Badger Meter, Inc. (BMI) Earnings Call Transcript & Summary

Again, I'm Connor Lynagh, I cover industrial equipment and technology here at Morgan Stanley. I'm here with the Badger Meter team. On the line here we have Ken Bockhorst, Chairman, President and CEO of Badger Meter; Bob Wrocklage, Senior Vice President and Chief Financial Officer of Badger Meter; and Karen Bauer, who serves several roles as VP of Investor Relations, Corporate Strategy and Treasurer. Before we get into the presentation here, please note that we're going to refer you to the Morgan Stanley Research Disclosures website at www.morganstanley.com/researchdisclosures. If you have any questions on that or the presentation here today, please reach out to your Morgan Stanley sales representative.

So, I think that we have sort of a mixed group on the line here. So, Ken, maybe you could just give us a high level 30,000-foot view of what Badger Meter does and what the main growth drivers and value creation drivers you see for the business are?

Yes, sure. Thanks, Connor. So, yes -- so Badger Meter is a proud 116-year-old manufacturer of flow measurement solutions, primarily for utility applications as well as industrial. And recently, we moved into the water quality monitoring space. So, if you break down our business on the metering side, our revenue is primarily in North America, which is the best smart water market in the world. On the metering side, we've generally operated as an oligopoly with 2 other competitors, between the 3 of us. It's a very rational market space, really nice stable growth where we share in this -- tied for first place, if you will, of market share. One of the things that really makes us unique compared to our competitors is the fact that we live by the mantra of choice matters. So, for us, we have the fullest suite of metering products, full suite of radio solutions and then the software as well to tie it all together and bring our utility customers real-time on-demand information to better efficiently manage their assets. Similarly, on the industrial side, as you see, more and more companies interested in being better water stewards. We're there to help them do that with our products and solutions. And then, on the water quality side, really excited that we were able to use some of our financial strength to add 2 really high-quality water quality assets that also are in the real-time on-demand space monitoring up to 60 different parameters of water quality. And while they're small companies, they both existed for 20 years, proven technology, with an installed base in over 50 countries. And as I said at the beginning, we've been primarily North America. One of the things we're excited about also is our opportunity to bring our products and solutions that have been very successful here for a century to other parts of the world as well.

Great. So let's maybe dive in on some of the technological aspects. When we look at the space, obviously one of the big sort of secular trends underlying it is increasing degrees of technology, increasing degrees of focus on smart metering. At the same time, there still is a fair degree of sort of basic meter sales and a fair bit of demand still remains relatively unconnected, if you will. I mean, what do you see as the path forward for driving the industry to full adoption or higher levels of adoption of these technology solutions?

Yes. So let's take it in 2 parts. So, first, there's the meter where there's different forms of technology. So, we've typically been the innovation leader in our space. And even though it's a slow-moving risk-averse space, being the innovation leader has served us well. So we were the first to bring the ultrasonic static meter to our market roughly 13 years ago. And so, for us, we are more than happy to consult with our customers and sell them the solution that's best for them, where some of our competitors consult with our customers and sell them the only offer that they have. So for us, having that approach and selling the customers the best for their solution even today after 13 years, 80% of our unit volume is still mechanical and 20% of that being ultrasonic. Now, a common question is, where do you see that going in the future in terms of adoption? Well, let's break it into 2 parts. On the residential side, where there's lower flow in all the different homes, which is the primary amount of our volume. The best case scenario for adoption will probably be roughly about a 50-50 split over a long period of time, 10 years. Again, it took us 13 years to get to 20%. I would suspect it's going to take quite a while still to get to 50-50, but there will always be parts of the market where the mechanical meter is just frankly good enough for their solution. When it comes to the technology side or adding radios, roughly 65% of the market has some form of radio technology today. Now that could be a driveby radio, which we sell driveby radios and we're happy to continue offering that to customers; or its advanced meter infrastructure, which can take on 2 forms, cellular radios, which is what we offer or fixed network. What we're seeing in the radio space is that technology adoption is growing at a couple of points per year. So, again, it's not going to go from 65% to 100% and have a huge 2 or 3-year blip, this is going to have a nice long tail of technology adoption long into the future. And then, as you go to AMI, that's when we attached our software to it as well to be able to bring our BEACON software to provide leak detection, billing data, usage information and so on. So overall, it's really a fundamental mix trend that's favorable for us because it continues to drive average sell price even within the meter adoption and average sell price of the package as you add a radio.

Makes sense. One thing we've obviously heard a lot about is a very big portion of the market is replacement demand. So, again, you broke it into the 2 parts here, but the slow adoption from mechanical to static meters as well as the addition of radios, how does this alter the industry's replacement cycle and, therefore, the volume outlook for the industry?

Yes. So it doesn't alter it at all. So, on the mechanical side, or just say metering in general, about roughly 80% of the meters that we sell every year are replacement, very mature market. The meter still is -- it's the cash register for the utility. So when you need to replace your meters, you do it. This isn't generally something that utilities are going to wait. So the replacement cycle on the fully installed base is very steady, very -- it's something that we can definitely count on. And then, if you take it to the radio side, radios have been in the market, drivebys have been sold since 1988, right? And we started selling our cellular radios in 2014. So, we're already into replacement cycles on the driveby radios as well. So, customers are going to continue to upgrade. The replacement cycle is stable and strong into the future.

That makes sense. And then, the other portion that you touched on was the software side of things. We can get more into this later in the conversation. But just to frame for those on the line who are less familiar, can you just remind us what percentage of your business is software and how you think about the growth profile of that portion of the business?

Yes. So, again, I just mentioned, we started selling the cellular radios around 2014, '15 and risk averse still moving. It takes time to get it rolling. Roughly 4 years ago, our revenue from software was basically a little bit more than zero. And in 2020, we just finished with it at 5% of our total revenue. So, we've really been proud at how we've been able to grow that over the past 4 years. And we definitely have a stated strategic target of getting that up to at least 10% through this strategic cycle here over the next 5 years as we look into the future. So, the thing that's great about our software offering is that every time we sell an Orion cellular radio, it has a 100% attach rate. So you wouldn't buy our Orion cellular radio, in fact you can't, without the software subscription or you won't get the billing reads and the information from it. Then what we really like about that is the stickiness that -- with which that software has. That radio is going to operate and be in use by the end user for at least 10 years or more. And the software isn't something that would ever be canceled because that's how they get all the data. So it's the stickiest of Software as a Service revenue in the market because it's not like someone would buy it for a year or 2 and then decide whether or not to renew. This is going to stay with that meter in that radio for the long-term.

Yes. Makes sense. And just a reminder to those on the line, please feel free within the webcast portal to answer questions that you have. We obviously have plenty prepared for the team here, but if there's anything that's top of mind for you, please put it in, we'll try to get to it towards the end of the presentation here. But maybe just stepping back. So certainly, your stock and frankly many within sort of the water and energy conservation type solutions industry have gotten a lot of attention from the ESG investment community. That's obviously something that's very much in focus and, I'd say, from [ our seat ], has really accelerated over the past, call it, year-and-a-half. I'm curious though what that evolution has looked like in your customer base. Obviously they've always cared about system efficiency and water conservation. Has there been any sort of marked increase in interest in select solutions or -- like technologies that you could point to over the last few years here?

Well, so one of the things that I'm really proud of, in fact, is that while there's all this tailwind around ESG, this is always who we've been. Our products and services have always been around conservation and helping preserve the world's most natural resource. So -- and it's always been in the culture of Badger Meter. You can go back 40 years into our company's history and see how people have cared about the environment. So, for us, it's not a trend, this is what we've been for a very long time. And our utility customers continue to want the same things from us. They've always wanted. So, our products and services are meeting those needs for ESG. Now, where we're seeing more interest is perhaps from our industrial users that truly now want to be better water stewards, whether it's just because they want to be or because they're trying to follow an ESG trend, which is also very favorable for us, particularly now that we've added the water quality monitoring. So now, we could go to an industrial user who wants to conserve and be a better water steward, use less water and understand what's in the water and how they're using it and what they're returning back to the system. So, definitely seeing more interest on the industrial side. On the utility side, this is what we've always been.

Yes. Do you think that there is -- one of the things you guys have always highlighted is the fragmentation and the scale on average of US water utility is quite small. Does the scarcity trend or just general focus, you think, result in more consolidation within that space or do you not see that as a very meaningful trend over the next few years here?

Yes. So I don't see it as a meaningful trend, but it doesn't mean some will happen. There's 50,000 water utilities in the US. So, there are companies that are out there that are buying some of these utilities. But for us, it doesn't matter either way. We have a product portfolio that works for a small utility all the way up to the largest, up to and including investor-owned utilities. So, even if investor-owned utilities buy up some of the smaller ones, it doesn't change what we see in industry-wise. So, I guess, industry-wise, that's agnostic to us. I think some will happen, but I don't think it's going to accelerate any more than it did before. It will continue going along at the rate it was, in my view.

Yes. Yes. Okay. So, maybe pivoting more to the policy side. The infrastructure bill has been something that we've been thinking about for a while and then just the broader desire to invest in the nation's infrastructure with various budget proposals. How do you think about the impact of federal funding on the water industry based on what you see out there today, what you're communicating with customers, what is your view of the impact of that?

Well, so in general, I think it's good whenever the government is thinking about investing in infrastructure for water, because obviously the infrastructure is very old and need some care. As I think about it specifically to us in the smart metering space, one of the things that we've always said, and I think has been proven out over the past year is that in smart metering, we don't need infrastructure funds to grow. And I think if you point back to Q4, after the election in November, when everyone thought there'd be infrastructure, we had a great order quarter. Q1, the Georgia elections turned the Senate back to the Democrats and it was becoming even more clear they'd be infrastructure and we had great orders. Q2, we have great orders. So our customers aren't waiting for infrastructure because they see the value in investing in what we sell. I think, on our water quality side now, I think we could see some potential tailwinds because the value of real-time on-demand information of what's in your water for water quality parameters, we could see some benefit. But overall, this infrastructure money is going to be spent over 8 years. It's targeted to some specific things like pipe replacements. So, for us, the key takeaway that I have is that we don't need it to grow, but it could provide some modest uptick for us.

That makes sense. I mean, at a high level, in your view, what is the sort of secular trend in the water quality monitoring? Why have you been allocating more capital there? And basically, what is the 5 to 10-year view of what you think that becomes?

Yes. Water quality has always been very important, right? And it's always happened in the lab and you're still going to have that amount of testing. But the idea that with the companies that we've acquired that do real-time on-demand water quality monitoring, there's definitely a trend where people want to know in real-time what's happening within the water space. And then additionally what we'll be able to do with this is, as we get it into water utilities, if there's a water event like there was in Oldsmar, Florida earlier this year, where there was a spiking in the chlorine in the system. With our products in place and with our BEACON software, we'll be able to, as we integrate this together, identify when immediately there's a spike in the parameters of concern. We'll be able to see how far it went through the distribution system so that the utility could efficiently flush in the areas that it was. And through our BEACON software, they could notify customers of an issue. To me, these are just trends where real-time information about something as important as water quality are just going to become more and more relevant.

Right. Right. Makes sense. So let's maybe sort of zoom out here. So you guys have highlighted obviously that you have a very good balance sheet, you have the ability to deploy capital. Just broadly speaking, what are your areas of strategic focus for capital deployment over the next few years here?

Yes. So in terms of just following on to what we talked about in water quality, we continue to do funneling within the water quality space. We think the companies that we bought is enough for us to really get some real progress. So we don't feel the need to roll up a bunch more water quality companies, but that's an area of interest for us. Another area of interest for us is on the software side. Again, we've grown our BEACON revenue to 5%. We want to get to 10%. Well, we can do that organically, but we'd also be interested in perhaps doing asset management or work order management or those types of things to also enable utilities to be more efficient. And then, anytime we can add a global nature to that. It's hitting on multiple pieces of our strategy. So take, for example s::can and ATi, 2 companies that have existed for more than 20 years and they have an installed base in more than 50 countries, countries where Badger Meter isn't today. So, one of the things we're excited about, and it does take time in this industry, but we think we have great cross-selling capabilities across the world. In North America, where we can leverage ATi and s::can through the Badger Meter strength and then through some of the relationships that ATi and s::can has grown in the UK, Southeast Asia and Europe.

Makes sense. Is there -- in the international arena and particularly more sort of emerging market or at least underdeveloped markets from your portfolio perspective, is there a difference in what you need to face the customer and do you need a more integrated solution to be able to compete effectively there or do you think that it's a fairly similar look in terms of what customers are looking for, given RFPs, et cetera?

Yes. That's a really broad question that country-by-country and region-by-region could be a different answer. So let me tell you the specific targets that we're talking about globally, and then I can maybe tell you why. So what we're not looking to do is rush into China or India or some of the markets where frankly they maybe don't value our offer, right? But there are several parts of the world that want the best technology and they're willing to pay reasonable prices. And if you think about that, like the former British Empire minus India, the UK is a good target market for us. Middle East, where we've already made some [ mid roads ] and continue to drive there. Southeast Asia, Australia, these are really good rational pockets where you don't have entrenched competitors or oligopolies like we benefit from in the US. So we know we can go there and win with our ultrasonic meter, with our radio competencies, but these take time. So it does take time to get in with utilities because even in the rest of the world, there's slow-moving and risk-averse. So -- but definitely we know where the regions are that we can go and what we need to do to win.

Right. So maybe just returning to the capital allocation conversation, obviously public market valuations in general are strong right now. You do have the balance sheet if you just want to do things via cash. But at the same time, share currency could be an attractive way of growing and paying for deals. How do you think about that within your capital allocation framework?

Yes. So for us, having a little bit more than $50 million in cash with no debt, having a very comfortable target zone of 1.5 to 2.5x EBITDA and the types of deals we're looking for are these technology tuck-ins like D-Flow that we did in 2017; AquaCUE that we did in 2014; s::can and ATi, they provide tremendous value to us. And our balance sheet allows us to do those types of technology tuck-ins and really leverage them in a strong way. I know that our currency is something that -- our stock is a very valuable currency that we could use. But we just don't think we need to do that to advance our strategy, not to say that we never would, but it just isn't -- it isn't something that we feel like we need to do.

Right. But returning to the point you made on -- you're relatively underlevered relative to your sort of long-term comfort level, how do you think about the -- obviously tuck-in acquisitions seem like an important use of capital. Where does it go beyond that? How do you think about dividend policy and buybacks, et cetera?

Yes. So, our capital allocation priorities have been very constant for us. So number one is, continue to invest in R&D and be the innovation leader in our space. So we're going to continue building out our ultrasonic product line on larger meters. We're going to continue to develop new next-generation radios. We're going to continue to develop more products to do the rest of the world, continue to develop our software. So that's number one. Number 2, this year, we increased our dividend for the 29th consecutive year, in line with our operating earnings. We expect -- well, we expect -- we will continue to increase dividends annually; and 3, investing in M&A. Now, your point about us being under-levered because we've done so well at maximizing cash, we put a pretty tough bar on ourselves to try to get to that leverage range. We've converted over 150% cash over the last couple of years. So we recognize the challenge on continuing to get great tuck-in assets and bringing them on board.

Yes, certainly under-levered as a result of over-execution. So [ that's the driver there ].

Yes. That's the way I like to explain it, yes.

Yes, understood. Speaking of execution, you guys -- supply chain, as we all know, is majorly in focus in the investment community. You guys have executed very well, but also been very sober in your view of how long supply chain issues would take to normalize. So, I guess, sort of a 2-part question. Where have you seen the greatest pressures? And what have you been doing to manage it? And what is your view of how long things take to improve?

Yes. So, the greatest pressure, it's been a multitude of things, right? So I would say, if I had to pick one point, electronics and semiconductor chips have been the most challenging. And a big portion of that is, if you look at where electronics are manufactured, it's the part of the world that's still being ravaged by COVID. It's the Southeast Asia and some of those pieces. So, you have this huge demand snapping back from the economy was doing really well and people need more electronics. And then the fact that the part of the world that does most of that is still struggling in a much more difficult way than we are here in the United States. Two, resins have been really difficult for a lot of people and we've stayed out in front of it. But since the deep freeze storm in Texas that took so much of the capacity off-line that resins have been a challenge. Logistics. Bob and I had the pleasure of being in Europe visiting some of our employees a couple of weeks ago. And as we stood at the plane, we saw some cargo being loaded onto our plane. Well, without the international flights, a lot of the ways that people move goods around the world aren't as plentiful, so just the logistics of getting things to places. It's such a multi-factor problem. And by the way, demand has never been higher. So not only are we in an unprecedented supply condition, we're at an all-time demand level. So, when you put all that together, I know you referred to it as a sober view. Yes, it's a realistic view that things aren't getting better anytime real soon. So we're hunkered down and we expect this to continue to last at least through '22 and -- yes, through '21 and deep into 2022 before we can really feel good. I think it's going to hang with us for a long time and we will continue to take the conservative overview until we're done -- until it's over.

And the [ tax 6 combat ] that are equally as plentiful, meaning there isn't one solution. It's not just we're ringing the price card. We're doing everything from engineering redesigns to bypass short-term constraints to procuring inventory at greater quantities and longer commitments to have a [ place in line ]. So while the challenges are plentiful, so too are the responses and it's challenged the organization, just like it has every other organization.

Yes. Understood. And then, just for a little further context on that pricing conversation or just the broader margin dimension of this. Do you have any sort of long-term frame agreement type contracts or anything where we should be looking ahead to potential margin pressures as everything rolls through your P&L? Or do you feel good about the levels that you're operating at right now being relatively sustainable?

Well, the thing to remember about our market is, it's small, medium and large. So then when you get into the different types of customers and the breakdown, yes, we've got some that are larger, that will be more challenging. We've got others that are in the renewal space. You got some that have CPI. So it's never -- I had to say this, but it's never a one-size-fits-all in our market, in our world. Certainly we'll see some pressure there. But our pricing -- our value-based pricing process has been very successful in mitigating thus far. And there'll be challenges, but I feel generally pretty good about how we can get through that. I don't know, Bob, if there's anything you want to add on that.

I would just say, as sober as we've been on the supply chain challenge, I think we've been equally as sober on price. Meaning, we think over the long-term, we have a pretty good ability to have favorable to neutral price cost dynamics, but there will be leading and lagging effects. To-date, we've done a really good job through the first 6 months of 2021. But we've yet to anniversary our peak commodity costs in our P&L. So I could see that being a challenge moving forward. The hurdle rate is going to be higher moving forward.

But the process is -- but the bottom line is, the processes are in place to execute and we'll be proud of our results whatever they are.

Right. Right. Yes, absolutely. Is the industry at large generally moving price? Are there any sort of bad actors within that oligopoly that are seeking to take some share at the cost of margin because they don't want to raise price as much? Or have you seen fairly rational behavior?

Well, the good news is, if you listen to their earnings calls, the same as ours, they talk about their ability and confidence in being able to recover price. And we've seen nothing to suggest otherwise in the market. So it's remained competitive, but yet rational.

Yes. Understood. And I guess, just the final question on the pricing dynamic is, with a value-based pricing model obviously through cycle, that is probably the optimal model. Does it make it more challenging to have a pricing conversation when it's more commodity or inflation driven or does it just generally sort of all work the same way, if you understand my question?

Well, so everyone reads the paper. Everyone knows whether your view that inflation is transitory or not. Everyone understands that copper, if you will, in a brass meter is a big piece of it. So, the conversations, when it's commodity based, are pretty simple in some ways. The value-based price where we're really proud of the efforts we've made, which was really just valuing and making sure that we provide our customers a great solution and that we get all the value from it that we deserve. And that's where we spent the majority of our time is really understanding that value and collecting it all.

Right. Right. Okay. Maybe just one higher level one to close it out here. The general consensus in this industry but frankly across the sort of industrial spectrum has been that digital solutions are a natural beneficiary, if you will, of the pandemic, having to work more remotely, having site access restrictions, et cetera, et cetera. I would argue for a greater degree of adoption. Have you seen any strong evidence from your customer base, that is the case? Are there any specific examples you would point to on that front?

Yes. So first of all, coming into COVID, that was already attracted. We were seeing the adoption of digitization and for the multitude of reasons we talked about, it's certainly better for customers in terms of efficiency. I think the area that's really helping to drive the tailwind down now a little bit is the worker shortage and the impending retirements of what already was going to be, some people call it as silver tsunami or however you want to refer to it. But COVID in most industries also accelerated the retirement chain, right? So more people retired within the last year than any other year. So, I think, as utilities are looking forward and saying, I'm not even going to have the people to be able to read meters, if I want to, right? So adopting the technology now and moving forward, that's one of the factors that we think is certainly at play. And the other is, you're getting younger people into the utilities that are more adept with technology and looking for real-time on-demand data.

Yes. Yes. Makes sense. All right. Well, we are about out of time here, but I'm going to pass the mic back to you guys. Just closing thoughts, how do you think relative to market expectations Badger Meter has the opportunity to outperform or create more value than expected? What do you think is sort of the underappreciated part of your story right now?

Yes. So I think the underappreciated part of our story is that we really have this wonderful position in the best smart water market in the world where we can grow without even having to take share because of the technology adoption where we can grow with or without infrastructure because the meter is so important to the customer system. It's the cash register, the heartbeat of the distribution system. We've got a great team of execution. If you look at every factor across our business of whether it be supply chain or value-based pricing or cash flow measurement, we're executing at a very high level through very difficult times. So, great business fundamentals and a great team executing. My point is, we can be successful in any market condition.

Yes. Absolutely. Great place to leave it. Badger Meter team, thank you very much. Those on the line, thank you for dialing in. I hope you found this useful. But if you have any questions or you want us to connect you with the Badger Meter team, we're more than happy to do it, reach out to myself, your Morgan Stanley salesperson. We're happy to put you in touch. But thanks everyone and thanks to those on the line.

All right. Thanks, Connor.