Good day, ladies and gentlemen, and welcome to the Q2 2014 Badger Meter Earnings Conference Call. My name is Stephanie, and I'll be your coordinator for today. At this time, all participants are in listen only mode. Following the prepared remarks, there will be a question and answer session. If you would like to participate in this portion of the call, please press star followed by one at any time during the conference. If assistance is needed at any time during the call, please press star followed by zero, and a coordinator will be happy to assist you. I would now like to turn the presentation over to your host for today, Mr. Rich Johnson, Senior Vice President of Finance and Chief Financial Officer. Please proceed.
Thank you very much, Stephanie. Good morning, everyone, and welcome to Badger Meter's second quarter conference call. I want to thank all of you for joining us today. 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 risk and uncertainties that could cause actual results to differ materially from those in these forward-looking statements. Please see Friday's earnings release for a list of words or expressions that identify 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 on to the second quarter results. Friday after the market closed, we released our second quarter 2014 results. We are happy to report that we had record sales for any quarter and record earnings and earnings per share for any second quarter. Sales were $95.7 million, compared with $88.3 million in the second quarter of last year. This represents an increase of $7.4 million or 8.4%. This increase was driven by higher sales of municipal water products, offset slightly by lower flow instrumentation and specialty product sales.
Let's take a look at each of these groups. Municipal water sales increased $9.5 million or 15.9% to $69.1 million in the second quarter of 2014 from $59.6 million in the second quarter of 2013. These sales represented 72.2% of sales for the most recent three months. We saw higher sales of residential meters, both with and without radio technology, as well as higher commercial water meter sales. Sales of residential meters and related technology increased 19.3%, due primarily to the higher volumes of product sold. Commercial meter sales increased 2.7% in the second quarter over the same period last year, also due to higher volumes of product sold. Over the past several quarters, we've been discussing a return to normal buying patterns, and we believe that trend continued this past quarter.
In addition, we are seeing results from our efforts to increase sales in other parts of the world, particularly the Middle East. Finally, we continue to have sales to former customers of Elster. Flow instrumentation products represented 25.1% of sales for the most recent three-month period compared to 28.9% last year. These sales decreased $1.5 million or 5.9% to $24 million from $25.5 million in the same period last year. There were more products within this group that had increased sales for the quarter. However, they weren't enough to offset decreases in three particular product lines, which accounted for most of the overall decline. Some of the decreases were due to part shortages, while others were due to timing issues. Specialty products represented 2.7% of sales for the last three months.
These sales decreased $600,000, or 18.8%, in the second quarter to $2.6 million from $3.2 million during the same period last year. This decrease was not unexpected, as we had planned for fewer sales of radios into the natural gas market. The decline was offset slightly by an increase in sales of concrete vibrators. The gross margin for the second quarter as a % of sales was 36.4% compared to 33.8% in the second quarter last year. The improved margin was due to higher unit volumes, which resulted in better capacity utilization that helped keep our cost in line. Selling, engineering, and administration expenses for the last three months increased just under $1 million, or 4.7%, compared to the same period last year. The increase was driven almost entirely by higher employee incentives due to our improved financial results to date.
The effective tax rate for the quarter was 36.6% compared to 36.1% in the second quarter of last year. Our latest estimate of the effective tax rate for the year as a whole is 36.9%. As a reminder, our interim provisions are tied to an estimate of the total annual rate, which can vary depending upon which states we sell into, the relationship of foreign and domestic earnings, and ultimately how much of a production credit we get on our tax returns. As a result of all of this, net earnings for the quarter were $8.8 million, or $0.61 per diluted share, compared to $6.3 million or $0.44 per diluted share last year. Our balance sheet remains fairly consistent. In the first half of 2014, we generated $12 million of cash from operations, which is less than the $15.2 million that we generated last year.
Higher inventory and receivable balances are the main reasons why cash flow is somewhat lower this year. Nevertheless, we were able to reduce our debt in the second quarter. At June 30th, debt as a % of total capitalization was slightly under 25%.
I will now turn the call over to Rich Meeusen, Badger Meter's Chairman, President, and CEO, who will have some additional comments. Rich?
Thank you, Rick, and thank all of you for joining us today. Last week, we committed the ultimate sin in the financial community. We released good news on a Friday night when most companies use that timing to bury bad news. I hope you all had plenty of time this weekend to review our results and to develop your insightful questions. I spent the weekend at a wedding in Bismarck, North Dakota, so I can assure you that I had plenty of time to develop insightful answers. Let me provide a few brief comments on this past quarter and the state of our business. As Rick said, we are obviously pleased with the results. These results were driven by the strength of our markets, with the usual tailwinds of meter replacement, new housing, and the conversion to automatic meter reading.
We are also seeing the impact of many of the new products that we have successfully developed and launched over the past several years. First, we developed the E-Series Ultrasonic Residential Water Meters several years ago. We initially developed it in stainless steel, but found that many customers also wanted a meter made of engineered polymer, which is lighter and has a lower price. We introduced those polymer meters last year. In this recent quarter, we saw a four-fold increase in E-Series meter sales compared to the same quarter last year. A portion of that increase was due to stainless steel meter shipped to the Middle East, but half of the quarter's sales were the polymer meters that we introduced last year. We expect to continue to see strong growth in this product line. We also developed and introduced our ORION SE meter-reading system last year.
As you may recall, this was the first truly simultaneous drive-by and fixed network radio system in one package, providing utilities with an easy migration path from one system to the other, as well as a drive-by backup system in case of a problem with the fixed network. Sales of these units have tripled over the same quarter last year, with new orders continuing to come in. Finally, earlier this year, we introduced the BEACON cellular-based meter-reading system, which uses existing cell towers to not only provide communication from the meter to the utility, but also to provide water usage information directly to the consumer. As we have explained in the past, our industry is relatively slow to adopt new technologies, and sales of any new system usually takes a year or more to become significant.
However, almost 100 customers have already purchased starter kits that include a small number of radios and access to the BEACON software for evaluation purposes. Also, we're very excited that we have already made our first sales of complete systems to several utilities. Customer acceptance and field reports for BEACON have been very positive. With these three new products, the E-Series meter, the ORION SE radio, and the BEACON system, we're very excited about the future long-term growth opportunities. In the near term, we have had a solid first half of the year, and we are cautiously optimistic about the remainder of 2014. With that, I'd be very pleased to take your questions.
Ladies and gentlemen, if you wish to ask a question, please press star one. If your question has been answered or you wish to redraw your question, press star two. Questions will be taken in the order received. Please press star one to begin. Your first question comes from the line of Richard Eastman with Robert W. Baird. Please proceed.
Hey, just a couple things. Rich, maybe you could just address as we exit the second quarter into the third quarter, there's always some question around seasonality and momentum and seasonality, and the third quarter can be up or down over the second. How do you feel about the early part of the third quarter here, just in terms of tone of sales and interest level?
Rick, we are continuing to see the strength as we go into the third quarter that we saw in the second quarter. I can't really say at this time that the third quarter is going to be stronger or weaker or whatever. It's really hard to know because we don't have that large a backlog to tell us. Are we still on the line? I just want to make sure. I heard a beep.
No, no problem. Yep, that's my phone.
Okay, good.
No, you're live. You're fine.
Thank you. What I would say is that, as we enter this quarter, we're continuing to see the strength that we've seen. We're continuing to see good sales, and like I say, we're optimistic about where this can go.
On the industrial flow side of the business, it sounds like you might have expected that to be a little bit stronger. It sounds like there was some timing issues in terms of shipments. Should that business, as we run through the balance of this year, is the tone there up year-over-year and was just a little bit of an anomaly here in the second quarter? Do you have any conviction on that?
No, I would say that from our point of view, we expect to see an up year. What happens on this business is a lot of it is project-related, and the timing of when they're putting up large plants, and we can get very large orders delayed or moved up, whichever, just based on the timing of when they want the shipments. Overall, things can swing between one quarter and another, but overall, we're still expecting an up year.
Okay. Just last, I'll jump out of the queue here, on the E-Series in the Middle East, have we had any follow-on business in that area onto the back of the $6 million order that we were able to announce earlier?
We have not yet. We have had follow-on visits. In other words, we have had visitors from other countries in the Middle East who have come and toured our plants in Milwaukee and our plants in Mexico, our plants in Germany, and the Czech Republic to look at the products and to qualify the products for purchase in their country. We're very optimistic about what we might see in the future.
Okay, excellent. Thank you so much. Nice quarter.
Okay, thanks.
Your next question comes from the line of Brian Rafn with Morgan Dempsey Capital Management. Please proceed.
Good morning, guys.
Morning, Brian.
Can you guys hear me? You keep breaking up a little. Maybe it's on my end.
Yeah, it's on your end, we can hear you.
Okay, sounds good. Let me just ask Rich for an insightful answer here a little bit. You talk a little bit about tone and pace and trend of business. Do you get any sense, and it may be a bit of a stretch, whether this is a capture of pent-up demand, or do you think this is more of an organic, just a build-up resurgence in just normal business?
What I would say is what you're seeing in the last quarter is a little bit of a pent-up demand. I think the whole market, I would be surprised if the whole market isn't up. I haven't seen my competitors' conference calls yet, I wouldn't be surprised if the whole market is up a little bit. I think we've layered on top of that some benefit from our new products.
Okay. All right. A little comment, maybe any, what you're seeing as it plays out into 2014, kind of this strategic shift in market share with Neptune and Elster exiting some of these markets. Are you seeing some pickup in some of that incremental business?
Well.
Yeah. This is Rick. We're seeing increased sales from what I call the former Elster customers, but I think it's a little early because we haven't all reported our results to the publishing entities yet, but we should pick up some market share as a result of that.
Okay. You talked a little bit about kind of a, as much as a 12-month, a little more adoption cycle with new products. Are you seeing with the 300% up in ORION SE, the dual network drive-by as well as network, are you seeing an adoption of that any quicker, given the kind of the ORION brand has been out there and obviously with that kind of technology, it would seem to be something that you can't miss. It's a fairly riskless adoption given the dual strategy.
You're right. Obviously, some of the pickup in the ORION SE sales is cannibalization of the older ORION versions where the customers are switching over. We are signing up new accounts, new customers who hadn't made a decision. The real benefit, in my opinion, of ORION SE is we had a lot of customers who were on the fence and could not decide between a drive-by or a fixed network. Now we were able to go to them and say, "You don't have to decide. You can buy one product that is both.
Yeah. Okay. You also talked about some fairly robust sales on the E-Series is the engineered polymer. Are you seeing, Rich, because you guys make stuff that's cast brass, and it's just massive, and it's got rigidity, and it's got last till Christ returns. Are you seeing more of a U.S. utility demand for engineered polymer?
Yes. Definitely the engineered polymer is of more interest to the U.S. customers. Bear in mind, too, that because of the design of our ultrasonic meter, we don't have as big a pressure vessel, and therefore, the engineered polymer can perform just as well as the stainless steel. When we get to the Middle East, they have concerns about temperature and the wear of sand that might be in the water hitting the meter, so they're much more interested in the stainless steel.
Okay.
Definitely the polymers are more U.S.-based.
Okay. Then just one more on the BEACON cells. When you say you had several customers adopt the entire complete packages, can you comment on dollar amounts or when you talk about a package, what is that? Is that something that would serve, I don't know, 10,000 customers or 1,000? Get a sense as to what a complete package is.
We have test kits out there to just well over 150 customers right now. Just like last year when we introduced the ORION SE, they put it on test, we're seeing increased sales this year. We don't have substantial sales of BEACON yet in any of these results, the interest is about as high for this product as anything we've ever seen. We anticipate that we will have the first orders this year, we're looking forward to increased sales next year.
Brian, the customers that have committed to the BEACON package, we're talking tens of thousands of meters and millions of dollars.
Okay. Thanks, guys. Appreciate it. Good job.
Perfect.
Thanks.
Again, ladies and gentlemen, to ask a question, please press star one. Your next question comes from the line of Chip Moore with Canaccord. Please proceed.
Thanks, Rich and Rick. Just on some of the residential strength this quarter, did you see any of that use it or lose it spend for those June year-end municipalities?
Usually we hear some type of an anecdotal story about that, and the honest answer is we've heard none.
Okay.
I'm sure it's out there. You always have these cities that have a June 30th year-end that have a budget expiring, and they're rushing out to use it. We really didn't hear a lot about that this time. I'm looking over my salespeople, and they're all-
They're all shaking their heads
they're all shaking their heads that they didn't hear much at all about it.
Sure. That jives well with what you're seeing so far in July, it sounds like.
Yeah.
Yeah.
On international, can you talk about some of the mix there for meters and radios this quarter?
It was probably just under $1 million of sales to the Middle East in this particular quarter. Remember when we talk international, we're talking outside of North America. We consider Mexico, U.S., and Canada all as kind of our domestic market, if you will. I know the terms aren't quite correct.
Right.
When we talk about international water meter sales, we've got a couple things going on. One is that opportunity in the Middle East, the other one is we've started shipping private labeled ORION Radios to a partner in Europe who is reselling them. Again, that's tens of thousands of dollars at this point. The Middle East was a little over $1 million.
Rick?
Yeah.
Just to be clear, when he says that, okay, when it's sales to Canada, Mexico, we do report them as international sales.
Well, yeah.
Just want to be clear.
In the 10-K, we comply.
Correct.
Right. For our own discussion purposes.
Right
We tend to refer to Canada and Mexico, North America, as one market.
Okay. That's helpful. On the reseller agreement with Itron, remind me, does that come up next year? When should we be thinking about a potential renewal on that?
2015? I thought it was 2016.
They're looking at each other right now. It's either 2015 or 2016, we're not sure.
I want to say 2016. It's 2016. Early 2016.
I think they believe it comes up in early 2016. We're not really concerned. We have a very good relationship with Itron. We continue to sell a lot of their radios, and so we're not concerned about any change in that relationship.
Okay. Just lastly, on the balance sheet, the tick-up in receivables, just what was driving that?
Well, the sales in the quarter were more skewed towards the end of May and early June. Especially when we presented against the end of the calendar year, the end of the fourth quarter, receivables are generally at their lowest level. It's a factor of the recent sales.
We don't feel we have.
Collection issues.
Collection issues at all.
Yep. Okay. Thanks, guys.
Okay.
Your follow-up question comes from the line of Richard Eastman with Robert W. Baird. Please proceed.
Hi, guys. I threatened I'd be back. On the gross margin side, could you just discuss maybe, given that we don't give guidance on gross margin, can we just discuss some of the variables that went in there? I think, Rick, you had mentioned absorption and the improvement in volumes, which I understand because I'm looking at the gross margin sequentially quarter-to-quarter, and the plus 170 basis points, I think, was the sequential improvement. Obviously absorption and volume. Can you just comment, were some of your pricing gains, were you able to hold some of your pricing improvements? Also the mix within residential, was there a better AMR or just automation quarter this quarter versus last?
No, the latter one, no. The automation was there. The pricing was negligible.
Okay.
The primary impact was volume in this quarter. One of the things that kind of affected margin negatively was the mix, because we had a higher percentage of municipal water compared to flow instrumentation.
Yeah. That was actually a negative. All the improvement really came out of the volumes. It really wasn't a mix issue, it wasn't a pricing issue. Obviously copper, again, you don't break that out, but that was more favorable.
Well, copper was not as big as you think in this particular quarter because the prices weren't substantially different from a year ago. The fact of the matter is, last year, I think we were on the tail end of the C851 brass.
Yep.
We still had C851 brass in the second quarter of last year. This year, for the most part, it's all BiAlloy, so that's not an issue.
Okay. Our gross margin, as long as the bottoms don't fall out of our volume, our gross margin should be sustainable and maybe improve a little bit if we can get our mix up, industrial flow improves.
Yeah.
I'll also add that I have now seen a few renewals for former Elster customers come across my desk.
Yeah.
We are being aggressive to try to improve that pricing more up to market pricing from what Elster was charging. You recall that when we got into a lot of the Elster customers, we said we had a one-year or 18-month contract, and we were going to try to move them along each time. I've seen those increases. I can't say that we're capturing market prices yet, but I think our plan is over several years to get them there.
Okay. Just the last question, again, I know it's small, but this specialty business, anything going on there? I know we got the concrete vibrator business. Now that's a good thing. But the gas meters, that seem to be more and more like a one-off opportunity and sale.
Yeah. I think, Rick, I think we've always said that it was way back when we got Duke, that was kind of a lottery thing.
Yeah.
Remember, we're not selling gas meters, we're just selling the radios that attach to the gas meters.
Mm-hmm. Yep.
Those opportunities are not out there as much because many of the gas utilities are aligning themselves with electric.
Okay.
The provider of the electric radio, the Itron, the Sensus of the world, they generally have a solution for water.
Okay. Yeah. There's nothing in there that could really propel that growth rate there off of the small base, I mean, for the time being?
No, unless somebody big comes along and even if it's a combo, if they pick someone who doesn't have a water solution, as was what happened with Duke, we're more than able to do it.
Sure.
It's kind of a if it happens, we'll take it.
Yeah. Okay. Fair enough. All right. Thank you again.
Before you take another question, just to clarify on Chip's question before, we have verified that the Itron contract expires in January of 2016. Stephanie, you can take the next question then.
Okay. With no further question in queue, I'm sorry. We do have a follow-up question for the line of Brian Rafn with Morgan Dempsey Capital Management. Please proceed.
Yeah, I just slip a couple under the rug here. Let me ask you, Rich, you talked a little bit about BEACON. Is your sense that those orders are being driven by utilities in Western areas that might be looking at droughts, or do you think that there is a residential customers that wanna look at their own individual water usages?
Actually, Brian, that is what I would classify as one of those insightful questions. We are not seeing yet. Right now, the BEACON order kits are pretty much coming from across the U.S. Clearly one of the big advantages of BEACON is the ability of a customer to take an iPhone or an iPad and see what their water usage is and look for potential ways to reduce water usage. I would think that we would see a lot of the drought-stricken states and cities that have major water problems wanting to push this technology, or even customers saying to their utilities, "Hey, we want this technology." I do believe in the long term, over the next several years, we're gonna see that trend. Right now, I can't say we're seeing it right now.
Okay. Thank you, guys.
With no more questions, thank you. I will turn the call over to Mr. Richard Meeusen for closing remarks. Please proceed.
Thank you, Stephanie. I wanna thank everybody for joining us today. Obviously, Badger is very pleased with our results. We feel like the products that we're offering to the market are gaining good acceptance, and we're seeing good strength out there, in addition to just basic strength in our overall markets. We're very optimistic about where things are going in the future, in the long run, and we appreciate everybody, all the support from everybody. Thank you.
Thank you for your participation in today's conference call. This concludes the presentation. You may now disconnect, and have a great day.