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Badger Meter (NYSE:BMI)

Q4 2007 Earnings Call

February 5, 2008 11:00 am ET

Executives

Richard E. Johnson - Senior Vice President of Finance, Chief Financial Officer and Treasurer

Richard A. Meeusen - Chairman, President and Chief Executive Officer

Analysts

Richard Eastman - Robert Baird

John Quealy - Canaccord Adams

Rob Chernow - RBC Dain Rauscher

Ryan Connors - Boenning & Scattergood

Brian Rafn - Morgan Dempsey Capital

Steve Sanders - Stephens Inc.

Brandon Olsen – Midwest

Operator

Welcome to the fourth quarter year end Badger Meter’s earnings conference call. (Operator Intructions) I would now like to turn the call over to your host for today, Mr. Rick Meeusen, Chairman, President and CEO; and Mr. Rick Johnson, Senior Vice President of Finance, Treasurer and CFO. Please proceed, gentlemen.

Richard E. Johnson

Thank you very much and welcome to this fourth quarter conference call. 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 risk 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.

Again, I will reiterate certain of 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 interest of our shareholders.

Now onto the fourth quarter results. Yesterday afternoon after the market closed, we released our fourth quarter 2007 results. We are pleased to report that sales from continuing operations were a fourth quarter record $57.2 million, a 4.9% increase over last year’s fourth quarter sales of $52.7 million. This increase was driven by increased sales of both AMR meters as well as local or manual read meters.

Before I give you more details on sales, let me make one comment on our French operations. As you know, in the fall of 2006 we made the decision to completely shut down and liquidate our French operations. I would like to report that the entire process was completed as of December 31 and that no additional charges are expected in the future.

Now let me give you a few details about our sales results. Residential and commercial water meter sales represented 78.6% of total sales in the fourth quarter compared to 79.7% in the fourth quarter of 2006. These sales increased nearly $3 million to $45 million compared to $42 million in the same period last year.

This was due to increased sales of Orion-related products with revenues there up 21.6%; also, higher sales of local read meters primarily driven by plastic meters; and higher prices as a result of price increases instituted over the last two years. Offsetting this slightly were lower sales of commercial meters.

Industrial products represented 21.4% of the total of sales for the fourth quarter of 2007. Those sales increased $1.5 million to $12.2 million compared to $10.7 million in the fourth quarter of 2006. The increase was driven primarily by volume increases in most of the industrial product lines.

Gross margins for the quarter were 34.9% compared to 32.5% last year. I will remind you that last year we were dealing with significant increases in metal costs, primarily copper, and the price increases we had put into effect really had not yet taken hold. The impacts of the price increases in both 2006 and 2007 have restored the margins on a number of product lines.

Our selling, engineering and administrative costs for the fourth quarter as a percent of sales, were 22.3% versus 23.6% last year. The percentage decrease is more a reflection of the increased sales, as actual expenses increased 2.6% due to normal inflationary increases.

Interest expense for the quarter is $143,000 higher than in the fourth quarter of 2006. Interest expense increased in the fourth quarter compared to the fourth quarter of 2006 due to interest charges related to the recorded reserves for 2006 federal tax refunds received due to deductions taken for our French operations. While we believe we have the appropriate support for the positions taken on that return, the uncertainty over it necessitates these reserves and we will continue to accrue interest until ultimate resolution of the issue.

Our effective tax rate for the quarter for continuing operations was 39.3% compared to 48.5% last year. We generally use the fourth quarter to adjust to the actual annual effective tax rate, which in this case for 2007 was 37.3%.

Earnings from continuing operations and for the fourth quarter were nearly $4.2 million compared to $2.3 million last year. Like our sales results, this was also a record for Badger in the fourth quarter. On a diluted basis, earnings per share from continuing operations was $0.28 compared to $0.16 in the same period in 2006.

Since this is the last quarter of the year, I’d also like to briefly comment on the year as a whole. After a slow start in the first quarter the company has performed very well in the last three quarters. As a result, sales, earnings and earnings per share from continuing operations were all records.

For the year, the company made nearly $18.4 million on sales of nearly $235 million in 2007 compared to $16.6 million on sales of nearly $230 million in 2006. On a diluted basis, earnings per share from continuing operations were $1.26 compared to $1.15 last year.

Our balance sheet remains solid. As a result of completing the liquidation of our French operations, you will no longer see assets or liabilities of discontinued operations. Absent that there have been no significant changes between years. Cash is higher than what might be expected at year end, simply as a result of timing of receipts. Our debt as a percentage of total capitalization at year-end has dropped to approximately 15%.

Looking at cash flow, nearly $24 million was generated from operations in 2007, compared to nearly $16.8 million in 2006. We have mentioned before we did receive a refund from the IRS earlier in 2007 of all the taxes paid in 2006 as a result of the tax position we took. The cash flow statement reflects the proceeds from the sale of our French assets, principally the buildings.

The most notable outflows on the cash flow statement are payments we have made on the second phase of our Mexican plant expansion, progress on which is continuing. Construction of that plant should finish this year and we anticipate being in full production by year end.

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

Richard A. Meeusen

Thanks, Rick and I’d like to also thank all of you for joining us today. For those of you from Louisiana, Happy Mardi Gras, and from those of you from the other 24 states, happy Super Tuesday.

We are obviously pleased with the results for the fourth quarter. It’s particularly good to follow the relatively weak first quarter we had with three record quarters. In fact, 2007 exemplifies the fact that our business can be somewhat volatile on a quarter-to-quarter basis, but our focus on long-term results can generate good growth in both sales and earnings from year-to-year.

Our Chicago project is in full operations with weekly shipments of plastic meters and Orion radios and daily installation. Although Chicago will have a favorable impact on 2008, revenues in the fourth quarter of 2007 were only about $1.2 million since shipments began in late November. I am happy to report that all units are operating as expected and we’ve had no problems with this project. The first quarter of 2008 will be the first full quarter with the Chicago impact.

Although we don’t provide forecast or earnings guidance, I think it’s important for me to make a few comments about our expectations for 2008 due to the current uncertainty in the U.S. economic outlook. If the U.S. economy slows significantly and enters a recession, we would expect to see some negative impact on our 2008 results.

However, at this time we are not seeing any major impact from the economic slowdown. In fact, we have entered 2008 in a much stronger position than the start of 2007. Orion orders and sales continue to be strong and our backlog is up significantly even without the favorable impact of the Chicago contract.

Although copper prices are higher now than one year ago, our margins are up due to the impact of our 2007 price increases and favorable mix. Overall, we are very optimistic about the first quarter of 2008. A major reason for our optimistic outlook is the significant market opportunity that we have with our Orion AMR product. As most of you know, in the late 1980s, Badger started selling the first water AMR product called Trace. As that product has come to the end of its life, we have replaced many of the Trace units with Orion. However, our customers still have over 800,000 Trace units in their systems and that replacement opportunity alone represents approximately $100 million of potential business for Badger.

On top of that, we sold over 2 million Orion units to over 1,000 customers. Many of those customers who have chosen Orion as their AMR system have only just begun to install the product. In fact, on average, our Orion customers have only converted about 25% of their metering systems, leaving about 6.7 million more units to install. We estimate that opportunity to be about $840 million. Combined with the Trace replacements, Badger is looking at almost a $1 billion opportunity for future Orion sales. This does not even consider sales to new Orion customers, which we are signing up at a rate of one new customer per day. We expect this opportunity will drive significant Orion sales over the next several years.

We are also seeing increased interest in our fixed base AMI product, Galaxy. But before I talk about that let me try to define some terms here. There has been a lot of confusion over the terms AMR, which stands for Automatic Meter Reading, and AMI, which stands for Advanced Metering Infrastructure. In the electric industry, AMI often refers to two-way metering systems that enable the electric utility to gather significant load management data and even to control devices within the customers’ premises. Most of these features are not applicable to the water industry.

The November 2007 Chartwell AMR Report, which is a respected industry publication, stated that based on their survey, water-only utility defined AMI as a fixed network system with no reference to two-way metering. Therefore, we have chosen to adopt the definitions being used by our customers and we will refer to the systems like Orion as AMR and we will refer to fixed base systems like Galaxy as AMI.

With that said it should be noted that fixed base systems have historically had a very slow acceptance rate among water utilities. In fact, according to the most recent Scott Report, fixed base systems represent only 7% of all automated metering systems in water on a cumulative basis through 2006, as compared to 13% for electric residential customers and 32% for electric commercial customers.

As we move into 2008 we are now seeing a greater number of inquires and formal RFPs for fixed base AMI systems among our water customers. That’s why we’re so excited that we’ve recently introduced the Galaxy PIN unit, which uses the same superior sealing technology that we currently use on our Orion product. We believe that Galaxy is now the most competitive AMI product in the water industry. Furthermore, it’s our intention to continue to make significant investments in the Galaxy product line to take advantage of future market opportunities.

We’re also starting to see strong market interest in our recently introduced low profile residential water meter. I’ll remind you that this meter exceeds the American Water Works Association 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 metal and allows our customers to install the meter in shallower pit boxes or tighter basement spaces.

Transitioning our customer base to this new meter will reduce our exposure to copper price fluctuations. As Rick mentioned, we’re 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 ship certain manufacturing functions into Mexico to achieve significant cost reductions. The project is on track and on budget and expected to be completed in the third quarter of this year.

With that let me conclude by repeating that we’re very pleased with this record-setting quarter and we remain optimistic about our long-term opportunities. At this time, we will take any questions you may have.

Question-and-Answer Session

Operator

Your first question comes from Richard Eastman - Robert Baird.

Richard Eastman - Robert Baird

When you weigh out the growth rates here, you said the utility business increased about 7% for the quarter?

Richard E. Johnson

I am looking here.

Richard Eastman - Robert Baird

As we move into ‘08 here, should we still be assuming that Chicago ships more or less on a straight line basis, 13 million a year? Is that still the best projection at this point?

Richard A. Meeusen

Your first question, it is about 7%. Your second question, right now that is the best estimate, the straight line. It’s just started, so there is nothing to suggest anything else at this point.

Richard Eastman - Robert Baird

Can you just give us a feel for what the pricing strategy will be here across the utility and the industrial business as we’ve entered ‘08, given your forecast on copper prices? How are you going to approach the year from a pricing standpoint?

Richard E. Johnson

We have for the last two years done our price adjustments in the middle of summer, the June-July timeframe. We will be looking at that again this summer. It will depend upon where, not just copper is, but oil prices because that affects our plastics, it affects fuel, transportation. So, we will be looking where all our costs are this summer and making a decision on pricing at that time.

Richard Eastman - Robert Baird

In the meantime gross margins should be reasonably stable at this level?

Richard E. Johnson

Yes.

Operator

Your next question comes from John Quealy - Canaccord Adams.

John Quealy - Canaccord Adams

Some of the things that you were saying Rich, in terms of the opportunity on the replacement cycle, you may have said this; what timeframe are we looking at here? Are we looking for seven, eight years for a round out of $1 billion of a replacement of an existing Badger AMR product, or how do you characterize that?

Richard E. Johnson

John, this is where I have done the calculation of the numerator for you by telling you what the opportunity is and you want me to give you the denominator as to how many years it will be over.

I am a little uncomfortable doing that. We’ve seen customers do everything from a replacement cycle of a couple of years to doing it over 15 years as their normal product wears out. Frankly I would be purely guessing as to whether those customers are going to change out all their Trace product or finish installing the Orion product over the next five years, ten years, I don’t know. But it’s probably in that range, just given history, but I really don’t know where it falls.

John Quealy - Canaccord Adams

In terms of your current base AMR and manual read business, is it mostly obsolescence or depreciation which causes people to swap out systems wholesale?

Richard A. Meeusen

It’s more obsolescence, it’s more desired to swing over to a new technology.

John Quealy - Canaccord Adams

The other comment you made, I thought was interesting, signing up one new Orion customer per day, if I heard that correctly?

Richard A. Meeusen

That’s correct.

John Quealy - Canaccord Adams

How does that compare to prior periods, Rich? I don’t imagine that’s on the higher end?

Richard A. Meeusen

Yeah, that’s accelerated. If you think about it, we’ve been selling Orion for about five years, and we have 1,000 customers. So, on average since we’ve started we’ve signed up about 200 customers a year, we are now up to close to 400 customers a year, we are at that pace.

John Quealy - Canaccord Adams

On the same distribution channel, clearly one of your competitive strength in your gaining share there it appears. Any major new initiatives or changes in how that functionality is working or any more investment there? Is it giving you a good enough return on capital?

Richard A. Meeusen

We are pretty pleased with how our sales channels are working. We go with a mixture of distribution and direct sales force and it served us very well for the past 100 years and we don’t see any changes we are going to make there.

John Quealy - Canaccord Adams

Rick, so SG&A, I know you had a small .6 inflationary movement on SG&A. How are you looking for next year? Broadly speaking, any major sort of corporate or overhead items pressing on you guys on that line?

Richard E. Johnson

Short answer is no. Nothing anticipated at this point.

Operator

Your next question comes from Rob Chernow - RBC Dain Rauscher.

Rob Chernow - RBC Dain Rauscher

I was especially pleased, Rick in the fact that your industrial products were up about 14%. I know this is a small part of your business, but it’s an area which you have improved over the last couple of years.

I just wonder if you might comment on the foreign portion of your business, specifically South America and Central America, how is progress going in that area?

Richard E. Johnson

The answer is for the most part, since 80% of the business is water meters it’s an up and down business. Occasionally we will get a project in South America that has U.S. aid and we will use positive displacement meters, but for the most part it’s not the technology that’s used there. So, I say it’s kind of hit and miss, we are always attempting.

On the industrial side, we are trying to make inroads in there, it’s hard to find the right channels in there, we are trying to work through distributors now, but I’d say sales have been up and down, sort of hit and miss, no real progress. But still about 10% of our sales are international overall.

Operator

Your next question comes from Ryan Connors - Boenning & Scattergood.

Richard A. Meeusen

First off, just on the macro headwind, I wonder if you could just talk a little bit more about that. I know that in particular, there seems to be a lot of concern out there that all these issues with municipal bond insurers and so forth and that that may have some kind of impact on municipalities ability and/or willingness to spend on infrastructure, water being one area of that.

I just wonder if you can comment whether you have seen any evidence of that, whether you expect to see that and just what you’re thinking is on that heading into ‘08?

Richard A. Meeusen

Ryan, I will agree with you, it could have some impact down the road if things become more difficult than they are. We are not seeing any impacts at this time. It’s true that most of our customers fund their meter replacement programs out of ongoing revenue from their rate structure and they don’t go out and bond. But sometimes when you get a very large project that they want to do quickly changing out to an AMR or an AMI platform, they will go out and bond and if the city bonding becomes a more difficult issue as the economy weakens that could have some impact, but we’re just not seeing it at this point.

Ryan Connors - Boenning & Scattergood

That then leads to the question in particular on Chicago, any reason to believe that there could be an impact there?

Richard A. Meeusen

None whatsoever. The Chicago funding is all set up and we’re being told that it is moving ahead exactly as planned.

Ryan Connors - Boenning & Scattergood

In a similar vein, it’s beating somewhat of a dead horse because I know you have addressed it many times in the past, but just in terms of the housing market we really did see a dramatic drop-off even from already low levels in December in terms of new housing starts and I know it does not appear to obviously have had an impact on you. I know some of your units are going to the new homes. If you could just update us on your latest thinking on the housing market and how it impacts your business.

Richard A. Meeusen

You are right Ryan, some does go into new homes, not as much as lot of people would think, because many homes are built in areas where they don’t have meters they have wells, and the meters get installed when city sewer and city water eventually is extended to those areas often much later. New housing starts don’t have a direct correlation on our sales. I have addressed that in the past.

However, cities do collect connection fees from new housings as suburbs go up in places like that. Sometimes those connection fees are used to fund meter replacements, so we’ve seen some cities that might say they would slow down because of a slowdown in connection fees being collected.

Also, I have often said that if the economic conditions in a city get really bad where they are seeing the major employers lay off, they are seeing unemployment increase, cities might rethink doing a major project at that time just politically it might not be the right time for them just to launch a major project. That’s why I made the comment that if 2008 really weakens and we enter some kind of recession it could have an impact. I don’t want anybody to believe that we are saying it wouldn’t; but right now, coming into 2008, we are just not seeing it. We are seeing an extremely strong tailwind with the company and the orders are coming in strong and we are just not seeing any slowdown

Ryan Connors - Boenning & Scattergood

You mentioned the AMI opportunity, fixed networks, sounds like there is really starting to be some traction there, that is great news. You referenced the 7% penetration rate from the Scott Report. How fast do you think that uptake takes place? I mean, does that 7% grow 1% per year or is it a faster uptake than that? I am just curious what your outlook is on how fast the water sector moves toward that type of technology.

Richard A. Meeusen

Understand I am just giving you my opinion, but I do think it could be faster than that. We saw an acceptance of Orion that came very quickly and even the acceptance of AMR back in the early 90s when it was introduced had a pretty steep curve as people started adopting it.

I think we are getting through this introductory phase of fixed networks where you had a lot of early adopters and now we are getting into the phase where it’s becoming more common.

We are seeing a lot of our RFPs, a lot of activity. We have won a few more accounts that we’re excited about and I just think the time is coming for that. It’s been a while, fixed networks have been out there for the last five to ten years, and it’s been a very slow acceptance but I think it could accelerate rapidly.

Operator

Your next question comes from Patrick Organ - Texas Securities. Please proceed.

Patrick Organ - Texas Securities

A follow-up on the Galaxy fixed base network product that you have. In general, for a decent-sized job, what would the price premium be for a Galaxy system over a mobile system? Is it somewhere in the range of 20%?

Richard A. Meeusen

I’d rather not talk specifically about Galaxy pricing, but what I will say is what we see in general in the marketplace, the cost of an AMI system, a fixed network system versus a drive-by system, whether it be Galaxy or any of our competitors’ systems. I would say you’re probably looking at anywhere from a 10% to 25% premium.

Because it may not be the end points, the cost of the radios going on the meters, but when you add on the equipment that goes up on the poles that’s where the costs can start to escalate.

Of course that cost is going to depend upon the topography of the system, how many endpoints you need to achieve the penetration, whether the city has existing poles to put the devices on, or whether you have to install poles. All of that can change the formula.

Patrick Organ - Texas Securities

The utilities business case for fixed network, they would be at a 10% to 25% premium, they would be able to apply savings from eliminating the route trucks and what have you?

Richard A. Meeusen

No, I wouldn’t agree with that, Patrick. The fact is if a utility simply wants a read, I don’t think there will ever be a cheaper system, or right now there is no cheaper system than a drive-by system. The drive-by systems for getting a read are incredibly efficient. The reason utilities go to fixed networks is when they’re looking for more than just a read. When they want interval data, they want hourly data, they want daily data or when they want improved customer service.

When a customer comes into the utility with a complaint about their water bill and they can immediately go to the computer and read that water meter while the customer is standing there, those are the types of intangibles that the utility looks for when they adopt a fixed network system, and that becomes much more important.

More interesting, we are also seeing what we call hybrid systems, where a city will say, I want a drive-by system for the majority of my city, but I have an industrial park which represents my large user, and there I want to have networks so that I can give them hourly information on their water usage; or for hard-to-read areas like gated communities, military bases or airports, where even getting in with a truck to drive around and read the meters is difficult. A lot utilities are opting to put fixed networks in there.

So we really believe that that we’re going to see more fixed networks on their own, and we’re going to see more demand for fixed networks through hybrid systems. And in both cases, we think Galaxy is a perfect fit.

Patrick Organ - Texas Securities

With respect to Galaxy, from a technology or a functional perspective, any comments you can make versus the competitive offerings from Itron and Hexagram?

Richard A. Meeusen

Well, all I’ll say at this point is that the difficulty with fixed networks is the environment. Because you’re trying to broadcast quite a distance from an object that’s underground and that makes it more difficult, and the pit environment’s a very harsh environment. We have finally gotten the Galaxy radio into the Orion package and we’re very pleased with that because that Orion package is such a bulletproof package. We’re excited about that.

So we think we’ve got the superior pit product for networks. Beyond that we are always enhancing it. We have several more projects in the works to further improve Galaxy, and we’ll be coming out with those as the year goes on, but I really don’t want to go into any detail.

Operator

Your next question comes from Richard Eastman - Robert Baird.

Richard Eastman - Robert Baird

On the local read business you had commented that that business did increase in the quarter. Was the increase volume-driven, or was it all price?

Richard E. Johnson

It was actually both. We had some unique orders from Mexico, plastic meters, and so we had an increased volume as a result of that. For the local read brass, we’re getting more price simply to cover the increased metal cost.

Richard Eastman - Robert Baird

When you look at your local read meter business just as a standalone, how much of that business in the quarter was plastic?

Richard A. Meeusen

Rick, let me comment on the plastic. The plastic meter business, especially when we’re selling into Mexico, can be a little lumpy, because they’ll have large projects that they’ll throw in from time to time and we did have some large projects in the fourth quarter that we had.

The reason, quite honestly, Mexico likes plastic meters is because they’re less susceptible to vandalism. People have been stealing a lot of the brass meters and turning them in for the scrap. The other thing a lot of our customers like about the plastic meters is they’re lighter and they don’t have the worker comp claims from all the lifting of the meters and the meter boxes.

Richard E. Johnson

The answer to your question is probably of the local read business in the fourth quarter, probably 30%, 33% of it was plastic.

Richard A. Meeusen

But, again, Rick, it was unique orders that we got from Mexico.

Richard E. Johnson

And Rick, I haven’t checked it at year end, but through the third quarter we were running at about 15% plastic meters, so the fourth quarter did have a bump in it for plastic, because of those Mexico orders. However, that 15% was up from the previous year; we were running about 8% plastic meters. So, we are seeing a bigger demand for the plastic meters. Our engineers don’t like us calling them plastic meters. They say we should call them engineered polymers, but we wouldn’t be kidding anybody, they are plastic meters. They’re very, very good plastic meters, just for the record.

Richard A. Meeusen

And again as we go forward, Chicago is plastic.

Richard E. Johnson

Chicago loves the plastic meters. They like them because they’re lightweight, easier to install, exact same warranty as our brass meters, exact same life, exact same accuracy. They perform just as well as the brass meters, they’re lighter and they’re not susceptible to vandalism because people don’t steal them.

Richard Eastman - Robert Baird

Do they have a similar pricepoint?

Richard A. Meeusen

Yes they do. It’s pretty close, might be a little bit less than the brass meters, but then with the brass meters at the end of life, you have some scrap value.

Richard Eastman - Robert Baird

The plastic meters going out to Mexico, are they AMR equipped?

Richard A. Meeusen

No.

Richard E. Johnson

These were not. These were just local read meters.

Richard Eastman - Robert Baird

On the industrial meter side of the business, how much of that 14% increase or for that matter, I think my math suggests maybe that business was up 12% for the full year, how much of that is currency?

Richard A. Meeusen

That’s a good question. That’s skewed towards Europe isn’t it?

Richard E. Johnson

Probably about half of the industrial sales in total are overseas but obviously the dollar did weaken against the euro, and a lot of those sales were in euros. So I’d say maybe one-third of the increase was FX, but that’s just an estimate; it’s a guess.

Richard Eastman - Robert Baird

What’s the CapEx plan here for ‘08 right now? I mean we’ll be polishing off [inaudible] by the third quarter.

Richard E. Johnson

We’re just guessing here, normally CapEx equals depreciation. We’ll probably spend another 6 or 7 to finish the Mexican project on top of that. That’s our estimate right now.

Richard Eastman - Robert Baird

So it will be up in the teens, like 13 or something?

Richard E. Johnson

No, I don’t think it’ll be that high.

Richard Eastman - Robert Baird

That 13 million estimate, that’s split between years, though, right?

Richard E. Johnson

I’d say total CapEx for ‘08 of about $8 million. That’s our estimate right now.

Operator

Your next question comes from Brian Rafn - Morgan Dempsey Capital.

Brian Rafn - Morgan Dempsey Capital

Rich, can you talk about what your install base is on Galaxy systems? I think you talked about 2 million Orion. Can you comment on that?

Richard A. Meeusen

We’ve only had about a half a dozen Galaxy installations at this point so the number of installed units is maybe in the 10,000 somewhere around there. Because over the last five years, we’ve been doing a lot of beta testing, improving the product, getting into position we want it, we did not want to aggressively market it in pit environments until we really had the pit package correct, because we’ve seen a lot of our competitors had problems with their pit packages where water intrudes. So that’s about 60% of the market is the pits.

Richard A. Meeusen

We’ve really focused on the Northern states where the meters would go in the basements and we’ve really got only about a half a dozen customers at this point.

Brian Rafn - Morgan Dempsey Capital

Is the accelerating adoption rate of Galaxy, is it a function of just the learning curve or is it, on your part, an acceleration of the marketing and the tutorial?

Richard A. Meeusen

The reason I’m very optimistic about Galaxy is I think there are two things that are happening at the same time. We have got the product now to the point where we feel it’s the best product that’s in the market and that it’s a superior product, we can go out there, we can really market it with a lot of confidence.

At the same time, the market itself is changing and starting to accept fixed networks in general more readily. For a while the market wasn’t sure whether they wanted fixed markets, what for and now they seem to have a better understanding of them.

So I would say both of those are converging and that’s what’s giving me a lot of confidence about the product.

Brian Rafn - Morgan Dempsey Capital

You guys have always talked about over engineering your brass meters and with an adoption cycle where you have an obsolete cycle of roughly 15 years and you got 6% to 7% of the in-field installation turning over, you talked kind at the margin about political pressures and not wanting to adopt something if the economy heads south. What is the robustness of your meters, 20 years, is it 25? How long could a municipality defer that?

Richard A. Meeusen

We give a main case guarantee of 20 years. That’s pretty much the industry standard. Now, on AMR, lives tend to be a little bit shorter because batteries, we guarantee batteries in the 15 to 20 year range, but generally it’s 20 years. The issue really isn’t so much how long can a utility wait? We know there are utilities with 30-year-old meters out there so they can wait a long time.

The issue is that as the meters get older, they tend to lose their accuracy and this is a fact of all meters. All meters lose accuracy with time and so a system where the average meter is 15 years old they may only be collecting 85% of the money for the water they’re pumping and that becomes an issue.

So very often, meter change-out programs are designed to keep the meters newer so that they’re more accurate, it’s more fairness within the system and that they collect for the water they pump.

Brian Rafn - Morgan Dempsey Capital

You can’t just swap out the recorder, you have to swap out the whole meter, it’s all integrated?

Richard A. Meeusen

No, you could take the register off the meter and the radio and swap it out, but it’s the meter that wears and loses its accuracy. Generally the attitude of the utility is if they’re going to go out to the site and incur the cost of going to the site to make the change-out, they’re also going to put in a new meter. That’s what Chicago is doing. Chicago has 162,000 meters, and they’re going to swap out and even some of those are fairly new, they’re going to swap out half of them. They’re going to swap out the oldest half because they want that accuracy improvement.

Brian Rafn - Morgan Dempsey Capital

You also, Rich, talked about the 2 million installed base on Orion and you used the number 6.7 million. Now, is that 2 million to be added to the 6 million to get 8.7 million on in-fill, or is part of the 6.7 million replacing the obsolescence of the 2 million already?

Give me a sense as to where you think that, because you used the number I think 840 million which would be about a $125 to $130 a unit.

Richard A. Meeusen

Right. The 2 million would be added. If we take all of the customers that have started to install Orion and we add up how many service connections they have, we get to 8.7 million. So, 2 million have already been done. That’s why I say about 25% done, it leaves about 6.7 million yet to do.

Brian Rafn - Morgan Dempsey Capital

If 25% are done, you guys have talked in the past that actually in-field installation rate, the new installation per year, is it still running about 50%?

Richard A. Meeusen

About 50% of the meters we ship have radios on it.

Brian Rafn - Morgan Dempsey Capital

You also talked, Rich about the delta change in the new customers per year going from 200 to about 400. Of the early adopters that got in or got in big, are you seeing any change in the average size of orders or is it all over the spectrum?

Richard A. Meeusen

It’s all over the spectrum, it really is.

Brian Rafn - Morgan Dempsey Capital

The expansion on the 120,000 square foot at Nogales phase II, when that’s done you guys are assembling registers down there I think?

Richard A. Meeusen

We are doing two things down there, we do all of our register and radio electronic work down there and we also mould plastic for the plastic meters down there.

Brian Rafn - Morgan Dempsey Capital

When that comes online versus Rio Rico, Arizona, how does that change your capacity across the company?

Richard A. Meeusen

Well first off, what we intend to do is when that comes on line we have a 60,000 square foot building down there now that we’ve leased. So we will move the assembly operation out of that 60,000 square foot building and into the new one. That leaves us about half the building empty, if you will which allows us for future growth.

Generally, for register and radio assembly it’s a very manual process, that’s why we have it down in Mexico. It doesn’t require a lot of capital equipment. It just requires more staffing. There seems to be plenty of that in Mexico.

As far as the meters themselves, we probably have the capacity, we are doing about 1.6 million meters a year. We probably have the capacity to go up to about 2.5 million without a lot of capital investment here.

Brian Rafn - Morgan Dempsey Capital

You guys talked about this Chicago installation. I think somebody asked the question whether cold weather or snow would impair the installation. We have gotten rock here in the Southeast Wisconsin and Chicago with snow. Has that affected at all your installation in December or going into January?

Richard A. Meeusen

No, it has not slowed us at all. The one thing that people from Wisconsin and Illinois have learned to do is to work in the snow. It has not slowed us down at all.

Brian Rafn - Morgan Dempsey Capital

Rick, anything on SG&A inflation? What are you seeing on labor and wage rates here in the U.S.?

Richard E. Johnson

Nothing significant, normal inflationary increases. This is what we are projecting.

Brian Rafn - Morgan Dempsey Capital

Healthcare costs?

Richard E. Johnson

That’s all netted in with our overall average, but we are self insured, so that is always a variable.

Brian Rafn - Morgan Dempsey Capital

On a cumulative basis you guys had talked not about just a price increase on copper, but an all-in resource -- diesel, oil and gas and net. What cumulatively were the price changes in the June/July period in ‘06 and ‘07?

Richard E. Johnson

We don’t disclose them.

Brian Rafn - Morgan Dempsey Capital

Your comment on ‘08 was you are going to be selective about the choices, is there pressure to do that in ‘08?

Richard E. Johnson

Pressure to increase or decrease?

Brian Rafn - Morgan Dempsey Capital

At this point here as we make the turn, January/February, does the delta change in cost look like an ‘08 price increase is inevitable or is it still too early to tell?

Richard A. Meeusen

I would say given where we are on copper and oil right now we don’t see any major pressure to do a big price increase but we will see where it plays out over the next six months.

Brian Rafn - Morgan Dempsey Capital

I think you guys mentioned that the utility side was a little softer, can you give us the their commercial utility water market, you talked about the residential.

Richard A. Meeusen

You are talking about the commercial water meters? That side of business, not the industrial?

Brian Rafn - Morgan Dempsey Capital

Right.

Richard A. Meeusen

The commercial water meters for the quarter were down a little bit, but that’s just lumpy, that’s timing. It will fluctuate up and down depending upon timing of some large orders to the cities. It wasn’t anything that made us feel like there was softness for the year or there was any major concern.

Brian Rafn - Morgan Dempsey Capital

Rick, tax rate for ‘08?

Richard E. Johnson

Probably similar to ‘07 at this point. Brian, that varies by whatever states we sell in and obviously I don’t know that now, but right now I’d use the ‘07 rate.

Brian Rafn - Morgan Dempsey Capital

Finally with the acceptance and certainly the design and getting the AMR and the popularity of that, is there any pressure from Diehl on availability of radios?

Richard E. Johnson

Availability of radios?

Richard A. Meeusen

You mean from Diehl Corporation?

Brian Rafn - Morgan Dempsey Capital

From Diehl, like sourcing.

Richard A. Meeusen

For those who don’t understand what Brian is asking, we buy our Orion radios. We source them from a company in Europe called Diehl and Diehl is a very large company, they make armament systems and they have a huge amount of capacity for making boards. We don’t see any problem. The fact is we could order those boards from any board house. So, if there was a capacity issue we could buy here in the U.S. if we had to.

Brian Rafn - Morgan Dempsey Capital

You guys have talked in the past about trying to take $2 or $3 of cost out of giving a low end economy, $20, $22, $23 meter. Is that the pit meter that you are talking about now, the plastic meter or is that still another design yet to come?

Richard A. Meeusen

No, Brian that’s the LP meter. That’s just a lower copper LP meter where we’ve taken some cost out of it by removing about a third of the metal.

Operator

Your next question comes from Steve Sanders - Stephens Inc.

Steve Sanders - Stephens Inc.

Can you talk a little bit about the sale cycle on the AMI side? Do you view the growing interest in AMI as more incremental or competitive with your AMR business?

Richard A. Meeusen

I think the sales cycle on AMI is the same if not a bit longer than the sales cycle on AMR because there have to be a lot of decisions made about locations of devices on towers or on municipal buildings. There is a lot of topography work that has to be done. So, we do see it being about a little bit longer, I would say.

Clearly, AMI will take some AMR. There are a lot of cities that say I want to go to a technology, it’s either going to be drive-by or it’s going to be fixed network and I have to make a decision. So I think to that extent, yes, there will be some cities that do that.

On the other hand, I think there are cities that have said I haven’t made an automation decision because I really don’t think a drive-by system will service my entire city and will give me everything I need. Now, that they have that option of putting in a hybrid system with AMI that may move them along. So I think we are going to get some kick from that.

Steve Sanders - Stephens Inc.

You have talked quite a bit about pricing on the meter side. Can you talk specifically about what you are seeing in the market in terms of pricing on the AMR, AMI side?

Richard A. Meeusen

I think generally in the market we are seeing pricing remain pretty stable. There was a time a few years ago when there was a disruptive technology that came in -- well, I shouldn’t say technology, a company -- that came in from England with a very cheap product that they were selling. It caused a lot of price pressure on the technology side. Fortunately for us the products started failing in mass across United States, the company filed bankruptcy and so I think people realized that buying the cheapest product isn’t necessarily the right answer.

So that probably benefited the whole market because we are all able to maintain our higher prices for the better products.

Richard E. Johnson

I don’t think price is the only consideration on the higher end. I mean it’s a key factor, but it’s not the only one. Whereas on the local read or the manual read meters, it’s probably 90% of the decision. There are others factors when you get to the high end.

Steve Sanders - Stephens Inc.

Rich on the gas AMR side, what kind of potential do you see there for Badger over the next couple of years?

Richard A. Meeusen

Well, we’re excited about it. We now have, and have released at DistribuTech we were demonstrating the product. We have the Orion radios for all of the major gas meters in the United States. The thing about gas is that unlike water there are 53,000 water utilities in the United States and there are only about 1,500 or so gas utilities in the United States. So with gas when you make one sale, it’s usually a big one.

So the question is when will we make a big sale? We have had some, we’ve had some success with a couple of gas utilities where we have shipped tens of thousands of units, and we’re in the process of talking to some others that we are pretty excited about that could have a big opportunity.

But for me to guess as to how fast it’s going to be ramp up, it’s kind of an all or nothing type thing and that makes it difficult. Let me also remind you that we are only selling Orion radios. We don’t make or sell the gas meters, we sell the radios to fit on existing gas meters.

Operator

Your next question comes from John Quealy - Canaccord Adams.

John Quealy - Canaccord Adams

Rich, on the last call you talked a little about M&A activity. Can you give us an update and your thoughts there as we go through ‘08?

Richard A. Meeusen

John, we are definitely still interested in looking at the right acquisitions. We did chase some acquisitions in 2007; we did not succeed on any of them. There were two in particular, pretty important ones that we felt we could get; I won’t say major in size they were all in the $40 million to $80 million sales range, but we thought that they would be nice additions to our product portfolio.

In both cases, we backed away because we felt the price was too high and we don’t want to overpay and there are people running around offering 14 time EBITDA multiples still which surprises me, and I just don’t think that’s appropriate.

So we backed away on some of those, but we are still aggressive, we are still actively looking. Having a 15% debt to capitalization ratio bothers me a little bit and we think that there are some acquisitions we could make that provide some nice synergies for our product lines.

John Quealy - Canaccord Adams

Did those acquisitions that you’ve chased down give you any headwind on the earnings side or was it just de minimis impact on the OpEx?

Richard E. Johnson

It would have been accretive.

Richard A. Meeusen

It would have been accretive.

John Quealy - Canaccord Adams

I’m sorry, in terms of any fees or anything like that actually?

Richard E. Johnson

No, we did not incur any significant fees at all. They would have been accretive if we would have gotten them at the price we wanted. I don’t necessarily think they would have been accretive if we would have paid what the ultimate winner did pay.

Operator

The final question comes from the line of Brandon Olsen - Midwest.

Brandon Olsen - Midwest

What was the average price increase on your units from Q4 of last year to Q4 of this year?

Richard E. Johnson

We don’t disclose particular details about price increases. The prices are up.

Richard A. Meeusen

The prices were up, Brandon, but we don’t like to disclose specifically what the price impacts were because we know from the list that we are looking at that a lot of our competitors are listening.

Brandon Olsen - Midwest

I was just trying to figure out growth in units versus growth in price. That’s fine. When you guys talk about the billion-dollar replacement opportunity, so let’s say a $150 million a year or something potential to you guys over a seven-year timeframe. How much revenues do you guys get right now per year on stuff that’s replaced versus stuff that’s sort of greenfield, new meters going in?

Richard A. Meeusen

Well about two-thirds of what we ship is replacement but that doesn’t translate to two-thirds of our revenues because a lot of the replacement is meter-only with local read meters and not radios. So I would say right now probably replacement is maybe 40% of our sales revenues and 60% comes from either people transitioning to AMR/AMI or new customers.

Brandon Olsen - Midwest

So replacement is like $100 million, but you think there is an opportunity for $150 million as there is a potential delta increase of $50 million in your revenues if you guys can execute on that replacement opportunity. Is that a fair characterization?

Richard E. Johnson

Well I didn’t come up with a $150 million number. You did.

Brandon Olsen - Midwest

Okay, a billion over however many years.

Richard E. Johnson

He also picked the denominator.

Richard A. Meeusen

Right. You picked the denominator this time. I do appreciate you are not asking me to give you that. But you can do the math anyway you want, but there is an opportunity out there.

Operator

Your next question comes from Brian Rafn - Morgan Dempsey Capital.

Brian Rafn - Morgan Dempsey Capital

Rich, with all of the talk about infrastructure and the EPA came out with a big number a couple of years ago, say over $500 billion in water infrastructure, and the Highway Bill being passed. Do you see any acceleration in the penetration? You guys always talked about 60 million, roughly 60 million or 64 million meters being out. Do you see any penetration beyond that kind of 50%?

Richard A. Meeusen

What do you mean?

Brian Rafn - Morgan Dempsey Capital

Well, in actual houses being metered. I mean you talked about the rural and then sewers going out to the rural. Do you see any delta change in that process or is it like population growth?

Richard A. Meeusen

No, we do. We estimate that there is about 12 million or 13 million homes in the United States that have municipal service, municipal water service to them, not wells. They have a municipality providing them water who are paying a flat fee. And we are seeing more and more of those looking into metering and recognizing that they have to go metering.

Chicago is an example; there are 340,000 buildings in Chicago, they are paying a flat fee that will eventually be metered. Central Valley, California, a lot of pressure for it in the Southwest and now we are starting to see pressure in the Southeast. I mean droughts are terrible things for most people, but not for us, they do tend to help us.

Brian Rafn - Morgan Dempsey Capital

Anything from the standpoint on the national account sales, we asked about these big cities, I know they are lumpy, they come along. Are you seeing more big city projects being put into play or is it just there is just no transparency there?

Richard A. Meeusen

We’re not seeing a lot of transparency.

Brian Rafn - Morgan Dempsey Capital

You talked about new customer additions. If you look at AMR customers and Galaxy customers, can you make a comment on new customers that Badger gets versus leakage and loss of customers on a net-net basis? Is your retention better than maybe competitors’ or as you gain one, you lose one overall?

Richard A. Meeusen

I think we have extremely high retention, but I also think at least our largest competitor, and I’ll name them, Neptune, I think Neptune also has very high retention. So sometimes we steal one of theirs, they steal one of ours, or kind of like Coke and Pepsi from that point of view. I think some of the other companies in the marketplace have lost customers to both of us.

Operator

There are no further questions. I would like to turn the presentation back over to your host, Mr. Rich Meeusen.

Richard A. Meeusen

Again, I would just like to thank everybody for joining us and we look forward to talking to you next quarter. Thank you.

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Source: Badger Meter Q4 2007 Earnings Call Transcript
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