Good morning, ladies and gentlemen, and welcome to the third quarter 2018 Badger Meter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. If you'd like to ask a question during this time, please press star, then the number 1 on your telephone keypad. If you would like to withdraw your question, please press the pound key. It is now my pleasure to turn the conference over to Karen Bauer, Director of Investor Relations and Corporate Strategy. Please go ahead, Ms. Bauer.
Thanks. Good morning and welcome to the Badger Meter third quarter earnings conference call. I'm Karen Bauer, Director of Investor Relations and Corporate Strategy. I joined Badger almost 3 months ago now, so this is the 1st of many quarterly earnings calls with all of you. On the call with me today are Rich Meeusen, Chairman and soon to be retired Chief Executive Officer, Rick Johnson, CFO, and Ken Bockhorst, President and CEO in waiting. Quickly, I'll cover the safe harbor, reminding you that any forward-looking statements made during this call are subject to various risks and uncertainties, the most important of which are outlined in our press release and SEC filings. Finally, please note that on today's call, we will refer to certain non-GAAP financial measures. Our earnings press release provides a reconciliation of the non-GAAP to GAAP financial metrics. With that, I'll turn the call over to Rich.
Thanks, Karen, and thanks all of you for joining us for our third quarter earnings call today. We are very pleased with the results for the quarter, both on the top and bottom line. As noted in the release, sales were a record for any third quarter, and our adjusted EPS of $0.46 was an all-time record at Badger Meter. Rick will walk you through the details of the quarter, and after that, Ken will talk about our key strategic initiatives and our outlook. Before turning the call over to Rick, I first want to talk briefly about the CEO transition announcement we made a few weeks ago. I will be retiring as CEO at the end of the calendar year, staying on as chairman of the board for 1 year.
As most of you know, the board and I conducted an extensive recruiting process, culminating in the hiring of Ken in October of last year. This past year has shown us we made the right choice from an integrity, culture, and business acumen perspective. I have all the confidence that Ken is the right leader to take Badger to the next level in terms of innovation and technology while preserving the strong 113-year legacy of the business. While this may be my last official earnings call, rest assured I will continue to be an interested shareholder and contributor at the board level. With that, let me turn the call over to Rich.
Thanks, Rich. After nearly 18 years of working together and a significant number of quarterly earnings calls, I'd like to say I'm going to miss doing these with you. I'd really like to say that, but I've never lied in this call, and I'm certainly not going to start now. Let's get down to business. First, let me remind you 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 specific components of cost of sales, for example, brass. More importantly, we do not provide specific guidance on future earnings, as we believe this does not serve the long-term interest of our shareholders. Now on to the results. I will be commenting on adjusted operating results in EPS.
To arrive at the adjusted results, I'm adding back both the final termination charge we took for the exit of our pension plan, as well as the non-cash charge required for the vesting of equity and cash compensation associated with Rich's retirement. Both of these are outside of our normal operating results, and therefore, we believe it makes sense to exclude these charges when examining the operating results. The pension charge was $11.7 million pre-tax or $8.7 million and $0.29 per share after tax. The majority of this was non-cash. This was a bit higher than the estimate I shared with you last quarter as a result of some final adjustments to the actuarial assumptions for the plan. We are pleased to have the pension termination and related charges behind us and to have completed the significant de-risking of our balance sheet.
The executive retirement charge was outlined in the 8-K we filed in September or early October and amounted to $2.1 million pre-tax or $0.07 per share after tax. Now turning to sales. Our third quarter sales increased 10.6% to $111 million compared to $100 million in the same period last year. This overall increase was primarily due to strong sales growth and favorable mix within the municipal water market, as well as an incremental amount of roughly $1 million associated with distributor acquisitions. Foreign currency was not meaningful. Just a reminder that seasonally, the second and third quarters represent the strongest of the year for Badger Meter, and we would expect the fourth quarter to be sequentially lower than the third quarter. Municipal water sales represented 78% of sales in the third quarter compared to 75% in the third quarter last year.
These sales grew to a very robust 16% on a year-over-year basis. The increase is due to higher domestic volumes of newer technology meters and related radios, as well as increased service revenue. We also experienced very robust international sales, most notably in the Middle East. Flow instrumentation products represented 22% of sales for the third quarter compared to 25% during the same period in 2017. These sales declined modestly year-over-year, primarily due to a sizable one-time order in the prior year, which it did not repeat this year. Excluding that, higher volumes in our targeted end markets, most notably water and wastewater, were largely offset by lower activity levels in the underemphasized markets. Gross margin was a very strong 39.7% in the third quarter of 2018 compared to 37% in the third quarter of 2017. There were a variety of contributors to the improvement.
In order of magnitude, the higher sales volume was the primary driver, with strong manufacturing absorption. Second was favorable product mix, with higher than average sales growth of meters with radios, ultrasonic meters, and service revenue. Finally, pricing was net positive in the quarter. Selling, engineering, and administration expenses for the third quarter increased $3.5 million, which included the $2.1 million of executive retirement charges. The remaining increase of $1.4 million primarily represents higher incentive compensation along with continued investments in R&D. As a percent of sales, selling, engineering, and administration expenses, excluding the retirement charge, declined 110 basis points from 24.7% to 23.6%. The income tax provision in the third quarter was 21.9%. Excluding the pension and retirement items, it was 22.8%, which compares to 34.5% last year, with the decline largely due to the lower federal statutory rate, which added about $0.05.
We still expect the full year to average in the low to mid-20, probably mid-20% range. Bottom line, adjusted earnings and EPS were $13.5 million, or $0.46 in the third quarter, an increase of 70% over the prior year, and as Rich mentioned, an all-time record. Our balance sheet remained solid. Free cash flow for the first nine months of 2018 was approximately $33 million, roughly in line with the prior year, and about 100% conversion of our adjusted net earnings. Our net debt to adjusted EBITDA declined to 0.3 times, which provides us ample liquidity to fund organic and acquisition growth, as well as return capital to our shareholders, as demonstrated with our annual dividend rate increase announced in August for the 26th consecutive year. With that little bit of background, I'll now turn the call over to Ken.
Thanks, Rick. I want to first express my deep appreciation and respect for how Rich has handled this transition and what he's built during his tenure as CEO of Badger Meter. I'm proud and honored to take on the role and understand the deep heritage as only the sixth CEO in our 113-year history. In many of our discussions I've had with investors over the past year, a couple key themes have emerged, which I want to address. First, I understand and appreciate the complexity surrounding leadership transitions. I've witnessed in my career both the good and the bad, and I've taken those lessons learned, and with the support of the board and Rich, believe we've set ourselves up in the best way possible for success. Second, I'm acutely aware of the strategic importance of preserving and nurturing the legacy of the enterprise.
At the same time, I believe we have opportunities to expand our technology offerings, improve our operations, and continue to globalize the organization. My goal is not to pivot 180 degrees, but to diligently and smartly build off a strong foundation. Just a few comments as I look out for the rest of the year and the start of 2019. First, I continue to feel good about our order rates and backlog, which remain strong. As Rick mentioned, sequentially, Q4 is expected to be lower than Q3 due to normal seasonality. Both our domestic and international markets are seeing good penetration of our E-Series ORION Cellular and BEACON lines, and we continue to invest in new technologies. For example, we will be incorporating our Cat M chips into our ORION Cellular offering in the first quarter of 2019.
Integration of these chips will improve battery life, extend range, lower our costs, and increase the number of on-demand reads for utilities. We launched the larger sized E-Series commercial meters with D-Flow technology, and we are steadily building a bid base and backlog there. We remain on schedule to complete the integration of D-Flow technology into our residential meters in the first quarter next year, also thereby reducing costs in 2019. I remain excited about our participation in the AT&T Smart Cities Alliance. We recently took part in a Smart City event in Dallas and gained further insights into the tremendous opportunities in smart water solutions for utilities.
We are experiencing the benefits of this alliance both in terms of the dialogue and quoting activity we're seeing with key municipal decision-makers, as well as on the technology side in terms of keeping abreast of the Internet of Things and future generation cellular connectivity. In summary, we had another very solid quarter, and we remain optimistic for the remainder of 2018 and into 2019. With that, we're happy to take your questions.
At this time, ladies and gentlemen, if you'd like to ask a question, please go ahead and press star, then the number one on your telephone keypad. Your first question today comes from the line of Richard Eastman of Baird. Your line is open.
Yes. Good morning.
Morning, Richard.
Hey, good morning. Morning, Ken, Rick, Rich, Karen. Hey, just a quick question around the pricing. Can you give us a sense of how much price capture you did get in the quarter? When you look at the top line growth rate at 10.6%, any thought as to what the gross price capture is there? Not net, but gross.
Of the 10% increase, probably 4%, maybe, ballpark, is roughly pricing.
Four points consolidated is pricing? Okay.
Yeah, because we're up about 10. A lot of it is pricing. Now, when I say-
Okay
it doesn't mean increased prices. It's also pricing, where we're getting better prices for the material. The big driver was the volume.
Wait. Okay. Better prices for the materials. Basically, you're saying 4% includes kind of a mix shift, more No.
Yes.
Okay. All right. More higher-priced products sold year-over-year-
Right
plus your list price increases get captured in there.
Correct.
Okay.
It's also a higher mix of higher-priced products.
Yeah. Therefore, that's all captured in the gross margin when you speak to the benefit of mix within the residential meters. That you'll get the higher price point products. Also the price capture on a net basis helps you there as well.
Correct.
That kind of feeds right to that commentary?
Yes.
Okay. Fair enough.
Rick, this is Rich. Maybe to help out a little bit. When we did our price increases on the utility side earlier this year, copper prices were going up, we were trying to catch some of that copper. Our list price increases ran 100-150 basis points-
Right
in that range. Okay.
Okay.
When you're talking about purely what did we raise price on our products-
Okay
that was about 100 to 150 basis points. Does that help?
Okay. Much better. Yeah, it does. Then mix would be beneficial there as well. Okay.
Correct.
I understand that on top. Okay. Then two other quick questions. One is on the Middle East side. We spoke, again, about, I presume, double-digit growth in Middle East sales. Is that coming out of backlog, or has there been some more wins there? Maybe, what's the trajectory of Middle East sales look like going forward?
Yeah, in the historical use of the word lumpy for Rich and Rick. If you remember the Middle East order that we took in Q1, we shipped a large portion of that in Q2 and the remainder of it in Q3. That order is now complete. We expect further orders from the Middle East for our products, but there's no large order in there now rolling forward.
Okay. Fair enough. Then, just two other quick questions. One around the balance sheet. Accounts receivables were up $5 million quarter to quarter, plus 20% year to date. What's being captured in there? Is that the Middle East order?
The Middle East has longer sales terms than a standard order. That's in there.
Yes.
Otherwise, it's just normal business. It's timing of orders.
Okay. Last question, just very recently, obviously the two hurricanes, one Hurricane Florence, I think that was the September Carolinas event, then Hurricane Michael here more recently, Florida, Carolinas. Any impact maybe on what we should expect around fourth quarter seasonality? For instance, might that delay enough business just to make a noticeable impact on the seasonality in the fourth quarter on the municipal side?
It did not affect us much at all in the third quarter. We certainly were watching it very closely for a while. UPS wasn't shipping to some of the zip codes we had orders to, but we did get a majority of that out. Maybe some flipped into the fourth quarter, but not enough for us to be concerned about.
Okay.
Don't really know anything about the latest storm here, being October, I guess I'm not concerned for the quarter, so it should be relatively fine.
Okay. Perfect. Thank you.
Your next question today comes from the line of Nathan Jones of Stifel. Your line is open.
Morning, everyone.
Morning.
Morning.
Congrats on making retirement there, Rick.
Thank you.
Start with a question on SG&A. It does look like that stepped up a little bit from 2Q to 3Q. Is there something discrete driving that increase in SG&A, and how should we be thinking about the SG&A number going forward?
First of all, obviously the $2.1 million charge in there for the executive transition. You pull that out of there, as I said, sequentially, we're down as a % of total revenue. There's just certain unique things that are timings, the incentives and like, but there's nothing of substance in there. Healthcare was up a little bit in the third quarter, and we've been running favorable earlier in the year. It's simply sometimes just the timing of items.
Okay. A question for Ken. One of the things Rich mentioned in his prepared remarks was that you're the man to drive innovation and technology going forward in the company. Can you talk about the things the company's going to be focused on in those areas going forward, and where you see the most bang for your buck?
Well, not to shortchange Rich's eye on innovation and technology in the future. I think he's going to figure out how to use his phone in Florida then. The market is really evolving, and as we've talked before about.
Yeah, that's not on our end. That's someone else who needs to mute their phone.
We've been evolving into this meters, then selling meters with radios and then software packages, and we're going to continue to see it evolve in terms of what more information can we bring to a customer through added sensors, whether that's pressure, heat, water quality sensing. What we're going to be focusing on is we already have a very large customer base that we can sell to that is becoming more and more inquisitive with data. How can we continue to focus on technology to bring them more of what they're looking for?
I'd just like to ask one about the Smart City Alliance. Can you maybe talk about what insights you gained, what opportunities you expect that to open up, and has there been any tangible, as in sales benefit from this yet, or is that something that you think will manifest in the future?
The first thing I want to be clear about is I'm really excited about this alliance, but I'm confident that we could win with or without an AT&T Alliance. Let me tell you where it's really strong for us. On the last call, I talked about just credibility in the cellular market for our products. Obviously, being in alliance with AT&T and 10 other Fortune 50 companies certainly gives us a credibility there. Joint marketing and joint sales. Without telling you the city, there's a large city that's going through a smart watering bid right now, very large bid. It's been a really nice collaborative effort where we've been on the lead. Our solution architects got in first. We brought in AT&T representatives to talk about the future of cellular and why that's such a great option for them.
Hearing that from AT&T probably carries a little more credibility than it does from us. That's been very helpful. In many cases, they've been able to get us relationships with CIOs and mayors in large cities, and it's just been a really good collaborative effort. It would be very difficult for me to tell you we're going to grow X% because of it, but I can tell you that our sales pitch, or what we're doing, just comes with a lot more credibility with them with us.
All right. Thanks very much for the time, congrats again, Rich.
Thank you.
Your next question comes from the line of Ryan Connors of Boenning & Scattergood. Your line is open.
Great. Thanks for taking my question. Yeah, congratulations on the smooth transition. I can't help but think maybe you guys should go give a lesson to General Electric about how to manage a CEO transition, that's another discussion for another time. I want to talk a second about backlog.
Very helpful. Yes.
You mentioned it several times in the press release and in prepared comments. I know in the past, Rick, you've said you don't like to get too deep on the backlog, but you have kind of mentioned it a few times here. Is there any way you can give us a little more flavor or color or quantification around those comments on backlog, even if it's just what types of projects and any deeper dive on your backlog comments would be helpful.
Ryan. This is Ken. In terms of the backlog, as Rick mentioned, Q4 sequentially will be lower than Q3. It is every year from a seasonality point of view. If we look at the backlog compared to last year heading into Q4, it is up in revenue on a year-over-year basis, which makes us feel good, and it's pretty broad-based. We do see the impact of pricing flowing through in that backlog. That's where the optimism comes from, is I think with the relative comparisons, it makes us feel good about where we're headed here for the short term. We don't carry a huge amount of backlog. It's not like we know for the next six, nine, or 12 months, but for the next period, we feel solid about it.
Okay.
Ryan, this is Rich. I'd like to also remind you that Badger Meter takes a very conservative approach to backlog. We may win a contract where the customer says, "I intend to buy 50,000 meters and radios over the next year." We generally will not book anything until we receive the actual purchase orders. We're very conservative about that. When you compare us to some other companies, there can be differences in policy.
Got it. Okay. I wanted to talk a second about flow instrumentation. Obviously, you mentioned that the little bit of softness there and the fact that comps do play a role in that, but it's a little surprising to see the softness there, given that industrial space more broadly does seem to be kind of a tailwind for many different companies. Any additional comments on the flow side and what exactly the weakness is stemming from there?
This is Rick. I'm not sure I'd call it weakness as much as if you look at the third quarter of last year, it was up like 16% over the third quarter of 2016. We had some unusually strong, in fact, almost huge orders that went out in the third quarter of last year that just didn't repeat this year. Some of this is simply a matter of timing. I think if we look back in terms of, we don't talk about flow instrumentation standalone per se, but that was probably one of the biggest record quarter we ever had last year. I agree with you. It was a tough comp. We didn't have some of those one-offs. In the markets we're emphasizing, the core markets, we are seeing increases.
We're seeing some sales fall off in some of the markets we're de-emphasizing. We're not particularly concerned about it. We continue to monitor it.
I guess for me, I don't expect this to be a trend. Right? The four target markets that we're after are very large markets. They are growing, and I'm highly confident this will be a blip rather than a trend.
Got it. Okay. My last one, just a bit of a bigger picture question around all this innovation happening on various fronts and different aspects of the product line from flow measurement with the ultrasonic all the way up to the AMI stuff. I guess my question is, Badger Meter is a well-established part of a nice oligopoly here domestically. Obviously, these technological evolutions are an opportunity. Is there also an element where there's a risk to the competitive structure of the market domestically, where more competition comes in? I'm thinking specifically as an example, ultrasonic, you've now got new players that are able to come in that maybe didn't do positive displacement as much. They're now coming into your market.
Can you just comment on kind of the impact of innovation on the market structure, maybe specifically on ultrasonic, but then more broadly as well?
Yeah. On the ultrasonic side first. You're right, there are people that are coming in. The thing to remember about the U.S. market is that, in particular, there's nearly 50,000 water utilities that we've been selling to for 113 years. We know all of them. We have strong relationships. One, it's very difficult to come in and just start taking over while the market is accepting the ultrasonic technology. It still hasn't become a less risk-averse market, right? It still takes some time, and we're strongly entrenched. That's one. Two, I feel really good about our ultrasonic position. Since we acquired D-Flow Technology, and we're integrated into our products to get a great cost position, to get into a larger product line, as they come in, it isn't like we're burying our head in the sand of mechanical meters.
We're making a strong transition at the same time. We'll be able to continue to fight as they come in, into the future. Understand your point, but I feel good about our position. On the AMI side, yeah, that continues to evolve, but I feel like, again, we're out on the front end of it, having a relationship with someone like AT&T and understanding the future of cellular and whether it's LTE-M chips and NB-IoT, I think we've got a pretty good handle on where that's going. Obviously, it's going to continue to evolve fast. We need to stay in front of it. Right now, I feel pretty good about where we're at.
Ryan, this is Rich. I'd like to add something else about the ultrasonics. You have to remember that we have been selling ultrasonics for and I'm going to pause and look at our VP of sales. How many years?
Eight.
About since 2009. Okay. We've been selling ultrasonics in North America since 2009. We were not only the first ones to come in the market with the ultrasonics, we were the only ones. Okay? Now we're seeing the me-too products come along nine years later. After nine years, ultrasonic sales are this year running about 30% of our metering revenue. Okay? Which is, for this industry, a reasonably fast acceptance rate. It is doing well and increasing and growing well for us. For other companies who don't have reference accounts, they haven't been in the market for a long time. They can't say, "Look, we've had these products out here for 10 years, and they're performing well." It's a lot tougher for them. I just want to echo Ken's comment that he feels very good about our position in ultrasonics, and I agree.
We are in a very strong position. Obviously, in our industry, it isn't just about technology, it's also about brand and channels. We have that strong brand and the strong channels to go to market with.
Got it. Well, that's very helpful. Thanks for your time this morning, guys.
Thank you.
Thanks.
Your next question comes from the line of Hasan Doza of WAM. Your line is open.
Hi, good morning, everyone. I have a couple of questions. The first on your point about list price increases, 100-150 basis points. The first question is, how often do you put through these increases? Is it like an annual event, or was this sort of an anomaly this year that you instituted this list price increase?
No, it was not an anomaly. Generally, we adjust prices on the first of every year in municipal water. This year, and I think we talked about this previous in the call, because of some of the increases we were seeing on the flow instrumentation side, we made some price increases on October 1st. Generally speaking, it's January 1st of every year.
Okay. This year the increase went into effect earlier this month, not earlier this year.
No.
Is that correct?
No, that was just for flow instrumentation.
For flow instrumentation, we announced that the price increase was going in on October 1st. That has started. We're currently under review of our pricing by products and by different types of technologies within the utility sector.
Got it. Go ahead, sorry. Go ahead.
The utility sector is where we increase on January 1 every year.
Right.
When I was talking about that 100 to 150 basis points, the bulk of that was related to the utility increase last January 1. We'll look at another utility increase possible on the coming January 1.
Got it. That's very clear and helpful. One follow-up I would have is when you institute the list price increases, let's stick to the municipal water utility industry, what is that accounting for? Is that accounting for higher costs? Is that accounting for you to keep your margins whole? What is your ultimate goal when you have this sort of quote-unquote, "list price increases"?
Well, yes to everything you said. It's obviously to capture any kind of cost increases. It's to adjust prices to market, to be competitive, everything combined. Obviously, we set prices so that we're able to continue to sell it and make a reasonable return. Hasan, again, this is Rich, just so there isn't any confusion. I'm not sure if you're saying the same word as I am. I was saying list price, L-I-S-T. We have our list prices out there, and those are what we adjust, and then certain customers get discounts off those list prices. When we did the one last January, there was a greater emphasis on meters that were made out of brass because we had the copper increase, and we were trying to capture that, and perhaps less emphasis on polymer meters or stainless steel meters or other things.
We take a lot of things into account. We're obviously trying to maintain our margins, and offset any increased costs.
I know your primary cost is not steel, which has bore the brunt of a lot of the tariffs in domestic steel increases. In terms of your inputs, what areas have you seen the highest input costs in your municipal water business?
Yeah. We've got a global supply chain manager that is all over this, right? What we're seeing is no different than you're probably hearing on other calls. Some increase in electronics, some increase in steel. For the most part, we have some impact. It's not a significant amount. That was one of the reasons we got out with the flow instrumentation increase earlier. We've got some, but we can overcome it with price.
Ken, you had mentioned earlier in the year, when I say you, I mean the company, that there were some supply chain issues related to the supply of chips that has been affecting the overall industry. Is that issue relating to chips resolved, or is that still a bottleneck in the industry?
Well, it's not just chips, but there's capacitors and other significant electronic components. Again, it isn't something that we're anticipating any huge increases or product stock-outs. We've got a good plan around, we know what those products are, and our supply chain group is out on the front of it.
Hasan, this is Rich again.
Yeah.
I think you misunderstood me when I said list price, and you said lift, but then I got even with you by calling you Harry instead of Hasan, and I apologize for that. The only other point I'd like to make is that come January 1, I'm not so concerned about the price of water meters. I'm more concerned about the price of margaritas. Consider that in your model.
Okay. One question on inventories. I noticed that the first three quarters, your inventory levels have been flat at the $85 million level, and one would have expected with the higher sales, your inventory drawdown to be a little bit faster. Any reason why your inventories have been flat so far this year?
No. Nothing in particular. It's just normal operating condition and nothing that's standing out.
I also like to think we're getting better on some of our forecasts, and we're hoping that we don't have to grow inventories. Now, remember, we still offer a variety of choices, which is why we carry some of these higher inventory levels. No, I agree with Ken. There's nothing that comes out and says, "Hey, there's a reason for this.
Okay. Thank you very much for your time this morning. Really appreciate all the color. Thank you.
Thanks.
Your next question comes from the line of Andrew Krill of Berenberg Capital Markets. Your line is open.
Hey, guys. Thanks for taking the question.
Sure.
I was wondering if you could talk about a little more about the utility sales. You had a nice quarter, seeing those accelerate to the mid-teens. What's driving this? I know, versus last year, it's a little easier comp, but is this more company-specific related to your sales efforts, or is it generally a good market that you're seeing out there?
Two things. You gave me the opportunity to say we're doing a great job, I'll say that because you asked if it was our sales efforts first. It is two things. We are seeing on a broad basis, more quotes. More quoting activity, just more things going on in the market at a base level. We're also seeing more quote activity for the larger bids, where people are transitioning from the just buying meters to moving up into adding radios and software packages to it, seeing some of the larger bids. I think activity just feels more robust. I saw someone had mentioned that we had five lackluster quarters in a row, I'd point out last quarter was almost 10% also. We've got two quarters here of runway.
From a sales point of view, I guess, it's probably a good opportunity to recap. Over the last few years, we've been buying our distribution, which was a strategy to bring ourselves closer to the customers and help bring them up the technology curves. We've created a new group of solution architects, which are people that are really adept at selling the higher level of technologies. We've improved our channels and our partners, again, with the AT&T alliance. There's a lot of things going on there that I think are not just market-driven, but I think our team is doing a really good job.
Okay, got it. If you could comment on M&A with these tuck-ins was going to be another source of inorganic growth over the next, call it a couple of years. Any update on the pipeline there, what you're seeing or anything, any conversations you're having you'd like to disclose?
Just in general, I know you're new to us, so this might be an older story for some of the others, but we really started looking at what our opportunities are from a technology point of view, from adding on the geographic side, and we really built out a pretty robust funnel of opportunities over the past 6 to 9 months, 12 months. We're now in the phase of we're talking to people and getting deeper in with companies. I would not in any way imply that a deal is imminent, but I would tell you that we do have a pretty good, robust funnel of opportunities where we could add to our technologies or perhaps increase our geographical reach.
Okay, got it. Maybe just one more if I could. I know, Rich, congrats on the next steps you're taking.
Thank you.
Curious if you'd like to comment into next year, how involved do you expect to be with the business? I know you're staying on as Chairman, but sounds like you're going to have some margaritas come January 1st. I'm curious if you could just talk about the day-to-day involvement or how you expect it to go.
First of all, let me make it clear, I will be a non-executive Chairman. Okay. I will be a board member. I'll be running the board meetings as Chairman of the Board, but also under my contract for four years, and obviously, I would probably do this for the rest of my life, contract or no contract. For four years, I will be available to Ken for consulting. Ken can call me at any time if he has questions or issues. In fact, I'm already planning to travel at the end of January over to our annual sales meeting and address our sales team. I will be having some involvement there. Like other board members and maybe a little more so, I'll be involved with Ken on strategy and discussing our strategic initiatives.
Clearly I'll be here as much as Ken wants me, but I will not have an office here, and I will not be day-to-day on site.
Okay. Thanks, Rich.
Your next question comes from the line of Richard Eastman of Baird. Your line is open.
Hi. I just wanted to circle back to a couple things. One is, when we were speaking to the utility revenue growth rate, you referenced the service revenue grew meaningfully. It was an area of the flag. I'm a little bit curious. What is, A, what is the service revenue? What might the base be? What drives the growth there?
Well, most of it is the BEACON revenue. Okay?
Okay.
Right now on an annual basis, probably this year, we'll run at about a $10 million rate. That's up substantially from last year. Hopefully next year it's going to be even higher because we're seeing more and more sales of the cellular radio along with the BEACON service. We are starting to call it out because now it is gaining some traction. It's getting to be a bigger number.
Okay. Fair enough. Also, we were talking a little bit about maybe tone of project business that was referenced. Could I ask if this smart city project that you're involved with AT&T, is that particular project, Ken, that you referenced, is that in the continental U.S., that city?
Yes.
Okay.
All we've told you it's not Alaska or Hawaii.
Okay. No. The reason I ask is your name has come up. We've been kind of tracking this massive project in Puerto Rico, this water project in Puerto Rico. Badger's name has been in that involved there, and I know it's a territory, it's not a state. I'm curious, as part of that bid, there's a fairly substantial financing component that they expect the contractors or the general to bring to that project. I'm curious if that, is that somewhat of a new trend, and in fact, is that something that Badger would actually be interested in doing, is financing their involvement in a project certainly that size?
Yeah. No, we're not going to get into the financing. What you are starting to see, Rick, is there are capital funds that are starting to set up to fund smart cities for the cities that would like to do smart city roll-outs but can't afford it.
Okay.
There's a group, but not us.
Not us. We would sell to them.
Yeah.
Right.
Is that like when you say capital funds, is that like government-driven or like federal or municipal-
Private.
-or is it private equity or private funds?
It's private funds, and then there's a lot more talk going on around these public-private partnerships. Yeah.
Sure. Okay.
That is evolving, which also does give me more confidence in the smart cities being less about just talk and really becoming more of a reality.
I see. Okay, fair enough. Just last question really quickly. The two initiatives that you mentioned earlier, one around these Cat M chips into the ORION Cellular, there's a cost out opportunity there certainly, the other comment around ultrasonic D-Flow technology into the residential meters in 2019. Is the combination of those two things, will we see a double-digit basis point reduction in your COGS? Is that going to be measurable and noticeable for us looking in from the outside?
From the outside, no. Internally, we'll see it. Okay?
Well, I hope so.
The fact that we talked about it.
I'm more interested in me, the world revolves around us .
Right.
Right?
I know that. I understand. The fact that we've talked about it implies that it's got substance, okay, and that it's important. Okay?
Okay.
One of the questions we get asked is, are we going to reduce price then to keep the margin and then try and gain market share, or how are we going to just make the higher margins? That's still the market's got to decide that. We're going to be watching that. That's going into the consideration, even in terms of when we're talking about what price increases we put in place on January 1, because that, to a certain extent, is going to help offset some of that. It is something we're watching very carefully. The fact we've been talking about it now for probably a year, okay, we do believe it's going to have an impact on the cost of goods sold. We haven't disclosed it, and we probably don't intend to at this time.
Yeah, fair enough. Okay. All right. Rich, good luck. It'll be good to see you around here, hanging around Badger, as well as Milwaukee. Good luck.
Well, at least Milwaukee. Thanks, Rick.
Yeah, you bet. Yeah.
There are no further questions. Thank you. I turn the call back over to Ms. Bauer.
Well, thank you everybody for joining our call today. For your planning purposes, our year-end call is tentatively scheduled for February 5th. I'll be around all day to take any follow-up questions you may have. Thank you. Have a great day.
Thank you for joining us today. This does conclude today's conference call. You may now disconnect.