amil Osha, JMP Securities LLC, Research Division - MD & Senior Research Analyst [39]

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Okay. The second one then would be as you think about the second half of the year, thank you for the detail on how those cost savings break down, but to return to an earlier question, is there any organic improvement in gross margins that occurs as the revenue rises? Or should we basically we think about gross margin as being static with the exception of these benefits flowing through from the cost reduction effort?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [40]

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Well, again, there's mix in there as well. So to the extent our Networked Solutions and Outcomes business are growing, those are higher margin businesses than the Device business, which is shrinking. So you are going to have the benefit of that mix as well.

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Joseph Amil Osha, JMP Securities LLC, Research Division - MD & Senior Research Analyst [41]

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Okay. So there is some organic improvement there. And then I guess the last question would be, I think it's -- we can see how EBITDA is trending. I'm wondering what your thoughts are about the businesses' ability to generate free cash flow in 2019.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [42]

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Yes, I mean, I think the free cash flow continues to be very healthy. For the year, this year, we generated about $50 million of free cash flow. I would expect us to close to double that next year.

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Joseph Amil Osha, JMP Securities LLC, Research Division - MD & Senior Research Analyst [43]

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Okay. And is that just operational improvement? Or is that working capital management? Or what's driving that nice improvement?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [44]

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It will be a combination of both.

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Operator [45]

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The next question will come from Pavel Molchanov, Raymond James.

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Pavel S. Molchanov, Raymond James & Associates, Inc., Research Division - Energy Analyst [46]

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In Q3 and Q4, as I recall, in talking about components shortages, the main culprit was MLCCs, and many of the component suppliers and consumers have commented in the last 2, 3 months that the situation with MLCCs has largely normalized. Is that consistent with what you're seeing? And if so, which other components continue to be a headwind right now?

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [47]

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I'll take that one, this is Tom. MLCCs are starting to normalize from our point of view. I don't want to go too technical, but it depends on the case size. Some of the smaller sizes are in a little bit better shape than some of the legacy technology, some of the older versions. So MLCC is getting better but I would say not quite solid yet. Other passives and discretes, so MOSFETs being another one that tends to be troubling. So FETs and MLCCs, chip resistors, you get some hot spots in each one of those depending on age of technology and specific type.

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Pavel S. Molchanov, Raymond James & Associates, Inc., Research Division - Energy Analyst [48]

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Okay, that's useful. Follow-up, kind of a broader question. We just had the biggest electric utility in the Western United States go bankrupt. Has that had any impact, positive or negative, on AMI modernization, the willingness of utilities to invest in modernizing the grid, perhaps from the standpoint of trying to avoid the infrastructure issues that PG&E obviously ran into?

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [49]

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Yes, Pavel, so I would say, yes, it has a beneficial -- I mean, it's a sad way to say it, a beneficial impact, the regulatory conferences and many utility conferences that I attend, the discussion is about reliability and resiliency. It's not just wildfires in California, it has to do with polar bombs and Superstorm Sandy and hurricanes hitting the southern United States, that there is a broadening awareness that volatile climatic events are going to require investments in hardening electric, gas and water infrastructure. And therefore, that we feel that, that is a sign that additional grid infrastructure is going to be made in the coming years.

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Operator [50]

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Our next question will come from David Katter, Baird.

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David Francis Katter, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [51]

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Wanting to ask a quick one on the backlog. It seems like, sequentially, you booked some kind of longer-tail business. I was wondering if you can talk about some of the dynamics at play there and whether that's kind of a trend you're seeing with the longer total backlog going up and the 12 months going down?

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [52]

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I don't think it changed that much.

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Kenneth P. Gianella, Itron, Inc. - VP of IR [53]

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No, I think -- this is Ken Gianella. The ratio within our backlog is just a slight change. I mean we came with a record total backlog of $3.17 billion and the 12 months came out about $1.35 billion and change. So it's flat on that perspective. As we said on the call, the mix associated with that, 2/3 of that heavily weighted towards the Networked business. And when you do that, you normally see a 3- to 4-year rolloff of backlogs. So for the additions we have and the amount I see in 1 year, that ratio pretty much fits to the models that we see for the profile we have in the backlog, David.

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David Francis Katter, Robert W. Baird & Co. Incorporated, Research Division - Junior Analyst [54]

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Got you, that makes sense. And then one more quick one. I know you touched on this but on the restructuring with the $70 million over the next 2 years, I was just wondering at a high level if you could talk about how some of the supply chain headwinds have impacted the cadence of the restructuring, which was kind of focused on the supply chain. Has that kind of delayed progress? Or how have you managed to navigate both the headwinds and the need to kind of optimize the supply chain?

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Thomas L. Deitrich, Itron, Inc. - Executive VP & COO [55]

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Yes, Tom here. I would say I don't know that it has materially changed it. It certainly has put some extra stress on the team and probably made us use some outside resources here and there to best cope with the situation. But I would say I don't know that it has materially changed the timing of what you see in motion. Certainly, it created the financial impact that you saw, but I don't know that I would talk too much that it has affected the timing of programs that are in flight.

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Joan S. Hooper, Itron, Inc. - Senior VP & CFO [56]

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That said, had we not been in the midst of restructuring, I think the supply chain headwinds would have hurt us a lot more than they did. So the ability to leverage the purchasing power of contract manufacturers was very useful.

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Operator [57]

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And everyone, at this time there are no further questions. I'll hand the conference back to Philip Mezey for any additional or closing remarks.

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Philip C. Mezey, Itron, Inc. - President, CEO & Director [58]

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Thank you, everyone. So again, a tremendous amount of progress that was made in 2018 from a strategic point of view in terms of not only our restructuring plans but obviously the acquisition of and integration of Silver Spring, which has gone extremely well, the integration of all of our financial systems and back offices, a lot of heavy lifting that's gone on in 2018, some of which is obscured as you know by the supply chain headwinds that we faced. And with that significant progress, we feel very strongly that the momentum that we're entering '19 is quite strong. And however, based upon the misses that we had in 2018, we are appropriately projecting some continued first half margin pressure and think that, that is absolutely the prudent thing for us to do. But the opportunity for us to continue to drive margins in the second half is there and in place and the projects are identified. So thank you all for your interest, and look forward to talking to you all soon.

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Operator [59]

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Ladies and gentlemen, 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 953-9336. Or you can go to the company's website, www.itron.com. That does conclude today's conference. Thank you all for your participation, and you may now disconnect.