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Badger Meter, Inc. (NYSE:BMI)

Q2 2008 Earnings Call

July 21, 2008 11:00 am ET

Executives

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

Richard A. Meeusen - Chairman of the Board, President, Chief Executive Officer

Analysts

Richard Eastman - Robert W. Baird

Ryan Connors - Boenning & Scattergood

John Quealy - Canaccord Adams

Patrick Forkin - Tejas Securities

Jaime Lester - Soundpost Partners

James Gentile - Newland Capital

Operator

Good day, ladies and gentlemen, and welcome to the Badger Meter 2008 second quarter conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Rich Meeusen, Chairperson, President, and CEO; Rick Johnson, Senior Vice President of Finance, Treasurer, and CFO. Please proceed, Mr. Johnson.

Richard E. Johnson

Thank you very much. Good morning, everyone and welcome to Badger Meter’s second quarter conference call. I want to thank all of you for joining us. As usual, 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 2007 Form 10-K for a list of words or expressions that identify such statements and the associated risk factors.

Also, I will give you my quarterly reminder about our guidelines. For competitive reasons, we do not comment on specific individual product line profitability, nor do we disclose components of cost of sales; for example, copper. More importantly, we will continue our practice of not providing specific guidance on future earnings. We believe guidance does not serve the long-term interests of our shareholders.

Now on to the second quarter results; this morning before the market opened, we released our second quarter 2008 results. We are pleased to report that sales, earnings from continuing operations, and diluted earnings per share are all quarterly records.

Sales were $74.7 million, a 20.1% increase over last year’s second quarter sales of $62.2 million. The increase was driven by increased sales of our AMR products and commercial meters.

Let me talk about the breakdown of sales. Residential and commercial water meter sales represented 83.3% of total sales for the second quarter compared with 80.6% last year. These sales were $62.2 million, an increase of $12.1 million over last year’s amounts of $50.1 million.

I indicated one of the reasons for the increase was increased sales of AMR technology. Consistent with past quarters, we saw an increase in Orion sales, which were up 9.1% over last year’s second quarter. And due to the mix of customers this quarter, we also saw a 39% increase in Itron sales over last year’s levels. Orion sales still outsold Itron’s by more than a two-to-one ratio.

Included in the second quarter revenues is $3.6 million for the Chicago contract.

We also saw substantial increases in our commercial water meter sales, with about two-thirds of that increase coming from volume increases and the balance coming from price increases.

Industrial products represented 16.7% of total sales for the second quarter of 2008 compared with 19.4% last year. These sales increased about $400,000, or 3.3% over last year’s level. The overall change is the net effect of substantially higher sales of valves, a modest increase in [impeller] sales, and decreases in the other industrial product lines caused primarily by volume declines due to the weaker economy.

Gross margins for the quarter declined slightly from those of last year to 35.3% from 36.2% in the second quarter of 2007. This slight decline is due primarily to the product mix for this quarter. As I just noted, we saw more Itron sales, which have a lower margin than our own proprietary products.

Increased sales volumes, higher prices, and better factory utilization did negate some of the product mix impact.

Selling, engineering, and administrative costs for the second quarter are $1.5 million higher than last year but as a percent of sales are lower. Among the reasons for the dollar increase is that this is the first full quarter in which we have intangible amortization expense for the recently acquired Galaxy technology. Other reasons include increased consulting costs for sales process enhancements and simply the increased sales levels.

As you know, we did acquire the Galaxy fixed network technology for $25.7 million in early April. Throughout much of the quarter, this was financed using short-term debt. In our case, this means we issued commercial paper with rates of 3% or less per annum.

Earlier this month, in July here after the close of the quarter, we did borrow $15 million on a two-year fixed rate note. The rate on that note is 5.04%. We are using this long-term money, if you can call two years long-term, to replace a portion of that short-term debt that existed at June 30th. Even with the increased debt to finance the Galaxy acquisition, our debt as a percentage of total capitalization is 26.3% at June 30th.

Our effective tax rate for the quarter is 38.3%, slightly higher than last year. This is necessary to get us to the current full-year estimate of 37.9%.

Earnings from continuing operations for the second quarter of 2008 were a record $7 million compared to $5.7 million last year. On a diluted basis, earnings per share from continuing operations were $0.48 compared to $0.39 for the same period in 2007, and as I noted, this is also a record for any quarter.

With that, I will now turn the call over to our President and CEO, Rich Meeusen.

Richard A. Meeusen

Thanks, Rick. I’d also like to thank all of you for joining us today. Obviously, we’re pleased with the second quarter results, especially when compared to the results of many other companies, both inside and outside our segment who are struggling in these difficult economic times. Badger Meter certainly faces many of those same issues, including higher commodity costs, higher freight costs, and a slower general economy, especially in the industrial sectors. However, unlike many other companies, we have been able to offset most of those headwinds through the continued strength of our water markets and the strong performance of our technology products.

I will remind you again, however, that our business can be somewhat volatile on a quarter to quarter basis. Nevertheless, we believe that our focus on long-term results can generate good growth in both sales and earnings from year to year.

The Chicago project continues to move ahead on plan and I am pleased to report that the Orion product and our plastic meters are performing exceptionally well for the city. As Rick mentioned, this quarter included $3.6 million of sales to Chicago, which is right in line with our expectations for this $40 million, three-year project. Our sales to Chicago under this contract have been a little over $7 million to date.

Let me again address the general economic conditions in our markets. For the past several quarters, I’ve told you that although the broader economy keeps slowing, we have not seen any impact on our water business. This statement still holds true today. In a few of our non-water industrial segments, we have seen some slowdowns. However, this has been offset by higher sales of our valve products, particularly for valves sold in the petroleum industry.

Having said that, I will also remind you that our water segment has not always been immune to the impacts of the general economy. Although we do not see any slowdown at this time, a prolonged economic recession could eventually have a negative impact on our water meter and AMR/AMI sales.

Regarding our Galaxy fixed network product, you may recall that we purchased all rights to that product last quarter. We are seeing only moderate sales of this product at this time but we do have a strong pipeline of RFPs and quotes which gives us continued confidence in the long-term potential for AMI in the water industry.

On the last few calls, we’ve updated you on the progress on construction of our new facility in Nogales, Mexico. The 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. This facility is expected to be completed this quarter, with move in during the fourth quarter.

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

With that, we’ll take any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Richard Eastman. Please proceed.

Richard Eastman - Robert W. Baird

Can you give us a sense of what the net price capture was in the quarter at the sales line?

Richard E. Johnson

We generally don’t disclose that, Rick. It was substantial enough to cover I’d say the increase in costs that we’ve seen over the past year.

Richard Eastman - Robert W. Baird

Okay. And was there -- when I look at your receivables number, it’s up about 24%. Is there any sense on your part that perhaps distributors are ordering ahead of the July price increase that you mentioned in the press release?

Richard A. Meeusen

Well, first off, we didn’t see the receivable increase as anything that raised our eyebrows because our DSOs actually went down. So it really was related to the normal activity of the business.

In the past, we’ve now had three -- with this year, we’ve had three July 1st price increases in a row, and so clearly we’re conditioning our distributors in the market to the idea that we are going to have annual price increases as long as commodity prices keep coming up on us like they have. So it is possible that some of the distributors put in orders and tried to get them filled before the July 1st price increase but we really didn’t see a big impact from that at all.

So we’re not anticipating a big drop-off in July because they pumped it all into June, or something like that. We haven’t seen that at all, Rick.

Richard Eastman - Robert W. Baird

And when you look at this July price increase, how does it look relative to last year’s July increase? I mean, is it half the rate, is it the same, or --

Richard A. Meeusen

Again, we don’t like to go into details on the price increases. It is lower, there’s no question, because last year we were still dealing with a lot of the big jump in copper and copper has settled more or less for the last few months. Although we did do some things with our freight charges because of the cost of -- I mean, we’re getting surcharges from our freight carriers, so we are passing those on.

So it was really more related to the freight side and then to certain products. It was not an across-the-board increase.

Richard Eastman - Robert W. Baird

Okay. And then Rich, another question I have, or Rick, another question on the Chicago business -- did it noticeably impact your gross profit margin line?

Richard A. Meeusen

You mean negatively or positively? I’m not sure --

Richard Eastman - Robert W. Baird

Negatively, because again we have some of the labor, the installation, we’re running that through the P&L. I mean, is there a year-over-year decrease in basis points in gross margin that [could be attributable] to Chicago?

Richard E. Johnson

The short answer is yes because also included in the $3.6 million is a portion of pass-through for the installation. If you’ll recall when we announced the $40 million originally, we said $24 million of it was for product and about $16 million of it was for installation, and that installation piece would more or less flow through.

Richard Eastman - Robert W. Baird

Okay. All right, and then just one last question; Rick, do you have an absolute number for SG&A expenses in the quarter? Just, you know, dollars? Just so I can get an operating profit, or either one.

Richard E. Johnson

$14,624,000.

Richard Eastman - Robert W. Baird

Okay, and that’s SG&A?

Richard E. Johnson

That’s -- yeah, selling, engineering, and administration.

Richard Eastman - Robert W. Baird

Great. Thank you.

Operator

Our next question comes from Ryan Connors, Boenning & Scattergood. Please proceed.

Ryan Connors - Boenning & Scattergood

Good morning. Congratulations to your and your staff on another great quarter. I just had a couple of quick questions. First of all, on the Itron resales, the strong performance there that you mentioned in the prepared remarks seems to sort of be counter to the trend that we’ve seen the last few quarters, and I just wondered how you are thinking about that. Are you looking at that as a shorter term blip, sort of the normal volatility or is there something more meaningful there that leads you to believe that that’s a trend?

Richard E. Johnson

I think we’ll both make a comment on this. My comment is that I can look at the quarter and pick out four customers that specifically drove that increase in this quarter and for the most part, they were Itron customers and they wish to continue to be Itron customers, and it’s just -- it’s a function of they all happen to hit in this quarter.

We always talk about the fact that this business is a little bit lumpy and it just so happens they all hit in this particular period.

Richard A. Meeusen

Ryan, there’s no question that jump in Itron sales caught us a little bit by surprise because our long-term trend, and we’ve shown the charts at our meetings and stuff, our long-term trend is for decreasing Itron sales and higher Orion sales. And so that was a little bit of a surprise that we had the jump in the Itron.

We went and looked at it very carefully and it was a handful of customers that were doing Itron projects. They wanted Badger meters with Itron radios and their long-term projects, they’ve been doing them for a while and they all kind of accelerated and took large orders in this quarter.

So we do view it as more of an aberration and we think our long-term trend is going to continue to be either flat or decreasing Itron sales and much stronger increasing Orion sales.

Ryan Connors - Boenning & Scattergood

Okay, great. And then sort of taking a bigger picture look, I mean, obviously the shift towards AMR and then towards Orion in particular is a big part of the investment thesis for Badger Meter. I wondered if you could just reset us on your latest thinking there in terms of what the total market opportunity looks like and in particular, whether you see that transition from manual read to AMR sort of accelerating or decelerating the next couple of years, given what you said in your prepared remarks about the fact that your sector is not totally immune from macroeconomic concerns.

Richard A. Meeusen

Well, first off, let me comment on the general trend. In our market in general, we think there’s about a $6.5 billion opportunity. If you assume that only about 25% of the water meters in North America have radios on them, that’s still a huge opportunity out there for us to go after. So we don’t see any weakening in that opportunity and I would think that in the long-term, we’re going to see increasing sales and increasing transitions to AMR as we go forward.

Badger itself with our Orion opportunity, I’ll remind you that of the Orion customers that we have already signed up, some are fully deployed, some are just beginning their deployment, like Chicago, but on average, they are about 25% deployed. So we still have a huge -- let’s call it an un-booked backlog of orders, of potential orders from customers who were finished their Orion deployments, and that represents probably about $600 million of potential sales, just to finish the existing customers without even considering new customers that we are signing up.

So I am still very optimistic about the future of the Orion product in specific and the future of the water AMR/AMI potential in general for our whole industry.

That having been said, let me clarify my comments about the economy; we still are not seeing any slowdown but historically, if the country goes into a really deep recession and a lot of the municipalities see major lay-offs and plant closings, they may think well, now is not a good time to start a major meter change-out program. And so we could see some impact down the road if that were to happen. But I have to keep emphasizing at this point, given the economy and where we are right now, we are not seeing any impact. We have seen no slowdown and you can see from our numbers, we’re still booking very strong sales and we just aren’t seeing the slowdown.

Ryan Connors - Boenning & Scattergood

Okay, yeah, that’s certainly clear. And then just switching gears, Rick, can you just give us an update on your thinking in terms of cash deployment, specifically how you are looking at the acquisition market and where your focus is there? I mean, would your focus be on consolidating the meter market itself or trying to roll up some of the smaller technology, niche technology acquisitions along the lines of Galaxy? Just give us kind of an update on where you are at and how aggressively you are looking out there on that front.

Richard A. Meeusen

Again, we are still very interested in acquisitions because as a company, we continue to kick off a lot of cash. And we think the technology acquisition of Galaxy was a good acquisition but Rick only did a two-year debt float because he feels that in two years, we’re going to be out of debt again. And so it is a concern for us and we want to find a good use for the capital that we are generating.

We look at our acquisitions in two different ways, and first off the fact that we haven’t made an acquisition other than the Galaxy one in the last few years should not be any indication that we’re not interested in it. We did chase two companies last year. We walked away from both of them because the price got too high. We don’t want to over-pay, so we’re trying to be very careful about it but we are still looking at companies that are out there.

And they fall into two groups; one is the smaller flow technology type acquisitions. These are acquisitions that may run in the $10 million to $50 million range, like the Galaxy acquisition, or we’re either buying a technology or -- an AMR type technology or a flow technology that we can kind of plug into our existing organization. And we still are looking at those and pursuing them.

The other one is the larger -- if you want to call it a transformation acquisition, where we would go out and buy something pretty major that would have a big impact on our company.

We’re open to either kind of acquisition and we are looking at both of those kinds, but more realistically the smaller acquisitions are the ones that we’re more likely to find going forward.

Ryan Connors - Boenning & Scattergood

Okay, that’s helpful. And then one last, one quick one; Rich, you mentioned that on the industrial side is one of the areas you saw a real strength was from the energy related end markets. Can you just give us a rough idea, order of magnitude, what percentage of the revenue in that segment comes from those types of energy related markets? Is it 10%, 50%?

Richard A. Meeusen

We don’t like to get down to that level of granularity, because it’s very hard to say exactly what’s in there. Bear in mind our valve business is really only about -- it runs in the 5% to 8% range of our total sales, so it’s not a huge amount of our sales. It’s just that when you look at that whole industrial segment of ours, which is less than 20% of our sales now, most of it was flat or down and valve was up pretty dramatically offsetting it. But we don’t like to go down into the granularity of how much is in which segment.

Ryan Connors - Boenning & Scattergood

Understood. Thanks for all the color this morning, guys.

Operator

Our next question comes from John Quealy from Canaccord Adams.

John Quealy - Canaccord Adams

Good morning, guys. Good quarter. Let me just go back to some housekeeping; I think under the water side, we were talking about commercial meters actually did well in terms of volume. Can you give us a little bit more detail what was driving that?

Richard E. Johnson

I’m sorry, the question is what about commercial meters?

John Quealy - Canaccord Adams

Under water, Rick, I think you said commercial meters --

Richard E. Johnson

Commercial meters, again, I reiterate our comment; we won’t comment on individual product line profitability but one of the areas that we did see a significant increase was in our commercial meter side, primarily -- I mean, driven a lot by volume increase.

John Quealy - Canaccord Adams

Okay, but there was no major new distributor or project there -- there’s just --

Richard A. Meeusen

No, John, but one of the things you have to understand is that when we land an account like a Chicago, let’s say, or any city that decides to convert to Orion or convert from a competitor’s meter to Badger, we always focus on how many residential meters there are but there are always commercial meters that go with that. There are always the larger commercial/industrial meters and so that’s what we are seeing. This is not a case of some city saying okay, we’re buying residential meters from somebody else but we want Badger's commercials. This is more the commercial meters that follow along with a lot of our residential and that’s where we saw a lot of increase.

John Quealy - Canaccord Adams

And then just a quick housekeeping for Rick; the impact of Galaxy on the P&L this quarter, can you break it out in terms of what amortization or interest expense was for us?

Richard E. Johnson

Well, interest expense is not significant to begin with for the quarter. It’s about $300,000 for the whole quarter. You know, we borrowed $25 million. I think you can do the math on that one, and the amortization is less -- I’d say it’s about $400,000 for the quarter, a little less, maybe. 380 or something like that.

John Quealy - Canaccord Adams

And then two more questions, one on Nogales; if you move in Q4, how long do you think it will get up to full capacity or full plan, and what do you think the related margin impacts are going to be? Are we going to have to wait a quarter or two for the margins to lift there or how do you model that moving forward?

Richard A. Meeusen

We’ve got a pretty good idea of what it’s going to take because as you’ll recall, last year we moved our plastic molding facility, we closed the Arizona one and moved it into a smaller building on the same site as we’re building the larger one in Nogales. And that took us about six months to get -- to start getting the full benefit that we were looking for, because obviously there’s disruption, there’s training, there’s a lot of that kind of thing. This one might be a little bit shorter but when we say we’re moving into the fourth quarter, we would expect to probably start moving in maybe in September and be done by December 31st. And basically be out of -- remember there’s a 60,000 square foot facility that we’re in right now in Nogales that we are leasing, so we would expect to be out of that by the end of the year and fully into this new 120.

Now, when you say when we expect to hit capacity, that building is going to have excess space for quite a while, because we built it to cover future growth. And also to allow us to shift work out of our higher cost facilities down there. That shifting of work may take a few years but we are going to get some immediate benefit just getting into the larger facility from the one we’re in, in efficiency and all that and I think that you are talking a few months.

John Quealy - Canaccord Adams

Great, thanks. And my last question, in terms of future opportunities, I think last quarter we chatted about the potential for follow-on on Chicago. Two questions, Rich; number one, how long do you think that decision takes to work its way through the Municipality of Chicago? And then number two, can you give us a little update on gas? There’s been a lot of chatter in the market on gas and I just want to get Badger's update there.

Richard A. Meeusen

I’ll take water and I’ll let Rick comment on the gas. I’ll take the Chicago issue. Our contract with Chicago is a three-year contract to do the $160,000 residences and buildings that have meters now, changing out half of them and putting Orion on the whole 160. That will represent about a third of the city when we’re done with that, and we believe that the city intends once that project is done to start installing meters on the other two-thirds of the buildings that don’t have meters at all.

I would think that within the next year to two years, the city is going to have to start the process of figuring out how that’s going to go, because if they want our crews to stay down there and just keep working, we’re going to have to know that ahead of time. So I would look for that somewhere between the next 12 and 24 months, where we’ll have a better feel for when that’s going to happen.

Richard E. Johnson

And with regard to gas, I think we’re seeing a lot of opportunities out there, a lot of RFPs. It’s an easy business for us to get into. I mean, we always talk about barriers to entry to get into certain industries. In our case, we already have gas Orion for that industry and if we hit some of these, that excess capacity in Mexico could soon be deployed making that. It’s one of the reasons we keep talking about needing that extra capacity. If we were to hit on some of these big orders for gas, it doesn’t take us much to ramp up production down there because for the most part, it’s just assembly. So that’s one of the reasons we’re kind of hedging on the answer about the capacity for Nogales. If that doesn’t pan out, we continue migrating work from Milwaukee down there.

John Quealy - Canaccord Adams

Great, thanks, guys.

Operator

Our next question comes from Patrick Forkin, Tejas Securities.

Patrick Forkin - Tejas Securities

Good morning. Congratulations on a good quarter. Guys, I have a couple of questions on -- longer term on strategy and competitive outlook for Galaxy and fixed network AMI for the water business. You know, recently there’s been a couple of really large contract awards, one in New York for about $875,000 by the City of New York that went to ESCO on the fixed AMI side. And then it looks like the City of Toronto is getting ready to award a contract in excess of $200 million for 465,000 meter replacements by Neptune and a fixed network by ESCO.

My question is are these the type of situations that you guys would -- you know, that Galaxy makes sense for? Did you participate in these solicitations and what your outlook is for those types of jobs?

Richard A. Meeusen

Patrick, we did not participate in those and we didn’t participate for several reasons. One is that obviously ESCO’s hexagram product has been around longer than any of the other fixed network products and it’s been deployed out there for I think over 10 years in some cities. So some of the cities immediately say we’re only interested in looking at products that have been deployed for a certain number of years, and that eliminates Galaxy and eliminates a lot of others.

The other thing is, some of these cities on the margins get really thin and they are pretty high risk because your required to set a fixed bid and you have the risk that if you need to put up a lot more towers to collect the reading, that’s all on your nickel. And I think some of our competitors, without naming names, have run into that in some of their larger city applications.

Where we’ve been playing with Galaxy and where we’ve been very successful is more in the mid-size and smaller cities, where we know exactly what it’s going to take to do it and we can better predict how many towers we’re going to need and how much infrastructure is going to be required.

So at this point, we are not targeting galaxy on extremely large cities. That’s not to say we won’t in the future but at this point, with ramping it up and getting it out there, we’ve been focusing more on the middle and smaller sized cities.

Having said that, let me point out that the New York contract was for the technology only and the burroughs are allowed to buy meters from any meter manufacturer and each burrough will be making those meter decisions on their own. We have sold meters into New York in the past. We expect that we will continue to sell meters into New York. Our meters do work with the ESCO technology. So there are still opportunities for us and I would think the same thing might exist on Toronto.

But as far as Galaxy goes, no, we did not target New York or Toronto with the Galaxy product.

Patrick Forkin - Tejas Securities

Okay, well, it looks like the price per endpoint on both of those are pretty healthy, so I’m not sure I totally agree with your conclusion on the margins. But with the --

Richard A. Meeusen

Well, you have to be careful, Patrick, because when you talk price per endpoint, are you talking about the price with installation, without installation? Are they factoring in all of the hardware that’s necessary, the infrastructure that has to be built? I mean, if you just take the total dollar value of the contract and divide by the number of endpoints, you are going to get a much higher number than what you would normally expect and you have to look at what those components are.

Patrick Forkin - Tejas Securities

Yeah, I’m quite aware of what the component pricing is. With these, do you see any chance that some of these larger AMI deployments you may end up actually hop-scotching over the transition from AMR? In other words, do some of these utilities that have nothing right now just go directly to AMI?

Richard A. Meeusen

I think that’s very possible.

Richard E. Johnson

It’s possible but also if you’re really just looking for reads and you’re looking to automate your reading, AMR we still think is going to be the predominant seller for the next several years because it’s still the most cost efficient. Where the AMI is going to help on a water utility, you know, and again, electric companies have different needs than water utilities. Where we really think it’s going to help is where you can’t -- you know, gated communities, air force bases, those kinds of things where you can’t get access to it. So we really view the sales over the next several years are going to be more hybrid systems, if anything.

I don’t know that water wants to go to a fixed network that fast, because it’s just not cost-effective at this point.

Patrick Forkin - Tejas Securities

If that’s the case, why is New York and Toronto doing what they are doing?

Richard A. Meeusen

They are large cities. I think they are a little enamored with the technology. It might not be as easy to read some of those larger cities by driving down the street, especially New York, a city like that. I think there are other reasons why they are looking at it.

Patrick Forkin - Tejas Securities

Okay, fair enough. Thank you.

Operator

(Operator Instructions) Our next question comes from Jaime Lester, Soundpost Partners.

Jaime Lester - Soundpost Partners

I’ll echo, great quarter. Can you just repeat what you said about the Itron revenues? I hopped on the call a little bit late.

Richard E. Johnson

Sure. They are up 39% Q208 over Q207.

Richard A. Meeusen

And what we said, Jaime, was that we viewed it as a little bit of an aberration because our long-term trend has been, and we expect it to continue, to see Itron sales either being flat or down. That’s what we’ve been seeing over the years. This was kind of an unusual jump. We could trace it back to four customers that had projects going for quite a while and simply took a large volume in that quarter.

Jaime Lester - Soundpost Partners

Have you ever discussed what actual percent of the sales are? I know in the 10-Q for the first quarter you said that Orion sales were around three times that of Itron. Does that mean Itron’s around a quarter of that?

Richard E. Johnson

We try and add some -- we try and give you some flavor but we do not disclose specific numbers on individual products.

Jaime Lester - Soundpost Partners

Okay, great. I guess the second question is you talked about the $600 million of un-booked backlog. Why aren’t these municipalities installing that $600 million? I guess is it a different ROI calculation for that part of the city versus what you’ve already installed? What sort of timeframe do you think that would take to --

Richard A. Meeusen

Jaime, we have cities that will do their entire city within one year, and that’s probably about the quickest that they can deploy it because remember, when you are putting these things in, it still requires in the north somebody to access the house, and in the south they are going out to the pits. Very often it’s a plumber who is turning pipes and so there is a limit to how fast these can be deployed. You’re not running down the street just tossing radios on to front porches.

So some cities will do it in as short a time period as a year; others will take a good 10 or even 15 years because some cities say, you know what, we’re only going to change out the meters as they wear out. It is costly to gain access to the home and to get down in there, so when the meter wears out, that’s when we’ll put the radio on.

So it isn’t always driven by the IRR. It’s often driven by just the city’s philosophy and how they want to adopt AMR.

Jaime Lester - Soundpost Partners

So is the right way to think of that $600 million as probably a 10- to 15-year revenue opportunity, because it --

Richard A. Meeusen

No, actually, I would tend to think of that as a shorter period because like I say, you’ve got cities doing it anywhere from one year to 15 years. So I mean, you know, you could try to take an average in between there. I’m not saying that would be the right thing but obviously there’s something in --

Jaime Lester - Soundpost Partners

But the one-year portion would already be in the backlog, right?

Richard A. Meeusen

One year might -- well, in our existing backlog, yeah.

Jaime Lester - Soundpost Partners

Yeah. Okay, anyway, I can go from there.

Richard A. Meeusen

And by the way, I’ll just -- when Rick says that $600 million number, you also usually say that assumes we never get another Orion customer, okay? And we are still adding Orion customers. I think you’re really doing that as an example of what’s out there.

Richard E. Johnson

Right, that’s saying if all of the customers who started deploying Orion already finish their deployments, it’s about $600 million more of sales.

Jaime Lester - Soundpost Partners

Yeah, I’m with you. Okay, can you talk about -- I mean, it seems like some of the larger cities, you’re not really going after because the margins are too thin. Maybe some of the smaller ones are too dispersed out there to warrant the sales effort also. Can you talk about what percent of the market is in the sweet spot for what you are selling?

Richard A. Meeusen

Sure, Jaime. There are 53,000 water utilities in the United States, and about 40% of the water meters are made up by the largest 400 utilities. And then the next 40% are made up by the next 4,000 utilities, and the remaining 20% of the water meters are represented by 49,000 water utilities, and those are very rough numbers but that’s one way to kind of think about how you might segment the market.

Badger's sweet spot for a long time has been those 4,000 utilities right in the middle there. The smaller ones are very often served by distribution and a lot of people -- you know, we don’t even necessarily deal with them. They deal with their local distribution, but the 4,000 in between are a lot of good accounts where we can earn a reasonable margin and do a good job. The 400 largest ones usually go out and it’s a very difficult bidding process and the margins get pretty thin.

Obviously Chicago is one of the large ones. We were successful there but it can get pretty tough on the larger ones.

Jaime Lester - Soundpost Partners

Okay, and then within that 40%, you guys have overall about a 30% share of the market, so is it fair to think that you guys have a well over 50% share of that 4,000?

Richard A. Meeusen

No, I don’t think so and I wouldn’t characterize it that way. We have 30% of the market and it really comes out of all of the segments. Yeah, there’s probably a little bit more in that middle tier but I wouldn’t necessarily say that we’ve got over 50% of the middle tier. That would seem to be a little high to me.

Jaime Lester - Soundpost Partners

Okay, so even though the top and bottom portion is not what you prefer, it’s still a pretty decent chunk of your business?

Richard A. Meeusen

Well, I prefer anybody who wants to buy a water meter, but --

Jaime Lester - Soundpost Partners

But for the right price. Okay, and can you talk -- is there any way you can give a little bit more color about what you are seeing with municipalities and how that process actually works? Is the budget cycle for most municipalities a calendar year budget? Is the water utility going to get an edict or something from the municipality itself saying restrict capital expenditures as of three months? I guess if we can think about kind of what the -- you know, where the streams in the municipality’s budget started to appear and whether or not that’s worked its way through a budget cycle, or whether we should expect that, and that’s maybe why your caution is coming out a little bit, or any color on that would be great.

Richard E. Johnson

We’re just naturally cautious by nature. I mean, that’s just the nature of the organization, so I’ll say that. But you’re asking a question and you’re asking for a generic answer on how 53,000 municipalities act and there is no one straight answer. I can recall a municipality that was having money problems but decided to put in new meters because the old ones were 15 years old and only reading at 92% accuracy, so they actually got a revenue increase without a rate increase because they put in new meters. So that went -- that was actually contrary to what the thinking is.

You have certain states where the water utilities are standalone entities and run kind of as a utility where they get a return on their assets, where essentially even though they are city owned, they are not allowed to share revenues. You get other states where whatever money comes in from the water utility gets used as part of general operations.

There is no way of looking at it, so you go back to Rich’s comment, we’re not seeing any signs at this moment. I think the note of caution we put out there is simply because of maybe the examples you see. Could municipalities start slowing down their spending because they are paying $4 for gas or the cost of asphalt has increased or whatever.

What we are saying is we haven’t seen that yet but going back to Rich’s prepared comments, there’s always that chance. We’re just not seeing it at the moment.

Jaime Lester - Soundpost Partners

I guess what maybe would be helpful is would you be seeing it based on the budget cycles of municipalities? Or if the bulk of them are on calendar budgets, would you not start seeing it until maybe the fall when they are starting to order for next year and the budgets are coming down going forward? That’s what I’m trying to get to here.

Richard E. Johnson

I understand but a lot of municipalities are also on a July 1st to a June 30th year, and so we are not seeing it at the moment. Not to say it can’t happen -- we’re just not seeing it.

Jaime Lester - Soundpost Partners

Okay, great. And then have you disclosed what percent of the, or roughly what percent of the meters that you sell go into new construction, either commercial or residential?

Richard A. Meeusen

We don’t know that, Jaime. It’s a hard thing because very often, probably about half our sales are through distribution and so we don’t always know exactly where the distributors are selling it. And when a city calls us and says send us 200 meters and we ship them, we don’t know if those meters end up on a new subdivision or in their replacement cycle. So it’s very hard. There’s no accounting for that so we really don’t get a feel for it at all.

Jaime Lester - Soundpost Partners

Okay, but it’s obviously not that much because it hasn’t really certainly had much of an impact on your results right now.

Richard E. Johnson

Jaime, two-thirds of the business is replacement. I mean, meters wear out and on average, they are replaced every 15 years. So I mean, two-thirds of it is there. We’ve talked in the past about housing does not have a profound impact upon our revenue -- a slight impact, yes, but not a profound impact.

Richard A. Meeusen

A lot of new houses are built in areas where people don’t have meters, where they are on private wells and it isn’t until they bring city sewer and city water to that area that you end up getting it metered.

Jaime Lester - Soundpost Partners

Okay, perfect. Thanks, guys, and congrats again.

Operator

Our next question comes from Richard Eastman from Robert W. Baird.

Richard Eastman - Robert W. Baird

Just as a follow-up, Rick, you had mentioned the commercial meter business being up, and you mentioned two-thirds was volume, a third price. How much up was it?

Richard E. Johnson

Well again, Rick, we don’t disclose individual line profitability. We really aren’t -- we don’t disclose that level of detail.

Richard Eastman - Robert W. Baird

Well, let me ask you this --

Richard E. Johnson

It was up -- overall revenues are up I’d say over a third, over 33%, overall.

Richard Eastman - Robert W. Baird

The overall commercial revenue?

Richard E. Johnson

Overall commercial meter revenues, right.

Richard Eastman - Robert W. Baird

Okay. And so -- okay, so you are saying that commercial meter sales revenue were up about 30%?

Richard E. Johnson

Yeah, you could say that. In that area.

Richard Eastman - Robert W. Baird

Okay, and that goes a fair amount away in the direction of bumping revenue, so when you talk about your overall revenue growth being influenced by mix, this would have been -- the commercial meter business would have been responsible for that?

Richard E. Johnson

That’s part of it, yes.

Richard Eastman - Robert W. Baird

Yeah, okay. All right, very good. Thanks.

Operator

Our next question comes from James Gentile, Newland.

James Gentile - Newland Capital

You’re in the enviable position of generating excess free cash flow and you’ve mentioned from time to time the acquisition strategy and really nothing has come to fruition, and I imagine that prices are a bit high in the areas in which you are interested in pursuing. Would you consider buying back stock?

Richard A. Meeusen

Well, obviously if you are generating excess cash, you’ve only got a few choices. One is to deploy it in the business somehow, either through acquisition or capital expansion or something like that, or you can give it back to the shareholders, either through buying back stock or a special dividend or something like that.

We’ve avoided the idea of a stock buy-back because one of Badger's problems used to be that we had such thin liquidity, thin trading, and our stock price was really volatile, based on the fact that there were days when zero shares traded.

Over the last five years or so, we dramatically increased our outstanding float and we don’t have that kind of volatility and we’re very happy with that. A stock buy-back would kind of go opposite of that move. So we feel we’re much better off finding ways to deploy that excess capital into the business in areas where we have some expertise and we can bring some synergies and that’s through acquisitions.

You are right that the acquisitions we’ve walked away from were ones where the price just got too high, and we are not going to pay 12, 14 times EBITDA for an industrial flow company. It just doesn’t make sense to us.

James Gentile - Newland Capital

Can I ask a question why I would be interested in buying a flow business at 12 or 14 times cash flow either?

Richard A. Meeusen

Well, I don’t think many people would, but -- other than Badger.

James Gentile - Newland Capital

Right, exactly. Because even at the EBITDA multiples that the market seems to -- you know, which clearly deserved, you know, those types of low double-digit EBITDA multiples would be accretive, no?

Richard A. Meeusen

Well, they could, yeah, and especially if we can get some synergies on the acquisition, yes, they could.

But again, one of the problems is a lot of these companies that are for sale, unlike Badger, are not growing companies that are seeing real success in the marketplace, and that’s the reason they’re for sale. And I’m often surprised to find somebody who is trying to sell a company whose sales have been flat or even down and they still think they ought to command double-digit EBITDA multiples. It just doesn’t make sense to me.

So those are the situations where we walk away from and usually there’s somebody from private equity with a bag of money that they just absolutely have to spend and they go and get it, and so be it.

I think we’re starting to see that change in the marketplace a little bit, so I think we’re going to have more opportunities and we are going to pursue those. But we will not overpay. We’re pretty disciplined about that.

James Gentile - Newland Capital

We certainly respect that but buying back stock at this juncture is definitely off the table, yes?

Richard A. Meeusen

We would only do that if we went for the next couple of years and just found no acquisition candidates. Then we’d have to start thinking about those other strategies.

James Gentile - Newland Capital

Excellent. Thank you very much.

Operator

At this time, there are no more questions. I would like to turn the call back over to Rich Meeusen. Please proceed.

Richard A. Meeusen

Well, I want to thank everybody for joining us today. Obviously we are very pleased with the quarterly results. We still see a lot of strength in our markets and in the acceptance of our products. We’re pleased with how Badger is performing and we are hopeful that we can continue to keep the strong performance going into the future. So thank you for your time today.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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Source: Badger Meter Q2 2008 Earnings Call Transcript
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