Badger Meter, Inc. (BMI) Q4 2011 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Quarter 4 2011 Badger Meter Earnings Conference Call. My name is Robyn, and I will be your operator for today. [Operator Instructions] I would now like to turn the conference over to your host for today, Mr. Rick Johnson, Senior Vice President, Finance and CFO. Please proceed.

Thank you very much, Robyn. Good morning, everyone, and welcome to Badger Meter's Fourth 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 yesterday's earnings release for a list of words or expressions that identifies such statements and the associated risk factors. Let me reiterate some of our guidelines. For competitive reasons, we do not comment on specific individual product line profitability, other than in general terms, nor do we disclose components of cost of sales, for example, copper. More importantly, we continue our practice of not providing specific guidance on future earnings. We believe specific 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 2011 results. In our last conference call, we predicted that concerns over municipal financing and slower housing starts would impact the fourth quarter. Unfortunately, we were correct in that assessment and its effects on our fourth quarter results. Sales for the fourth quarter were $60.7 million versus $64.8 million in the same period in 2010. This represents a $4.1 million or 6.4% decrease. This decrease is caused primarily by lower sales of residential water meters and a decrease in sales of radios into the natural gas industry compared to the fourth quarter of 2010. It is mitigated somewhat by the inclusion of Remag sales in the fourth quarter this year, which were not part of the 2010 fourth quarter results. Water applications represented 79.7% of sales for the fourth quarter compared to 80.6% in the prior year. Sales of water application products decreased nearly $3.9 million or 7.5%, at $48.4 million compared to $52.3 million in 2010. The decrease is due to lower volumes of meters sold, particularly Itron-related products. While ORION sales were down 4.3% in the fourth quarter compared to 2010, Itron sales were down nearly 49%. In this most recent quarter, ORION-related products outsold Itron-related products by a ratio of over 3:1. Sales of GALAXY fixed network products were up over 40%. We also saw declines in local or manual read meters. Commercial sales were relatively flat between years. Specialty products sales represented 20.3% of sales in the most recent quarter compared to 19.4% in the fourth quarter of 2010. These sales declined approximately $200,000 or 1.6% to $12.3 million from $12.5 million last year. Included within this group are sales of radios into the natural gas market, and the decline in these sales is the primary reason for the specialty products decrease. All other specialty products showed increases Q4 over Q4 as the economy continues to improve. The fourth quarter of this year also included $0.8 million of Remag sales, about $800,000. Gross margin as a percent of sales was 31.9% compared to 38% in the fourth quarter of last year. The primary reason for the lower percentage is the lower volume of products sold and the related impact on absorbing our fixed costs. This negative impact was offset somewhat by reduced copper prices and the price increase we put into place on January 1, 2011. Selling, engineering and administrative expenses, we call it SMEGA, increased nearly $2.4 million or 15.8% over the same period last year. Some of the increase was attributable to Remag being in the 2011 number. But there are 2 significant charges that are included in this category that need to be pointed out. First, as most of you know, we acquired Racine Federated just last week on February 1. However, the agreement was signed at the end of the year and most of the acquisition charges associated with this were expensed in 2011. These amounts total almost $1 million or about $0.04 a share on an after-tax basis. As we go into 2012, we are not expecting significant additional acquisition costs. Another significant expense incurred in the fourth quarter was a onetime noncash charge for pension curtailment. We recently signed a new 5-year contract with our only union in Milwaukee, in which the union agreed to certain changes that give the company flexibility in managing the Milwaukee plant in exchange for certain work guarantees that the company made. One of the changes the union agreed to was to move away from a defined benefit plan or the defined contribution plan similar to what the rest of the company's U.S. employees receive. Because the defined benefit plan is frozen as of the end of the year, the company incurred this noncash, onetime curtailment charge. I should note that this so-called charge was already reflected on the company's balance sheet as part of other comprehensive income. The agreement with the union simply triggered an accounting event where it needed to come out of that account and be recognized in the income statement. The curtailment charge was nearly $1 million. The portion that affected the income statement was approximately $0.03 per share. Our provision for income taxes was 39.6% of pretax income. While this appears to be high, it is really just a mechanical arithmetic issue due to the much lower pretax income in the quarter. For the year, the effective tax rate was 29.9%. As we told you in the last conference call, the third quarter did contain recognition of previously unrecognized tax benefits for certain deductions that we took on our 2009 tax returns. These benefits totaled nearly $1.5 million and were recognized in earnings in the third quarter. Had that not happen, the effective tax rate for the year would've been about 34.5% compared to 35.5% for 2010. As a result of all of this, net earnings from continuing operations were about $1.2 million or $0.08 per diluted share in the fourth quarter compared to $6.3 million or $0.42 per diluted share for the same period in 2010. For the year as a whole, our sales were down about $13.7 million or 5% to $262.9 million. A year ago, we commented that while we thought a recovery in our business is underway, there would be continuing headwinds associated with what we perceived as high copper prices. While those copper prices have come down a little, we did not realize the market would be so profoundly affected by events of the past year. Poor weather early in the year, debt ceiling talks in Washington in summer, the continuing European fiscal crisis and the volatility in the stock market all contributed to great uncertainty over municipal financing. Combined with lower housing starts, it appears as if the industry took pause in 2011 to assess the impact of all of this as it moves forward. One of the reasons we cited for our first quarter results last year was the winter weather that had plagued much of the Midwest, Northeast and even parts of the deep South. I'm almost hesitant to say this, but so far this winter, at least in these parts, it's been relatively mild, which certainly cantered business as we move into 2012. Just a quick comment about our financial condition. At year-end, our balance sheet remains solid. Our debt as a percentage of total capitalization is now less than 1%, although that changed last week when we executed the purchase of Racine Federated. To those of you who are curious, we have financed the Racine Federated purchase using our existing line of credit. We are in the process of assessing cash flows for the next several years and will determine whether or not we turn that into some type of term loan and restore the line of credit. Just a note though that our term loan will likely would not be longer than 2 or 3 years as we believe we will continue to generate cash from operations. And finally, let me mention the stock repurchase plan that was announced in November. We will begin this plan shortly. Prior today, we've been in blackouts due to the Racine acquisition and the regular year-end reporting period. It is our intention to repurchase up to $30 million of Badger Meter common stock in the open market or in privately negotiated transactions over a 2-year period, depending on market conditions. With that, I will turn it over to Rich who will add his comments. Rich?

Thanks, Rick, and thank all of you for joining us today. Obviously, we were very disappointed with both the fourth quarter results and the entire year of 2011. Even without the 2 unusual Q4 charges mentioned by Rick, the earnings in the fourth quarter were much lower than we had expected. Correspondingly, our channel checks indicate that the entire municipal water meter industry was sluggish throughout 2011. As such, we believe that we did not lose any significant market share during this downturn. One positive aspect of 2011 was the significant increase in our non-utility full [ph] products, such as magnetic meters, turbine meters and valves. And this occurred both domestically and internationally. These products continue to grow as the economy improves and as customers upgrade their production facilities. In particular, Cox Flow Measurement, which we acquired in 2010, has seen significant growth in their turbine and oval gear meter sales for the agriculture and petrochemical markets. We expect to see this growth continue in 2012. And while we do not give formal guidance, I do think it's appropriate for me to make a few comments about 2012. As we noted in the press release, we have seen some strength returning to our municipal utility market as we move into 2012. January has seen an increase in both orders and margins, certainly as compared to Q4 of last year, but also as compared to Q1 of last year. In fact, our January sales were up about 20% over January of last year. Although one month is not necessarily indicative of the quarter's results, we are optimistic about 2012. Copper prices are also favorable compared to last year at this time. As you know, copper is a major input cost for us. In the first quarter of last year, copper reached $4.50 a pound. This year, it has stayed well below the $4 mark. If it stays low, we expect that these copper prices will help us as we move into 2012. Even though 2011 was a difficult year for sales, we continued our commitment to maintaining our technology leadership by investing over $8 million in R&D during the year. This is a record level of R&D spending, which will enable us to bring new products to the market and will benefit future years. We also completed the purchase of Racine Federated as of February 1. We expect this $57 million acquisition to be accretive for 2012. However, due to purchase accounting rules related to inventory write-up, we will probably not see any significant benefits until the second quarter. Racine Federated is a well-run company with a strong product line, primarily consisting of industrial flow meters, with about $43 million in sales in 2011. About 40% of Racine sales are flow meters for various water applications, including wastewater, processed water and HVAC systems. Another 40% of sales are flow meters for non-water applications, such as chemicals, food processing, petrochemical, et cetera. The remaining 20% of sales of products for the concrete industry, which, not surprisingly, has been depressed lately but is now seeing some growth. From a technology point of view, the Racine acquisition now gives Badger Meter a much broader offering of flow meters. For the first time, we can offer our customers variable area meters, vortex meters and differential pressure meters to name just a few. We will also be able to combine our sales channels to market Badger Meter's products to Racine's customer base. While our total sales in water metering, both utility and industrial, remain over 70% with this acquisition, we have reduced our exposure to the U.S. water utility market. On a pro forma basis, Badger Meter sales would shift from about 72% utility water metering products to 62% with the addition of Racine Federated. Further, we see significant growth opportunities in the $5 billion global flow metering market for the future. With that, Robyn, you could turn this over for questions. Thank you.

[Operator Instructions] And our first call comes from the line of John Quealy of Canaccord.

It's Chip Moore for John. I was wondering if you could, on the charges for the acquisition and the defined contribution plan switch there, is that all allocated to SG&A? And then on a go-forward basis, what are the benefits of that pension switch?

The charges for the acquisition all are in the SMEGA cost, yes. The pension -- the changes are, is that we get rid of the volatility. Recent years, it's a surprise of no one, the return on our assets has not been that significant or has not been that great. It's actually been losses. And the idea is that we're seeing significant volatility in pension cost as a result. We'd like to stabilize it, moving to a defined contribution where you set the percentage of what you're going to set aside for each employee each year, allows us to accurately forecast our costs. And frankly, there's actuarial risk that has existed historically with pension. We'll never get rid of that completely until this plan really actually dies at some point in the future. But it does save us going forward from adding new participants to that plan.

And Rick, I'm not sure you answered the first part of the question. You mentioned that the acquisition costs were all included in sales, marketing, engineering G&A line. But the pension cost...

The pension curtailment cost, most of it is included in the SMEGA line, a portion of it gets allocated to cost of goods sold. So there is a small piece of it probably still sitting in inventory, but the lion's share of it hit the P&L in the fourth quarter.

Okay. That's helpful. And then what's the increased bookings with some higher margins so far here on the new year? Can you just talk a little bit more about what's driving that, whether it's mix or volumes? Obviously, copper down by 15% should help in Q4, should help in Q1 and even a little over a year, or maybe you could just give a little more color there.

Yes. And it's a little early yet, that we haven't finished closing all the details on January, so it's hard for me to comment a lot on where that mix is coming from. But it does seem to be more mix that's driving a stronger margin than what we saw a year ago. Our backlog is also up about 12% at the end of January versus one year ago. And that, too, is a positive sign that we're looking at. So the fact that January sales were 20% higher, the backlog is up 12%, we're seeing the stronger margins, all of those are starting to drive us to be a little more confident about 2012 as we move into it.

All right. Perfect. And on the competitive environment, is there -- are you still seeing a lot of competition on price or anything there this quarter?

I don't think there has been much of a change to the competitive environment. Basically saying that it is still highly competitive out there and pricing is very difficult as it has been over the past year. I think with the housing being softer, Badger Meter and all of our competitors have some excess capacity, and we're out there or all out there aggressively trying to fill it.

Okay. And then just lastly in terms of your appetite for M&A, particularly in light of that buyback, what are your thoughts there?

This is Rick. I still think we have sufficient room to borrow for the right acquisition, we would find a way. I mean, quite frankly, I mean when we're sitting here, trying to determine if we continue financing this on a short-term basis for 2, 3 years or actually decide to put some long-term money out there, if we found the right acquisition, I'd have no doubt that we'd be able to structure something longer-term and to be able to finance it. So the financing is not the key, the key is finding the right fit at the right price.

Right now, all of Badger's debt is basically without collateral and without any significant covenants. So if we wanted to start putting up collateral and accept some covenants, we could certainly garner more funds that if we needed them to make an acquisition. We had a significant enough acquisition, we can always look at going to the equity markets. But right now, we think we can continue to look at good acquisitions that are out there in the coming year and financing with debt.

And our next question comes from the line of Carter Shoop of KeyBanc.

First, can we dive into the sales growth you're seeing so far in January? I appreciate that the quarter isn't officially closed yet, but can you at least give us some color in regards to there being a couple large orders in there or sales in there, or is it pretty broad-based?

No, there are not large orders in there. That is a broad-based increase. We do not have one big city driving that or one big order.

Okay, great. And then in regards to tax rate assumptions for the first quarter of 2012 and for the full year, what are you looking at now?

If I had -- were building a model, I might use about 35%. The truth of the matter is it varies year by year, depending upon what states we fell into and then how much income is foreign, because some of our -- our foreign income is not necessarily that [indiscernible] some of it is taxed at lower rates. But we're at 34.5% this year without that onetime credit, we had 35.5% in 2010. 35% is probably a good starting point.

Great. And then I'm not sure if I missed this, but CapEx for 4Q '11 and then expectations for 2012?

CapEx for the year as a whole was probably about $5.3 million for the year as a whole. I don't have it for the particular quarter because I don't have the third quarter cash flow sitting in front of me, but that compares to about $9 million, $8 million last year. What we've said historically is that CapEx moving forward over a rolling 3 to 5 year period should not exceed depreciation and amortization. And couple of years, we were over. This past year, we were under.

And then last question. You mentioned that you didn't see a significant shift in market share in 2011. Would you be willing to comment on where you believe your market share is in 2011, how that compares to where you were in 2010?

I don't want to duly [ph] comment on specific numbers. We get our information from the Scott Report and from a report called Proprietary Publishing, which gives us our percentages. And we have run in the high 20s to 30% market share over the last several years and we haven't seen that change much. However, I will say that all of those reports are through 9/30. Obviously, nobody has kicked out a 12/31 report at this time, it's way too early, it takes a while for those to come out. But through 9/30, we did not see any significant change.

And our next question comes from the line of Richard Eastman of Robert W. Baird.

Could you just -- Rich, could you just talk a little bit to the order growth? You see order growth that you mentioned here in January, how was that influenced by ORION, kind of the ORION SE with the AMA? Have you seen an uptake in orders there since release in the third quarter?

I wouldn't say we see the big uptick. This product, like most new products in the utility side of our business, take a while to gain customer acceptance. We have a lot of customers that have ordered starter kits where they put 10, 20 or even 100 units out in the field to see how they perform, and we saw a lot of that during 2011. I wouldn't say that we're seeing any big jump in it at this point, but we're still optimistic about it going forward. I have to remind you, when we first introduced ORION 10 or more years ago, it too took a few years to gain acceptance because customers are very leery of new technology and they want to take a while to test them out. So no, I wouldn't say that it was a big uptick as a result of that.

Yes, okay. And then also your Itron sales being down virtually 50%, is this basically just adjusting for the lumpiness from last year still?

Yes. Last year, we had some unique large orders to certain customers and we're trying to fulfill those. Because you'll recall last year, we were telling it was up for that same reason.

Yes, okay. And then just a question on the specialty side of the business. Duke having runoff here, have there been any large gas projects kind of enter the bidding pipeline here that you could comment on? And what's the tone on potential gas sales?

Yes, we do have -- I mean, first off, we are selling gas products to about 60-some gas utilities during the course of 2011. Obviously, Duke is of the lion's share, that Duke was the strongest. It was the largest of those so there were a lot of smaller gas utilities that were buying the product and they like it and it's working well. We do have another large, a Duke-size opportunity that we are looking at and is moving forward. We're not ready to comment on it at this time and it has not been formally awarded, so we haven't made any kind of announcement. So we do have one that is moving further along. And then there are other ones out there that are just in the very early discussion stages.

You said -- are you implying that you've been chosen on this larger one or is it still in the bid process?

No, it's still in the bid process, okay? I'm saying it's out there and people are -- and we are in the bidding process on that.

Okay. And then can I just flip back for one second to the water side? Can you just comment -- has -- did Cleveland start to ship? And the reason I'm asking is, as we go into '12, I know that's just meters, but can we expect better absorption with the volume out of Cleveland?

In the fourth quarter, there were some sales to Cleveland, but not under that recent award. We really haven't really started shipping under the most recent one that was awarded. So a very small amount, maybe a couple hundred thousand dollars or whatever in the fourth quarter with regards to that. There are -- it's not kicking off necessarily in the first quarter. And as with any customer, we're kind of reluctant to talk about exactly when purchase orders are going to come in. There's no reason to believe it won't start sometime this year, I just don’t want to comment on the specific without the customer's kind of blessing off on that, so.

And then, Rick, the information I have right now is that the award on Cleveland is about an $8 million award.

Right, yes.

And our best estimate right now is that it might start sometime in the summer. But again, that's up to the customers to when they start doing something. But Rick is right. We have always been shipping to Cleveland, we've always had sales to Cleveland and we continue to. The award just hasn't started yet, the larger one.

Okay, I got that. And then just one last question. Rick, your response to the CapEx question for '12, can I just back up, do you have an estimate for '12's D&A, which would then obviously be inclusive of RFI?

DNA, are you talking genetics?

Depreciation and amortization, is that what you're saying?

Yes.

Oh, depreciation, D&A. I heard DNA, I'm sorry.

I heard DNA, too. And Rich is an accountant and he didn't get it. Off the top of my head, I don't have one combined. But our depreciation and amortization combined is, holding up fingers, $8 million a year.

Yes. And I would think there'd be a step-up probably on the amortization, well both, with RFI. And the reason I'm asking is you don't expect your CapEx to exceed D&A, but I would think it would be -- your CapEx would be below $8 million, wouldn't it?

Correct. We do -- let's correct it. We don't expect it to exceed historical D&A. And at this point, one major project is with the settlement of our union contract. We're now looking at the Milwaukee facility on ways to optimize production in the Milwaukee facility. So there might be some spending there in 2012, maybe to the tune of a few million, but we really can't think of anything else that's major at this point that we need to do.

And our next question comes from the line of Hassan Dosa [ph] of Water Asset Management [ph].

I wanted to get some color about capacity utilization. Would you guys just talk about the capacity utilization at your factories during Q3 and Q4, and how do they compare to levels versus a year ago?

It was lower. And I'm not trying to be flip with that. Historically, we make about 1.5 million meters a year. And just we know that the volume was down this past year, it was probably down in the magnitude of the 20% to 25%-type scenario. It is -- so on the fixed costs, and more so in the third and fourth quarter because Qs 1 and 2 were a little bit better, and then we really saw the softening near the end of the year. That's what drove -- in our mind, that's what drove the gross profit percentage significantly lower, is that volume impact against those fixed costs.

And as far as our capacity utilization, we have the ability. We have all of the equipment and the ability to do well over 2 million units per year without a significant increase in CapEx spending. So if you wanted to do some kind of capacity utilization, prior to the housing crash, we were at about 1.5 million units a year and we're down to about 1.2 million now with the housing crash. We could easily go over 2 million, so you can do the math.

[Operator Instructions] Our next question comes from the line of Steve Sanders of Stephens Inc.

I just wanted to see if we can get a little bit more color on the Racine deal. First, Rick, how are you going to report that across your 2 segments?

Well, first of all, we only have one segment, but we have a couple of different product lines. I think we're still finishing discussions, but I think what we're going to do is we're going to wind up talking about water applications in terms of water metering applications and other water applications. And then we'll probably talk about specialty in terms of an industrial flow type flow and then what I call pure specialty, which is radios into the gas industry, these concrete vibrators that are sold by Racine, and maybe we'll throw in the valve business in there or something like that. So we're still toying with that, but again, just to clarify, that's just -- we'll report on sales probably in those categories.

Yes. And Steve, I want to clarify what Rick said, because I think he misspoke without realizing it. We've talked in past about water and specialty, that's how we broke it apart. But really talking about the possibly of maybe going to 4 groupings, talking about utility water metering and non-utility water metering, okay? Rick said water metering and other water. We're talking about utility water metering and non-utility water metering. And then industrial flow metering and the specialty products. Those are the 4 categories we're thinking about moving to, but we're still talking about that.

Okay. And then any additional color on the potential sales synergies?

You mean between Racine and Badger?

Yes.

Yes, we have started the process of looking at all of the reps, and Racine primarily sells through reps and so does Badger on the industrial side of the business. So we have started the process of going down the list and looking at all the reps, and deciding where we have strength, in what areas and how to best optimize that. There are certain reps that will gain product lines. We will -- if Racine has a particularly strong rep in a certain area, we will give them the Badger product lines to add to that. Likewise, if Badger has a strong rep, we'll look at adding the Racine product line. But in these industrial markets, you're really talking about a lot of market segments that you have to get involved with, like you may have a rep who specializes in petrochemical and another rep who specializes in pharmaceutical and then another one who specializes in food processing. So we really have to go through the process of determining where we have strength and how best to go to market. We think there are significant opportunities here because we -- you can argue about how many different ways there are to measure flow, and physics people love -- and engineers love to talk about this. But when I look at it, I see there's roughly 16 ways to measure flow. Badger historically has had 7, Racine has had 7, we've only got 2 that are overlap and we sell them into different industries. So when you combine, we now have, instead of having 7 of the 16 ways, we now have 12 of the 16 ways. So we're getting much closer to being able to offer every possible way there is to measure flow. And I think for some of these reps, that's going to be a huge opportunity for them.

Okay. And then as we think about the supply chain and the manufacturing, how do we treat Racine? Is it standalone for now or are there opportunities to shift some production for them like you've done with your other businesses? What do you think at this point?

Well, we -- so at this point, we don't see a plan to shift production out of Racine. In fact, the Racine facility has empty space. And one of the things that was attractive to us was the opportunity to add some production into Racine. So we will be looking at that and looking at optimizing it. So that's a positive thing. On the supply chain, we will be going aggressively and looking at whether or not we can combine our purchasing capabilities and things of that sort in order to drive some more synergies.

Okay. And then last question, how should we think again on Racine about the margin profile relative to Badger's historical? And I know there's been quite a bit of volatility there but...

Generally, Racine carries a higher margin than Badger's historical margin, which is true of Badger's industrial products, too. The industrial products overall are a little more capital intensive, it's a little lower volume, more specialized in engineered products. So Badger's industrial products carry a higher margin than our corporate average, and Racine also carries at higher margin.

And what do you kind of baseline is the corporate average? Because we've seen high teens and we've seen...

I would say mid to high '30s is the corporate average. And I'm talking about gross margin. I'm not talking about operating margin, I'm talking about gross margin.

Sir, there are no more questions at this time. I would now like to turn the call back over to Rich Meeusen for closing remarks.

I would like to thank everybody for talking to us today. Obviously, 2011 was not strong, but as we look at 2012, we see all of our fundamentals are still there. We see January as coming out of the chute with a strong month. We like what we see in the backlog at this point. All of those things tend to make us believe that 2011, especially the second half of 2011, was a bit of an aberration and that -- to what is otherwise a very good long-term growth story. So we are optimistic about 2012, and we will be working hard to turn in some good results for that year. And with that, I'll thank you.

Thank you very much. This concludes today's conference. Thank you for your participation. You may now disconnect, and have a great day.