Good day, ladies and gentlemen, and welcome to the third quarter 2013 Badger Meter earnings conference call. My name is Tony, and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a Q&A session. If at any time you require operator assistance, please press star zero, and we will be happy to assist you. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host for today, Mr. Rick Johnson, Senior Vice President of Finance and Chief Financial Officer. Please proceed.
Thank you very much, Tony. Good morning, everyone, and welcome to Badger Meter's third 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 yesterday'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 third quarter results. Yesterday afternoon, after the market closed, we released our third quarter 2013 results. I am very pleased to report that third-quarter sales, earnings, and diluted earnings per share are records for any quarter. As compared to the third quarter of 2012, our sales increased to $93 million compared to $87.1 million last year. This increase is a result of higher sales of municipal water products, offset somewhat by lower industrial flow and specialty product sales.
Municipal water sales increased $8.4 million, or 14.3%, to $67.2 million in the past quarter, compared to $58 million in the third quarter of 2012. This represented 72.2% of sales for the quarter. The increase was due to higher sales of residential meters, both with and without radio technology, as well as higher commercial meter sales. Sales of residential meters increased 10.3%, and sales of commercial meters increased 33.1%, both due to higher volumes of products sold. Part of the increase this quarter was due to sales to former Elster customers. We know that direct sales to former Elster customers totaled $1.7 million in the quarter. Since nearly 50% of our total sales are through distributors, we can also infer that there were additional sales to former Elster customers through distribution, although probably not in the same relationship as our company-generated sales.
We conservatively estimate that anywhere from $500,000 to $800,000 of additional sales may have been sold to these customers through distributors. As we've indicated on prior calls, the pricing for products that we are selling to these former Elster customers is not at our desired margins, but we do have the opportunity to work with them on improving those margins in the future. The remainder of the sales increase was in line with our expectations of a return to more normal buying patterns. Historically, the second and third quarters of a given year are generally the strongest for municipal water. Industrial flow products represented 23.9% of sales for the most recent quarter, compared to 27.5% last year. These sales decreased a net amount of $1.8 million, or 7.5%, to $22.2 million from $24 million in the same period last year.
Sales were affected by lower volumes of products sold in most of this group's product lines due to general economic conditions. Specialty application products represented just 3.9% of sales for the most recent three-month period. These sales decreased $700,000, or 16.3%, compared to the third quarter of 2012, to $3.6 million from $4.3 million. The decrease was due to lower sales of gas radios and concrete vibrators. Gross margin as a % of sales was 35.6% in the third quarter of 2013, compared to 39.4% in the third quarter of 2012. The decline was due in part to a greater percentage of municipal water sales compared to industrial sales, which carry higher margins, certain obsolete inventory charges, and the higher cost of metal alloy related to the industry shift to lead-free brass, which is nearly complete.
Also, as I noted before, the margins on Elster customers are generally lower than those of our regular business. Helping to offset some of these factors were the higher sales volumes and better capacity utilization in our factories. Selling, engineering, and administration expenses decreased $1 million in the most recent quarter compared to the third quarter of 2012. The third quarter of 2012 included a $1 million charge in connection with the write-down of the company's investment in an emerging technology company. Excluding this charge, the selling, engineering, and administration expenses were relatively flat quarter-over-quarter. This year's amounts did include approximately $300,000 of amortization charges associated with the Aquacue acquisition. Offsetting this were lower employee incentive charges compared to last year due to the lower-than-expected earnings on a year-to-date basis.
Interest expense for the quarter just ended decreased slightly compared to the third quarter of 2012 due to lower-than-average debt balances. The effective tax rate for the third quarter was 33.5% compared to 35.9% in the third quarter of last year. We recognized some additional 2012 research and development credits that were identified in the third quarter of this year. In addition, we reversed reserves for certain tax positions taken in prior years. As a result of all this, net earnings for the quarter were $9 million, compared to $8.9 million last year. On a diluted per share basis, earnings were $0.63 compared to $0.62 last year. A review of the balance sheet shows no significant changes. Receivables are higher than they were at the beginning of the year, simply due to the seasonality of the business and the fact that we had record sales.
We have been able to reduce inventory somewhat, which has helped with our cash flow. In the most recent quarter, we paid the remaining $4.5 million due to the former owners of Racine Federated that had been in escrow since purchase in early 2012. Our debt to total capitalization ratio at September 30th was 26%, and we believe we will continue to generate cash going into the future. With that, I will now turn the call over to Rich Meeusen, Badger Meter's Chairman, President, and CEO, for his comments. Rich Meeusen?
Thank you, Rick Johnson, and thank all of you for joining us today. We were obviously pleased with the quarter's results as we continue to see strength in our utility markets and as we grow market share, partially aided by the addition of the former Elster customers. This strength in our utility markets has fortunately more than offset a weakness in our industrial markets as the economy continues to limp along with a very slow recovery. At this time, we are not seeing any impact from the federal shutdown, which apparently ended this morning. A prolonged shutdown could start to impact certain areas of our business, primarily sales of industrial meters in the aerospace and military markets. Hopefully we won't see a repeat in January, what we just saw. At this time, the shutdown has not had any impact on our municipal utility business.
As Rick Johnson mentioned, our margins are not as strong as they were last year, although they continue to improve sequentially. The decrease in the higher-margin industrial sales and the impact of taking on the lower-margin Elster accounts both contributed to the year-over-year decrease in margins. However, the most significant impact was the switch from leaded brass to lead-free brass. In the third quarter of last year, over 40% of our water meter sales were comprised of the lower-cost leaded brass. This year, with new federal regulations taking effect on January 1, 2014, it was less than 1% as customers shifted quickly to the more expensive lead-free brass, which had a negative impact on our margins. We are implementing a price increase effective January of 2014 to pass on a portion of these increased costs.
We expect to begin seeing efficiencies on our shop floors and throughout our supply chain, as we only have to use one type of brass going forward. As we deal with the opportunities and challenges that come from increased sales, we are also continuing to invest in new product development projects to maintain our technology lead in the industry. In April, we purchased a Silicon Valley technology company and have been working since then to integrate their technologies into our products. That integration is going well, and we expect to release several new products in the first quarter of 2014. As Rick Johnson also mentioned, our balance sheet remains strong, and we believe that we are well-positioned to take advantage of new opportunities as they arise.
Our market continues to benefit from the strong fundamentals, including the increased housing starts, the concern over water shortages, and the move to automation in meter reading. With that, we'll be happy to take your questions.
Your first question comes from the line of Mr. Ryan Connors. Please proceed.
Thanks. Good morning.
Morning, Ryan.
Morning, Ryan.
I had a question for you, just, I guess, Rick, on SG&A. Can you help us out with that line item going forward? You've talked in the past about employee incentives, sales incentives, and that sort of thing causing some of the volatility there. Can you just update us on the outlook there? If you can do this, kind of ballpark what % of SG&A is employee incentive-related, and what portion of that is more fixed?
Well, what I'm talking about basically are some of the annual bonus programs and some of the long-term management incentive plans, which are generally three-year rolling periods. We had some accrued in the numbers last year. We don't have anything accrued for the most part this year. Very small amount. I'm not going to disclose the numbers. It's significant and obviously enough to talk about. It's a variable cost. Really what we're doing is we're paying the price for the first quarter of this year, because despite the fact that we've had two very decent quarters here, okay, the first quarter was still not up to snuff, and so it's doubtful very much that anyone will be getting an annual bonus this year.
Yeah.
Okay.
Ryan, almost all of our bonuses in this company are based entirely on the ability to increase earnings year-over-year. If we have a year where we don't increase earnings, you'll see that we don't pay out bonuses. It's as simple as that.
Okay. I guess if I read between the lines there, then at least for the fourth quarter, you'd expect that we kind of just, the three Q level of SG&A is kind of a run rate that we should assume would just continue where it's at.
Yeah. There won't be bonuses coming back in.
Okay. I had kind of a bigger picture question. Rich, you talked about the new products there. Obviously a lot of technological change going on. Without tipping your hand too much, can you give us some color on what types of things you're working on? Is it comms? Is it flow measurement? Is it something else? Just a general idea of where your focus is in R&D.
We have a few focuses. Again, you're exactly right. I don't want to tip my hand at all to our competitors as to what it is we're developing and what we're going to be introducing. I will say there are some major initiatives in both the software area and in the communication area. Software that's more powerful, that gives the utility more options, and even gives the ability to reach out to the customer and allow the customer to get more information. Meaning the utility's customer, or I would call them the consumer. Those are the primary areas. We also have work going on in the meters themselves. We're improving our magnetic meters and our ultrasonic meters. Those projects that I have going with Aquacue, the company we bought, are primarily in the areas of software and communications.
Okay. That's kind of a segue into the one other question I had, Rich. Can you comment on the partnership side? We've been hearing some of these meter data management companies like Smart Earth Technologies, for example. They're claiming that they're having success in, I guess, inserting themselves in between the utility customer and the meter OEM, and therefore enabling the utility to low bid the meter piece and disintermediate the flow measurement device itself. Can you speak to that, and whether that's happening anywhere in the marketplace, and how that impacts your business, and whether or not your new initiatives are in any way designed to sort of respond to that?
Yeah. First off, I know what you're talking about because I hear the same things, them talking about how they're coming up with billing systems or meter data analysis systems that will work with any water meter out there and will exactly kind of insert themselves. We have not seen it at all. We haven't seen it in any of our customers. Our customers are still buying our meter reading and data analysis systems with the ORION or the GALAXY system. I haven't seen anybody say, "Rich, I want to buy your meters and your radios, but I don't need the software because I'm using somebody else's software." It's just not out there.
Okay.
What we are introducing is not in response to that. The software we're working on is more software to extend the range to allow the water utility to provide data to their consumers. I think a lot of water utilities would like to do this to help the consumers conserve water. There are some products like that on the market. We think we're going to be able to come out with something pretty good.
Okay. That's great. Just one last one. You mentioned this price increase for lead-free brass. Can you give us any rough magnitude on that?
Not at this time. We're still working on it. I think if you look at some of the other companies and statements that they've made out there, all of the companies are looking at it, because we're all feeling this bite, that we historically did not charge a premium at all for lead-free, and we just accepted a lower margin on the lead-free brass. Now that it's switched over 100%, it's affecting all the companies, and I think there has to be some price relief as a result. We will be putting in a price increase on January 1 and try to recover some of those additional costs. I'll also remind you that we can still sell the leaded brass to Canada and Mexico.
We may still be selling a little bit of leaded brass, but like I said, in the last quarter, our purchases of leaded brass were less than 1%, it's not a lot.
Okay. Well, thanks for your time this morning, guys.
Yep.
Okay.
Ladies and gentlemen, if you would like to ask an audio question, please press star one on your phone, immediately record your name, followed by the pound key. Your next question is going to come from the line of Mr. Richard Eastman. Please proceed.
Yes. Good morning, Rich and Rick.
Good morning, Rich.
Just a couple of questions. I just want to double back for a second. On the gross profit margin, again, there was maybe some assumption here going from the second quarter into the third that we would see more improvement sequentially. I think you talked about what was in the backlog, and that margin looked better. Can I just ask, this issue of lead-free meters now maybe surprised you a little bit by the uptake and the pace. Now it sounds like the margin's lower there. Is that kind of the missing data point here? Because you're not selling enough Elster meters at this point to have ratcheted down your gross margins like they are.
No, you're right, Rick, maybe I can give you a little color on this. You're right that the cutoff going from leaded to non-leaded dropped faster than we expected, and we got caught with quite a bit of leaded brass still on our books. We did a write-off in there. That impacted us probably about 100 basis points on our margin. That's kind of a one-time thing. We wrote the stuff down to scrap value. We're still.
I'm sorry, is that a year-over-year 100 basis?
Year-over-year.
Quarter-over-quarter.
Yes, okay.
Well, that's a third quarter impact that wasn't in the second quarter, wasn't in a year ago.
Right. Okay. I'm with you. I'm sorry.
All right. You're with me so far.
I'm with you.
That's maybe the missing point. Sales mix was also a big part of it. The lower margin on the Elster sales probably cost us about 50 basis points off the thing. Not as big.
We also probably took a hit for foreign exchange, Q3 over Q3, simply because we buy the radio boards in Europe, and there was some of that impact in the margin also.
When I look at this third quarter, and I'm looking year-over-year, I've got the lead-free mix shift. I've got the write-down. I've got the sales mix that comes from softer industrial-
Yep
Which is higher margin.
Yep.
I've got the impact of Elster.
Yep.
Those are the issues.
Foreign exchange.
Yeah. The FX is basically on the boards?
Yep. Yes.
We're going to carry most of these issues without the write-down, of course. Most of these issues we carry into the fourth quarter, and we'll get some relief, hopefully, from price after the first of the year.
Correct.
Okay.
Although you probably won't get price relief until near the end of the first quarter. Yeah, it takes a while.
Sure. I understand. Can I also Rich, in the press release, you talk about the economic recovery helping, and I'm assuming that's on the utility side with housing starts?
Right.
Again, I would think the industrial products and quite frankly, even the specialty products, they should be showing some positive growth, shouldn't they?
Well, first off, you have to understand that industrial meters that are used in new building construction, plant construction, if you will, are one of the last things to go into the plant. If a plant is under construction and it takes 2 years to build the plant, at the end of the 2 years, you start to add the meters. I think what we've seen, over the last year or so with our industrial products is that there was a slowdown in industrial construction a few years ago, and it's kind of biting us now. It will start picking up again as you start seeing plants being built again. A lot of our meters go into plants. You have to remember that.
Okay.
The dairies and breweries and oil processing refineries. A lot of our flow meters are used in those processes.
Okay. That's on the back end of a capital spend?
It's on the back end of the capital spend.
Okay. Then, to double back one second, your commentary in the press release talks about the second and third quarter seasonally being stronger than the fourth. Presumably, you're not suggesting that that changes here this year. I mean, you can-
Correct
interpret that statement two ways. One is, don't forget the fourth quarter seasonally softer. The other way would be to say that's normally the case, we have some share gains.
No.
Okay. There's no chance the fourth quarter matches the third quarter in revenue. If that's the case, presumably lower volumes means you'll have a hard time building off of your third quarter gross margin in the fourth.
Right. Well, Rick, I guess all I was trying to say there is, although we've got some good tailwinds going into the fourth quarter, we feel pretty confident about the fourth quarter compared to the fourth quarter of last year-
Okay
remember that the fourth quarter is not going to be as strong as the third quarter.
Yes. No, I understand.
because of our seasonality. I just wanted to remind people of that.
Okay, I got that. Again, the gross margin, we're going to fight off the fact that we have lower volumes. We have these other issues carrying in from third to fourth. Again, to make any additional sequential improvement on the gross margin is probably a long shot as well.
Well, except that, remember, the fourth quarter, the gross margin usually improves a little bit because the seasonality is in the utility business, not the industrial business.
Okay.
So-
Okay
I hate to give you another factor that you've got it working, because I know you financial analysts love having all kinds of moving parts.
Almost out of.
That is another piece.
Almost out of capacity. Okay. All right. Thank you.
Your next question comes from the line of Mr. Glenn Wartman. Please proceed.
Yeah. Good morning, guys.
Morning, Glenn.
Yeah. Can you just maybe talk a little about the general tone, from your municipal customers, as we're kind of heading into the end of the year and setting up for 2014?
We've spent some time talking to our salespeople and to our distributors and directly with some of our larger customers. They all seem pretty positive. We're not getting much negativity out in the market at all like we were maybe a couple of years ago. We saw that weak first quarter and that concerned us, so we spent a lot of time on the road talking to people. We really viewed that as an aberration. Sure enough, when we got to the second and third, we did see a return to normal. I think that's, excuse me, I think that's what we're hearing from the marketplace, is that this is a return to normal, that they don't see any negative things affecting their buying patterns.
Okay. On the price increases, at least from your competitors, I know you don't have an exact number yet, but have your competitors come out with exact numbers yet?
Well, since I first announced that we're planning price increases yesterday, I don't think my competitors have had much time to react. I have heard some of the competitors give speeches and mention the need for price increases and some of our non-competitors, some of the other companies. For example, Watts Water is a company that has mentioned that with the shift to non-lead, they're going to have to look at price increases. I think it's going to be more of an industry-wide thing, with the whole water industry.
Okay. Then, Rick, what should we be modeling for the tax rate going forward?
If you exclude the unique items that we've recognized so far, we're at about 36% for the year. Now, these R&D, some of these items that we recognize that bring the rate down in the short term. For the fourth quarter, I'd use 36%.
Okay.
Incrementally.
Okay. Thanks for taking my questions.
You bet.
Your next question comes from the line of Mr. Chip Moore. Please proceed.
Thanks, folks. Appreciate all the color. I think most of my questions have been answered. Just last one, you brought up Mexico. Any year-end orders south of the border here we should be paying attention to?
At this time, we really haven't heard a lot about unique orders that have to be get out before the end of the year. I guess my initial reaction to your question is no.
Okay, thanks.
Your next question comes from the line of Mr. Maza Amselan. Please proceed.
Hello. Good morning.
Good morning.
Morning.
I have a question regarding Elster. Based on my understanding, Elster sold $60 million in revenues last year. How do you think that amount will divide between the U.S. industry players?
Well, that's a good question. First off, yes, Elster sold, I don't believe it was 60. I think it was something a little bit less than that, but a substantial amount. You have to understand that that wasn't all meters. That wasn't all U.S. meters. Some of that was radios that were resold, mostly Itron radios that they were buying and reselling, or radios from Europe that they were trying to sell here, and also certain electronic meters from Europe that they were bringing in. Their actual meter sales without radios was about $20 million. From that point of view, if we had no deal with Elster, I would say Badger Meter ought to get 30% of that because that's roughly our market share, and we ought to see 30% of the $20 million or about $7 million, $6 million or $7 million.
With the deal we had with Elster, we're actually seeing a bigger pickup than that. We estimate that we picked up between $2 million and $3 million of sales. The reason it's an estimate is we know for a fact we shipped $1.8 million directly to former Elster customers during the quarter. We also have our distributors who are picking up Elster customers, and there we're estimating how much exactly is going to those customers. If we had to put a number on it, we'd say around $2.5 million. Now, if we're picking up $2.5 million in a quarter out of a $20 million year, that would say we've got about 50% of the Elster customer base already. We still feel we have more to come. We feel pretty good about the capture that we've had so far.
You can probably figure that the other 50% or less is going to be caught by our other competitors.
Yeah, right. Thank you. It's very helpful. Thank you.
You're welcome.
There are no further questions in the queue at the moment. Please proceed.
Well, if there are no further questions, I want to thank you all for spending time talking to us today. Obviously, we were pleased with the third quarter. It was a record quarter for us. As I said in the press release and in my comments, we're still very confident in our fundamentals in our industry. We still see a lot of demand. Only about 30% of the water meters in the United States have radios on them, the conversion to radio is still a huge tailwind for us. Also, as housing starts continue to improve, that drives additional sales. There are still utilities out there that do not have meters that are starting to meter, all of those things are driving water meter sales.
I think as the economy improves and we see more industrial construction finishing up, you're going to see an improvement in our industrial sales too, going forward. We're pretty confident about all of our fundamentals, and we thank you for your support. Thanks.
Ladies and gentlemen, that concludes today's presentation. You may now disconnect, and have a great day.