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Badger Meter, Inc. (NYSE:BMI)

Q3 2007 Earnings Call

October 16, 2007 11:00 am ET

Executives

Rick Johnson - SVP - Finance, CFO and Treasurer

Rich Meeusen - Chairman, President and CEO

Analysts

Rick Eastman - Robert W. Baird

John Quealy - Canaccord Adams

Steve Sanders - Stephens, Inc.

Operator

Good morning, everyone, and welcome to the Badger Meter Incorporated Third Quarter Conference Call. Today's call is being recorded and will be available on Badger Meter's website for rebroadcast.

Joining us today are Rich Meeusen, Chairman, President and CEO and Rick Johnson, Senior Vice President, Finance, Chief Financial Officer and Treasurer.

At this time, I would like to turn the program over to Mr. Johnson. Please go ahead, sir.

Rick Johnson - SVP - Finance, CFO and Treasurer

Thank you very much and welcome. I want to thank all of you for joining us this morning. I will begin by stating that we will make a number of forward-looking statements on our call today.

Certain statements contained in this presentation as well as other information provided from time to time by the Company or its employees may contain forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in these forward-looking statements.

Please see our 2006 Form 10-K for a list of words or expressions that identify such statements and the associated risk factors.

I want to remind you about our guidelines. For competitive reasons, we do not comment on specific individual line profitability nor do we disclose components of cost of sales. For example, copper.

Most importantly, we will continue our practice of not providing specific guidance on future earnings. We continue to believe guidance does not serve the long-term interests of our shareholders.

Now on to the third quarter results. Yesterday afternoon, after the market closed, we released our third quarter 2007 results. We are pleased to report that sales were a record $62.8 million, an increase of 4.3% over last year's third quarter sales of $60.2 million. Continuing a theme you have heard before, the sales increase was driven by sales of ORION automatic meter reading products.

Let me give you a few details. Residential and commercial water meter sales represented 80.4% of total sales in the third quarter compared to 82% in the third quarter of 2006. These sales increased $1.1 million to $50.5 million compared to $49.4 million in the same period last year. This was due to increased sales of units utilizing AMR technologies and higher prices as a result of recent increases.

Offsetting this somewhat were lower volumes of local read and commercial meters. For this quarter, ORION sales were nearly 32% higher than the third quarter of last year, while Itron products saw a 20% decline from their levels of 2006.

Industrial products represented 19.6% of total sales for the three months. Those sales increased $1.5 million to $12.3 million compared to $10.8 million in the third quarter of 2006. The increase was driven primarily by volume increases in all product lines.

Gross margins for the quarter were 36.1% compared to 29.7% last year. You will recall last year that we were dealing with significant increases in copper costs and the price increases we had put into effect really had not yet taken hold. This year, we are seeing the impact of those price increases, which have restored the margins on a number of product lines.

Our selling, engineering and administrative costs for the third quarter as a percent of sales were 20.6% compared to 18.4% last year. This increase is a result of higher employee incentives associated with the increased sales and improved profitability and some increases in our reserves for uncollectible accounts. In addition, we have normal inflationary increases, but we are continuing our cost containment efforts.

Interest expense is down slightly between years due primarily to the fact that our debt balances continue to decline. Our effective tax rate for the quarter was 36.1% compared to 37.6% last year. We revised our annual estimates of an effective tax rate to 36.7%, which did affect the third quarter rate.

Earnings from continuing operations for the third quarter were a record $6 million compared to $3.9 million last year. Like our sales results, this was also a record for Badger Meter in any quarter in our history. On a diluted basis, earnings per share from continuing operations was $0.41 this year compared to $0.28 for the same period in 2006.

Reviewing our financial conditions, there were no significant changes since the last time we spoke. Receivables continue to be higher than at yearend, which is to be expected with record sales and the seasonality of our business, particularly in the fourth quarter.

With regard to cash flows, we continue to generate cash. Cash generated from operations for the first nine months of 2007 was approximately $20 million compared to $6.3 million last year.

As we mentioned in our last conference call, we did receive a refund from the IRS earlier this year of all taxes paid for 2006 as a result of a tax position that we are taking with regard to the discontinuation of our French operation. As a reminder, all of the tax benefits associated with the French operations are fully reserved along with accrued interest until the ultimate resolution of that issue.

Our statement of cash flows also reflects proceeds from the sale of our French assets, notably the building. Offsetting these, we have made partial payments on the construction of the second phase of our Mexican plant expansion, which Rich will comment on momentarily. With the cash generated, our debt as a percentage of total capitalization has now dropped to less than 17%.

With that, I will now turn the call over to our CEO, Rich Meeusen, who will have some additional comments. Rich?

Rich Meeusen - Chairman, President and CEO

Thank you, Rick. I would also like to thank all of you for joining us today. We are obviously very pleased with the results for this quarter, but I want to again remind you that our business tends to be difficult to predict on a quarter-to-quarter basis.

Decisions by a few large customers to accelerate or delay shipments at any quarter-end can have a significant impact on our short-term results.

While we have now had two strong quarters, we remain somewhat seasonal business with higher summer sales and traditionally slower winter sales. Our management team has always been and will continue to be focused on long-term results as opposed to be focused on short meeting quarterly expectations.

With that said, we continue to be optimistic about both the current year and our long-term prospects. We've been able to offset much of the negative impact of copper prices with price increases, and the negative impacts of the recent slowdown in the general economy have been offset by the higher demand for our ORION radio frequency system.

We are also starting to see strong market interest in our recently introduced low-profile residential water meter. This is a meter that exceeds AWWA standards and has the same accuracy and long life as our standard meter, but does so in a smaller body that uses one-third less copper and allows our customers to install the meter in shallower pit boxes or tighter basements spaces.

Transitioning our customer base to this new meter will reduce our exposure to copper price fluctuations. We continue to invest aggressively in our R&D programs for both utility and industrial products.

Specifically, we are developing new versions of ORION as well as investing in new features for our Galaxy Fixed Network System, which we believe is a superior product for those utilities that want their own dedicated fixed network system.

We are also continuing work on our new facility in Nogales, Mexico. This 120,000 square-foot facility will enable us to meet the growth requirements of our business and to shift certain manufacturing functions into Mexico to achieve significant cost reductions. The project is on track and on budget and is expected to be completed in the third quarter of next year.

Now, let me comment on the status of the Chicago contract, which was signed and announced last quarter. As a reminder, this is a three-year project for approximately $40 million with 162,000 Orion radios and 80,000 Badger water meters. This amount includes $24 million for meters in the Orion radios system and $16 million for installation labor, which we have subcontracted out.

Also the majority of the meters will be Badger's plastic meters, which Chicago has used for many years. Obviously, these meters are not subject to the impact of copper price fluctuations. The contract called for a pilot installation of approximately 400 meters, which was designed to help us work out any reading and building interface issues.

We are happy to report that the pilot has been completed and that the Orion units have exceeded the city's minimum performance requirements. As such we expect greater shipments to begin in mid-November. However, you should also note that under proper revenue recognition rules we will not record any sales until the units have been installed, inspected and tested by the city. This could push any sales impact into December.

So let me conclude by repeating that we are very pleased with this record setting quarter. And we remain very optimistic about our long-term opportunities.

At this time, we will take any questions you have.

Question-and-Answer Session

Operator

(Operator Instructions)

And the first question comes from the line of Rick Eastman with Robert Baird. Please proceed.

Rick Eastman - Robert W. Baird

Yeah, I just had a couple of questions, Rick or Rich. Could you just address gross margin maybe a little bit closer? You know should we be thinking at this point that, given the current mix of business that gross margins are pretty stable? In other words price is offsetting copper prices?

Rick Johnson - SVP - Finance, CFO and Treasurer

This is Rick. I think that is a fair assumption. I think you also have to weigh in the fact that we are heavily weighted on Orion in this particular quarter. As I said, you know, volumes of local read meters were down. Volumes of commercial meters were down. This was really driven by an increase in volumes of Orion meters.

Rick Eastman - Robert W. Baird

Okay. And so going forward, again, we will still be balancing copper price with probably Chicago, which will carry -- that revenue will carry a lower gross margin just by definition?

Rich Meeusen - Chairman, President and CEO

Yeah. This is Rich. Chicago, as we said, overall will carry a lower gross margin because we did not mark up the installation as much. So that’s going to have a negative impact on margins going forward. Copper, right now was up around a $3.70 a pound range, but it has been jumping around. In fact, today it’s down a little bit lower than that.

If copper stays in that range, we should see stability. If copper goes up a lot higher it could hurt us. If it comes down it could help us. We can't adjust our prices as quickly as copper changes, obviously. So copper is going to be an impact going forward. But if you assume copper stays in that range you factor in a little bit of Chicago and Chicago doesn't have a big impact. We think we will be able to keep the gross margins roughly in the range where they are.

Rick Eastman - Robert W. Baird

Excellent. And just as a percentage of total sales growth or as a component of total sales growth, how much did price actually add year-over-year? Is it a point of the 4% growth or --?

Rick Johnson - SVP - Finance, CFO and Treasurer

This is Rick. I think, Rick, for competitive reasons we just don't want to disclose that, but the fact of the matter is Orion volumes were up but the other volumes were down. You know a good chunk of what you're seeing is price.

Rick Eastman - Robert W. Baird

It’s -- but it's price given the increased ASP of AMR. It’s not price given increased price of a local read meter for instance?

Rick Johnson - SVP - Finance, CFO and Treasurer

I'm not sure.

Rick Eastman - Robert W. Baird

Are you suggesting it’s more mix or are we actually capturing a percentage point or less of price on local read meters, where we are having copper issues?

Rich Meeusen - Chairman, President and CEO

This is Rich again. We have captured our price increases and we have had two of them now. We had a price increase in August of 2006, and then another one in July of 2007. And those increases have both improved our pricing on local read meters. So there is some impact on local read meters. But I would say the bulk of it really is the mix.

Rick Eastman - Robert W. Baird

Okay. All right. And just a last question and I will get out of the queue here. But in terms of Chicago, I guess, I understand we'll do a little deferring of revenue here. Would -- once you ship will it generally be installed in the same -- you know, within a 30 day period? In other word, the impact on a quarter-to-quarter basis would be fairly minimal?

Rich Meeusen - Chairman, President and CEO

Yes. It will. What we ship we expect to be installed within 30 days.

Rick Eastman - Robert W. Baird

And the -- do you also -- are you going to match the cost against that revenue recognition?

Rich Meeusen - Chairman, President and CEO

Yes we are.

Rick Eastman - Robert W. Baird

Okay. So you are not going to be taking the cost as incurred?

Rich Meeusen - Chairman, President and CEO

No.

Rick Eastman - Robert W. Baird

Okay.

Rich Meeusen - Chairman, President and CEO

No, the cost will also be deferred and we expect the city will be doing weekly inspections and testing and approvals. So we expect that there will be this initial lag, but then things will move along pretty promptly.

Rick Eastman - Robert W. Baird

I understand. Okay. Thank you.

Operator

And the next question comes from the line of John Quealy with Canaccord Adams. Please proceed.

John Quealy - Canaccord Adams

Hi. Good morning, folks. Congrats on a good quarter there.

Rich Meeusen - Chairman, President and CEO

Thank you.

Rick Johnson - SVP - Finance, CFO and Treasurer

Thank you, John.

John Quealy - Canaccord Adams

First thing, let's just go back to Chicago if we could, for a second. In terms of the weather guides what's the bigger factor? The temperature or the precipitation if installs get delayed or how are you managing those expectations for the December, January period for --?

Rich Meeusen - Chairman, President and CEO

A blizzard would have a bigger impact than just cold weather. A lot of these units are being installed indoors. So we don't see temperatures as having as big an impact, but obviously if there is a blizzard that could slow things down.

Frankly, that is what impacts -- that is one of the things that causes the seasonality of our business. We sell a lot to the Northeast and the Northern states. And as we get into the winter months, they slow down their buying just because they know they are not going to be able to install as many meters during January, February, March as they do during the summer months.

So there might be some slowdown in Chicago, but frankly Chicago has -- we have the team standing by to install the meters. I think they are going to be pretty aggressive on wanting to get the project done. So I don't -- other than the occasional blizzard that could gridlock the city, I don't see weather having a big impact. We are not planning any big impacts.

John Quealy - Canaccord Adams

In rough numbers, what's your run rate of installs per day when this project is up and running in terms of your productivity of your installers?

Rich Meeusen - Chairman, President and CEO

Well, you know, we are not disclosing specifics, but it’s 162,000 radios over three years and if you roughly figure 50 weeks a year that's about 1,000 a week. I mean that's the back of the envelope calculation. And that's kind of what we are using in our mind right now.

John Quealy - Canaccord Adams

Okay.

Rick Johnson - SVP - Finance, CFO and Treasurer

So we are hoping to get 200 radios in a day, meters where they are changing all meters that may take a little…

Rich Meeusen - Chairman, President and CEO

Little bit longer.

Rick Johnson - SVP - Finance, CFO and Treasurer

Take a little bit longer, so that could slow some things down but generally that is going to be our run rate.

John Quealy - Canaccord Adams

Okay. Thanks. And then to just get some clarification on the mix in the AMR radio side. So Orion up 32%. Itron looked like it was down 20%, if I got that comment correctly.

Rich Meeusen - Chairman, President and CEO

Correct.

John Quealy - Canaccord Adams

Is this customer's opt appreciation schedules looking for a refresh? Is this greenfield customers? Can you give us a little bit more characterization on what's going on, on that side of the market?

Rich Meeusen - Chairman, President and CEO

You know, John, that's a hard one for anybody to answer including us, because we tend to ship ORION radios to our distributors and to our customers.

And we don't get good feedback from them as to whether these meters, these radios are being used to replace old radios or whether this is new installation. And it is going to become an industry issue going forward trying to estimate that number.

At this point, we still feel the bulk of what we are shipping is new installation, that we aren't seeing a large amount of replacement. And if I were guessing, just from the oral statements from the field that we are probably doing less than 10, 15% replacement and the bulk of it is new meter installation -- new radio installation.

John Quealy - Canaccord Adams

Okay. And then my last question on Mexico, as much as you can give us. What sort of capacity will you be shipping down there in the back half of '08? Just a little bit more color on what exactly the efficiencies you are looking to get?

Obviously the labor content, but I would assume some automation content as well adds in Mexico?

Rick Johnson - SVP - Finance, CFO and Treasurer

Well, John, what we have done in Mexico already is, you may recall, is we closed our Rio Rico Arizona facility, which was about 40 employees moved that operation, which was primarily a plastic molding operation over into Mexico.

And that's where we mold the plastic meters that we are selling to Chicago and other cities, so that operation is done. This additional 120,000 square foot building will enable us to get out of the 60,000 square foot building that we have leased down there where we make all of our registration and radio equipment.

We will move that operation up into the 120 that will probably take more than the 60,000 square feet it is in, because it's kind of busting at the seams. Growth has pushed that facility to the limits.

But in addition, we will be looking at doing additional meter testing and assembly down in Nogales when that building is finished as we go into the future. As far as what we are shipping out of there at this point in time, we don't have definite plans to ship directly out of Nogales.

We would still be bringing the meters back to Milwaukee for final inspection and that sort of thing before it goes out the door although we are not ruling that possibility out in the future.

John Quealy - Canaccord Adams

Okay. Answer my last question. So looks like you are under levered based on Rick's comments. What are your thoughts at this point on M&A or any strategic things like this?

Rich Meeusen - Chairman, President and CEO

We are continuing to look for good strategic opportunities. You know, we are looking for the small acquisitions that we can tuck in on the industrial side or even something a little bit larger that might make sense for us on the utility side.

But we are definitely trying to get a little more aggressive on the M&A front and see what is out there and what we can go after. One of the problems we've had historically is the high multiples that have been paid in our industry and that's been -- that's made it very difficult to go after things with all the private equity money that was out there.

A lot of that money is drying up, and I think the strategic players who have kept their powder dry are going to see an opportunity going forward and we are hoping we can be one of them.

John Quealy - Canaccord Adams

All right. Thanks, guys.

Operator

(Operator Instructions)

And the next question comes from the line of Steve Sanders with Stephens Inc. Please proceed.

Steve Sanders - Stephens, Inc.

Good morning. Good quarter.

Rich Meeusen - Chairman, President and CEO

Thanks.

Steve Sanders - Stephens, Inc.

Just a quick follow-up on Nogales. Since it sounds like you are basically moving from one facility down there to another, will you be able to avoid any inefficiencies associated with that, should that be a fairly smooth transition?

Rich Meeusen - Chairman, President and CEO

Steve, that's a pretty easy transition, because there isn't a lot of automation in Nogales. It is just a lot of manual work. And we believe that we can basically pick up that operation and move it over the course of maybe a week without a lot of disruptions.

Steve Sanders - Stephens, Inc.

Okay. And then, obviously, ORION has made some pretty impressive share gains over the past several years. How do we think about your potential there, relative to your meter market share?

And if you could, work in a comment about Galaxy as it sounds like you've got some building interest there.

Rich Meeusen - Chairman, President and CEO

Well, let me first comment on market share. As you know, I think I made this comment in the past, that we have two independent sources for market share information and that's the Scott Report which is compiled by Dr. Howard Scott.

That reports on the AMR market share. And then we have information from Proprietary Publishing. They compile a water meter units and dollar sales data from all the major manufacturers in the US.

The Scott Report still lists us as the largest seller of AMR products in North America -- in North America water industry and we believe with ORION we are holding that position very well.

Even as we -- as our ITRON sales drop off we have got enough ORION sales that are picking that up. So we believe that we are going to continue to hold or increase that market share as we go forward.

I think the 2005 Scott Report and I haven't seen the 2006 yet, I think it is supposed to be out soon, but 2005 showed us at being at about 23% of the market. As far as seller, now, since we sell a lot of ITRON, that doesn't count us as a producer, but as a seller we were at 23%. We think we can hold that.

Regarding the meters themselves, Proprietary Publishing, we are at about 27%, 28% of the market share. And we think we can grow that on the strength of ORION. So we feel pretty good about that.

Galaxy, as you know the fixed networks have not grown the way five years ago people had expected them to do. A lot of people had predicted that fixed network, Wi-Fi all of these things were going to be taking over across the United States.

And we haven't seen that in the market. We’re pleased with Galaxy. We've got several cities where it’s installed and we've got a lot of opportunities that we are chasing out there. There are cities that want their own fixed network system and it makes sense for them and Galaxy is a perfect fit for that.

We don't see Galaxy as being a huge driving force on our market share unless the nature of the market changes where there is a huge demand for fixed networks that isn't there right now.

Steve Sanders - Stephens, Inc.

Okay. And then two quick follow-ups just on the commercial water meters. I think you indicated that business was flat. Just your outlook on that business. And then just an update on your strategy for the non-utility business. Mecca is behind you now, so I assume you've got some opportunities on the M&A side?

Rich Meeusen - Chairman, President and CEO

Sure. Let me start with the commercial water meter. That business is lumpy. We have some quarters that are up dramatically. Some that are down, some that are flat. Every once in a while we will have a large city that will decide that they want to replace a lot of their big turban meters and we will get a big order.

So I don't view the flat quarter as being or even a down quarter -- as being any indication of a long-term trend. It's just the nature of the business. That jumps around a lot more than the smaller residential meters where you have got a higher volume to cover for it.

Regarding the industrial side of our business and the opportunity for acquisitions, that is an area where we are looking. You know every year for many years we've chased small acquisitions.

In some cases we backed away, because private equity money has come in and they have been willing to pay out a multiple that we thought was unrealistic. But we are still pursuing that. We think there are some very logical flow measurement companies that we could acquire as a tuck-in type company that would benefit us.

Steve Sanders - Stephens, Inc.

Okay. Thank you very much.

Operator

(Operator Instructions)

And the next question is a follow-up from the line of John Quealy with Canaccord Adams.

John Quealy - Canaccord Adams

Just to round out so Q4, Rick, can you just give us an idea Mecca plus what are we still looking for, for chargers or tax effects or just the accumulative effect for that for Q4?

Rick Johnson - SVP - Finance, CFO and Treasurer

Yeah, I think we are going to disclose in our third quarter 10-Q that we expect the cumulative loss to probably be about $6.2 million, $6.3 million. We are still debating the number here and there, but we are really down to a handful of assets and a handful of liabilities to be paid off.

And then there's also some -- I don't want to say crazy accounting rules, but we have whatever the accumulative translation gain or loss is sitting in equity already has burst out back through the income statement.

So it really depends upon what happens FX-wise in the next couple of months. But we are not expecting any significant hits in the fourth quarter.

Rich Meeusen - Chairman, President and CEO

As a point of clarification the $6.2 million, $6.3 million Rick mentioned cumulative, almost all of that has been recognized.

Rick Johnson - SVP - Finance, CFO and Treasurer

Yeah 5.8 is behind us already.

Rich Meeusen - Chairman, President and CEO

5.8 is behind us so there may be a little more coming but we don't think it is going to be anything significant.

Rick Johnson - SVP - Finance, CFO and Treasurer

Right.

John Quealy - Canaccord Adams

In terms of the other side, if it is an over reserve, you wouldn't expect it to be material either way as you close that down?

Rick Johnson - SVP - Finance, CFO and Treasurer

That's correct.

John Quealy - Canaccord Adams

Thanks a lot, guys.

Operator

Gentlemen, currently no other questions.

Rich Meeusen - Chairman, President and CEO

Well, we want to thank everybody for joining us today and we appreciate it and we look forward to our next call.

Operator: Ladies and gentlemen this does conclude the presentation. You may now disconnect. Thank you very much and have a great day.

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Source: Badger Meter, Inc. Q3 2007 Earnings Call Transcript

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