Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations
BUSINESS DESCRIPTION AND OVERVIEW
With more than a century of water technology innovation, Badger Meter is a global provider of industry leading water solutions encompassing flow measurement, quality and other system parameters. These offerings provide customers with the data and analytics essential to optimize their operations and contribute to the sustainable use and protection of the world’s most precious resource. The Company’s flow measurement products measure water and other fluids and are known for accuracy, long-lasting durability and for providing valuable and timely measurement data through various methods. The Company’s water quality monitoring solutions include optical sensing and electrochemical instruments that provide real-time, on-demand data parameters. The Company’s product lines fall into two categories: sales of water meters, radios, software and related technologies, and water quality monitoring solutions to water utilities (utility water) and sales of meters and other sensing instruments, valves, software and other solutions for industrial applications in water, wastewater, and other industries (flow instrumentation). The Company estimates that over 90% of its products are used in water related applications.
Utility water, the largest sales category, is comprised of either mechanical or static (ultrasonic) water meters along with the related radio and software technologies and services used by water utilities as the basis for generating their water and wastewater revenues, enabling operating efficiencies and engaging with their end consumers. It further comprises other sensor technology used in the water distribution system to ensure the safe and efficient delivery of clean water. These sensors are used to detect leaks in the distribution piping system and to monitor various water quality parameters throughout the distribution system. The largest geographic market for the Company’s utility water products is North America, primarily the United States, because most of the Company's meters are designed and manufactured to conform to standards promulgated by the American Water Works Association. The majority of water meters sold by the Company continue to be mechanical in nature; however, static meters are an increasing percentage of the water meters sold by the Company and in the industry, due to a variety of factors, including their ability to maintain measurement accuracy over their useful life. Providing ultrasonic water meter technology, combined with advanced radio technology, provides the Company with the opportunity to sell into other geographical markets, for example the Middle East, Europe and Southeast Asia.
The flow instrumentation product line primarily serves water applications throughout the broader industrial markets. This product line includes meters, valves and other sensing instruments sold worldwide to measure and control the quantity of fluids going through a pipe or pipeline including water, air, steam, and other liquids and gases. These products are used in a variety of industries and applications, with the Company’s primary market focus being water/wastewater, heating, ventilating and air conditioning (HVAC) and corporate sustainability. Flow instrumentation products are generally sold to original equipment manufacturers as the primary flow measurement device within a product or system, as well as through manufacturers’ representatives.
Utility water meters (both residential and commercial) are generally classified as either manually read meters or remotely read meters via radio technology. A manually read meter consists of a water meter and a register that provides a visual totalized meter reading. Meters equipped with radio technology (endpoints) receive flow measurement data from battery-powered encoder registers attached to the water meter, which is encrypted and transmitted via radio frequency to a receiver that collects and formats the data appropriately for water utility usage and billing systems. These remotely read systems are classified as either automatic meter reading (AMR) systems, where a vehicle equipped for meter reading purposes, including a radio receiver, computer and reading software, collects the data from the utilities’ meters; or advanced metering infrastructure (AMI) systems, where data is gathered utilizing a network (either fixed or cellular) of data collectors or gateway receivers that are able to receive radio data transmission from the utilities’ meters. AMI systems eliminate the need for utility personnel to drive through service territories to collect data from the meters. These systems provide utilities with more frequent and diverse data from their meters at specified intervals.
The ORION® branded family of radio endpoints provides water utilities with a range of industry-leading options for meter reading. These include ORION (ME) for migratable AMR meter reading, ORION (SE) for traditional fixed network applications, and ORION Cellular for an infrastructure-free meter reading solution. ORION Migratable makes the migration to fixed network easier for utilities that prefer to start with mobile reading and later adopt fixed network communications, allowing utilities to choose a solution for their current needs and be positioned for their future operational changes. ORION Cellular eliminates the need for utility-owned fixed network infrastructure, allows for gradual or full deployment, and decreases ongoing maintenance.
Information and analytics are critical to the water metering ecosystem. The Company’s BEACON® software suite improves utility visibility to their water and water usage. BEACON is a secure, cloud-hosted software suite that includes a customizable dashboard, and has the ability to establish alerts for specific conditions. It also allows for consumer engagement tools that permit end water users (such as homeowners) to view and manage their water usage activity. Benefits to the utility
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include improved customer service, increased visibility through faster leak detection, the ability to promote and quantify the effects of its water conservation efforts, and easier compliance reporting.
Water meter replacement and the adoption and deployment of new technology comprise the majority of water meter product sales, including radio products. To a much lesser extent, housing starts also contribute to the new product sales base. There continues to be a growing trend in the conversion from manually read water meters to meters with radio technology, and for AMR systems to be upgraded to AMI. The Company estimates that approximately 70% of water meters installed in the United States have been converted to some form of radio solution technology.
In addition to our water utility flow measurement solutions, the Company provides various water quality monitoring solutions utilizing optical sensors and electrochemical instruments that measure a variety of parameters including turbidity, pH, chlorine, nitrates and approximately 40 others. Utilizing these solutions, water quality can be monitored continually or periodically throughout the network from its original source to the point in which it is recycled and returned. Real-time water quality parameters enhance the scope of actionable data for water utilities to improve operational security, awareness and efficiency.
The Company’s net sales and corresponding net earnings depend on unit volume and product mix, with the Company generally earning higher average selling prices and margins on meters equipped with radio technology, and higher margins on ultrasonic compared to mechanical meters. The Company also sells registers and endpoints separately to customers who wish to upgrade their existing meters in the field.
Flow instrumentation products are used in flow measurement and control applications across a broad industrial spectrum, occasionally leveraging the same technologies used in the municipal water category. Specialized communication protocols that control the entire flow measurement process and mandatory certifications drive these markets. The Company provides both standard and customized flow instrumentation solutions.
The industries served by the Company’s flow instrumentation products face accelerating demands to contain costs, reduce product variability, and meet ever-changing safety, regulatory and sustainability requirements. To address these challenges, customers must reap more value from every component in their systems. This system-wide scrutiny has heightened the focus on flow instrumentation in industrial process, manufacturing, commercial fluid, building automation and precision engineering applications where flow measurement and control are critical.
A leader in both mechanical and static flow metering technologies for industrial markets, the Company offers one of the broadest flow measurement, control and communication portfolios in the market. This portfolio carries respected brand names including Recordall®, Hedland®, Dynasonics®, Blancett®, ModMag® and Research Control®, and includes eight of the ten major flow meter technologies. Customers rely on the Company for application-specific solutions that deliver accurate, timely and dependable flow data and control essential for product quality, cost control, safer operations, regulatory compliance and more sustainable operations.
In addition, the Company provides various water quality monitoring solutions utilizing optical sensors and electrochemical instruments that measure a variety of parameters providing industrial customers with both process and discharge water quality monitoring capabilities.
The Company's products are sold throughout the world through employees, resellers and representatives. Depending on the customer mix, there can be a moderate seasonal impact on sales, primarily relating to higher sales of certain utility water products during the spring and summer months. No single customer accounts for more than 10% of the Company's sales.
Long-Term Business Trends
Across the globe, increasing regulations and a focus on sustainability are driving companies and utilities to better manage critical resources like water. Some customers measure fluids to identify leaks and/or misappropriation for cost control or add measurement points to help automate manufacturing. Other customers employ measurement to comply with government mandates and laws including those associated with process and discharge water quality monitoring. The Company provides flow measurement technology to primarily measure water, but also other fluids, gases and steams. This technology is critical to provide baseline usage data and to quantify reductions as customers attempt to reduce consumption. For example, once water usage metrics are better understood, a strategy for water-use reduction can be developed with specific water-reduction initiatives targeted to those areas where it is most viable. With the Company’s technology, customers have found costly leaks, pinpointed equipment in need of repair, and identified areas for process improvements.
Increasingly, customers in the utility water market are interested in more frequent and diverse data collection and the use of water metering and quality analytics to evaluate water distribution activity. Specifically, AMI technology enables water
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utilities to capture readings from each meter at more frequent and variable intervals. There are more than 50,000 water utilities in the United States and the Company estimates that approximately 70% of their respective connections have converted to a radio solution. The Company believes it is well positioned to meet this continuing conversion trend with its comprehensive radio and software solutions.
In addition, certain water utilities are converting from mechanical to static meters. Ultrasonic water metering maintains a high level of measurement accuracy over the life of the meter, reducing a utility’s non-revenue water. The Company has over a decade of proven reliability in the market with its ultrasonic meters and has recently launched its next generation of ultrasonic metering with its D-Flow technology, which the Company believes increases its competitive differentiation.
For over 117 years, the Company has offered innovative flow metering and control solutions for smart water management, smart buildings and smart industrial processes. The acquisition of s::can and ATi, leading providers of water quality monitoring solutions, adds real-time water quality parameters to the Company's capabilities and enhances the scope of actionable data for our customers to help measure, conserve and protect water. The combined solutions from Badger Meter, s::can and ATi offer technology that measures both the quantity and quality of water.
Finally, the concept of “Smart Cities” is one avenue to affect efficient city operations, conserve resources and improve service and delivery. Smart water solutions (“Smart Water”) are those that provide actionable information through data analytics from an interconnected and interoperable network of sensors and devices that help people and organizations efficiently use and conserve water. Badger Meter is well positioned to benefit from the advancement of Smart Water applications. Cities have a keen interest in Smart Water as it provides both a revenue base, quality monitoring and conservation outcome. With its strong relationship with AT&T, among others, Badger Meter stays abreast of emerging cellular technology changes which the Company believes is the premier infrastructure-free AMI solution.
Current Business Trends
During the first half of 2022, the Company continued to operate under various safety and COVID-19 protocols. Customer order rates have remained strong and modestly improving logistics constraints and effective supply chain execution have led to sustained year-over-year sales growth. However, the Company’s ability to fully satisfy the increase in demand for certain products continues to be challenged due to varying component availability and supply chain issues. In addition, cost inflation of materials and other expenses are pervasive. In response, the Company has continued to pursue pricing initiatives to offset inflationary cost pressures where possible. The Company believes the broader market, including its primary competitors, experienced lead time extensions, inflation, and pricing dynamics, and therefore does not believe its competitive position has been negatively impacted. While the Company is navigating this dynamic and fluid environment through operational agility to support customers, these disruptions increased the Company’s backlog to record levels and are likely to increase the unevenness of sales patterns for the remainder of 2022.
It remains difficult to estimate the severity and duration of the impact of the ongoing effects of the COVID-19 pandemic and the current inflationary environment on the Company’s business, financial position or results of operations. The magnitude of the impact will be determined by the duration and span of the pandemic and any subsequent COVID-19 variants and their severity, operational disruptions, including those resulting from government actions, delivery interruptions due to component supply availability or global logistics constraints and the overall impact on the economy. The Company is monitoring the ongoing situation and keeps the Board of Directors informed of developments.
Acquisitions
Effective January 1, 2021, the Company acquired 100% of the outstanding stock of ATi, headquartered in Collegeville, Pennsylvania, a provider of water quality monitoring systems.
The total purchase consideration, net of cash acquired, was $44.0 million. The Company's preliminary allocation of the purchase price at December 31, 2021 included $3.9 million of receivables, $3.9 million of inventory, $2.5 million of other assets, $21.0 million of intangibles and $16.4 million of goodwill that is deductible for tax purposes. The intangible assets acquired are primarily customer relationships, developed technology and trademarks with estimated average useful lives of 12 to 15 years. The Company also assumed $1.4 million of accounts payable, $0.6 million of deferred tax liabilities and $1.7 million of other liabilities as part of the acquisition. The allocation of the purchase price to the assets acquired was based upon the estimated fair values at the date of acquisition.
As of December 31, 2021, the Company had completed its analysis for estimating the fair value of the assets acquired with no additional adjustments. This acquisition is further described in Note 4 “Acquisitions” in the Notes to Consolidated Financial Statements.
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Revenue and Product Mix
As the industry continues to evolve, the Company has been at the forefront of innovation across metering, radio and software technologies in order to meet its customers’ increasing expectations for accurate and actionable data. As technologies such as ORION Cellular and BEACON AMA managed solutions have become more readily adopted, the Company’s revenue from Software as a Service (SaaS) has increased significantly, albeit from a small base, and is margin accretive.
In addition, the Company has expanded its smart water offering with the addition of online water quality monitoring solutions, adding real-time water quality parameters to augment the scope of actionable data for water utility and industrial customers to optimize their operations.
The Company also seeks opportunities for additional revenue enhancement. For instance, the Company has made inroads into the Middle East market with its ultrasonic meter technology and is pursuing other geographic expansion opportunities. Additionally, the Company is periodically asked to oversee and perform field installation of its products for certain customers. In these cases, the Company assumes the role of general contractor and either performs the installation or hires installation subcontractors and supervises their work or performs the installation.
Results of Operations - Three Months Ended June 30, 2022
Net Sales
The Company’s net sales for the three months ended June 30, 2022 were $137.8 million, an increase of 12.2% compared to $122.9 million during the same period in 2021. Excluding the impact of a stronger US dollar, sales increased 13.7%. Sales into the utility water market were $114.2 million, an increase of 14.1% from the prior year’s $100.1 million. The Company’s net sales grew as a result of increased ultrasonic meter, ORION® Cellular endpoint and BEACON® SaaS revenues, as well as ongoing price realization. Sales of products into the global flow instrumentation end markets were $23.6 million compared to the prior year’s $22.8 million, an increase of 3.8%. Flow instrumentation sales increased as a result of strong order demand partially offset by supply chain constraints which limited production.
Earnings
Total operating earnings for the three months ended June 30, 2022 were $22.1 million, or 16.0% of sales, compared to $18.7 million, or 15.2% of sales, in the comparable prior year quarter. Gross margin dollars increased $4.6 million, with gross margin as a percent of sales of 39.7%, a decrease from 40.8% of sales in the prior year comparable quarter. The year-over-year increase in inflationary pressures, coupled with production volatility caused by intermittent component delays, tempered gross margins in the current year. Selling, engineering and administration (“SEA”) expenses were $32.7 million or 23.7% of sales compared to $31.4 million or 25.6% of sales in the comparable prior year quarter. The year-over-year improvement in SEA expense leverage is the result of effective spending controls and higher sales.
The provision for income taxes as a percentage of earnings before income taxes for the quarter ended June 30, 2022 was 24.4% compared to 25.0% for the comparable prior year period. Interim provisions are based on an estimate of the overall annual rate that can vary due to state taxes, the relationship of foreign and domestic earnings, and other credits and allowances.
As a result of the above-mentioned items, net earnings for the three months ended June 30, 2022 were $16.7 million, or $0.57 per diluted share, compared to $14.0 million, or $0.48 per diluted share, for the same period in 2021.
Results of Operations - Six Months Ended June 30, 2022
Net Sales
The Company’s net sales for the six months ended June 30, 2022 were $270.2 million compared to $240.7 million during the same period in 2021. Sales into the utility water market were $224.5 million, an increase of 14.6% from the prior year’s $195.9 million. The Company’s net sales grew as a result of increased ultrasonic meter, ORION® Cellular endpoint and BEACON® SaaS revenues, as well as ongoing price realization. Sales of products into the global flow instrumentation end markets were $45.7 million compared to the prior year’s $44.8 million, an increase of 2.1%. Flow instrumentation sales increased due to strong demand across the majority of end-markets and applications, offset by supply chain constraints.
Earnings
Total operating earnings for the six months ended June 30, 2022 were $40.9 million, or 15.2% of sales, compared to $36.4 million, or 15.1% of sales, in the comparable prior year period. Gross margin dollars increased $6.0 million, with gross margin as a percent of sales of 39.0%, a decrease from 41.3% of sales in the prior year comparable period. As expected,
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inflationary pressures were seen across all elements of the cost structure, which was partially offset by successful pricing actions and increased production. SEA expenses were $64.5 million or 23.9% of sales compared to $63.0 million or 26.2% of sales in the comparable prior year period. The year-over-year improvement in SEA expense leverage is the result of effective spending controls and higher sales.
The provision for income taxes as a percentage of earnings before income taxes for the six months ended June 30, 2022 was 24.1% compared to 23.6% for the comparable prior year period. Interim provisions are based on an estimate of the overall annual rate that can vary due to state taxes, the relationship of foreign and domestic earnings, and other credits and allowances.
As a result of the above-mentioned items, net earnings for the six months ended June 30, 2022 were $31.0 million, or $1.06 per diluted share, compared to $27.8 million, or $0.95 per diluted share, for the same period in 2021.
LIQUIDITY AND CAPITAL RESOURCES
The main sources of liquidity for the Company are cash from operations and borrowing capacity. In addition, depending on market conditions, the Company may access the capital markets to strengthen its capital position and to provide additional liquidity for general corporate purposes.
Primary Working Capital
The Company uses primary working capital (“PWC”) as a percentage of sales as a key metric for working capital efficiency. The Company defines this metric as the sum of Receivables and Inventories less Payables, divided by trailing twelve-month net sales. The following table shows the components of our PWC:
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June 30, 2022 |
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December 31, 2021 |
(In thousands) |
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$ |
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PWC% |
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$ |
|
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PWC% |
Receivables |
|
$ |
77,247 |
|
|
14.4% |
|
$ |
65,866 |
|
|
13.1% |
Inventories |
|
|
111,437 |
|
|
20.9% |
|
|
99,611 |
|
|
19.7% |
Payables |
|
|
(61,597 |
) |
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-11.5% |
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|
(41,859 |
) |
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-8.3% |
Primary Working Capital |
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$ |
127,087 |
|
|
23.8% |
|
$ |
123,618 |
|
|
24.5% |
Overall, PWC increased $3.5 million compared to the previous year-end. Receivables at June 30, 2022 increased $11.4 million due to higher sales activity and shipment pacing in the quarter. Inventories increased $11.8 million due to component cost inflation and higher safety stock levels associated with varied component shortages. Payables at June 30, 2022 were $19.7 million higher than year-end due to inflationary increases, increased inventory balance and the timing of payments relative to quarter end.
Cash Provided by Operations
Cash provided by operations in the first six months of 2022 was $28.9 million compared to $45.1 million in the same period of 2021. Strong earnings drove solid cash generation in both years. The year-over-year decline in operating cash flow was due primarily to higher working capital to support increased order activity, and the impact of ongoing supply chain challenges to the timing of shipments between years. Additionally, management incentive payouts negatively impacted cash from operations between years.
Property, plant and equipment expenditures for the first six months of 2022 were $2.8 million compared to $4.4 million in the comparable prior year period.
Cash and cash equivalents increased to $100.2 million from $87.2 million at December 31, 2021, the result of cash provided by operations offset by the quarterly dividend payments.
In July 2021, the Company entered into a new credit agreement, replacing its prior facility. The credit agreement includes a $150.0 million multi-currency line of credit that supports commercial paper (up to $100.0 million). The facility includes several features that enhance the Company’s financial flexibility including an increase feature, acquisition holiday, and favorable financial covenants. The Company was in compliance with all covenants as of June 30, 2022. The Company believes that its operating cash flows, available borrowing capacity, and its ability to raise capital provide adequate resources to fund ongoing operating requirements, future capital expenditures and the development of new products. The Company had $156.5 million of unused credit lines available at June 30, 2022.
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Other Matters
The Company is subject to contingencies related to environmental laws and regulations. A future change in circumstances with respect to these specific matters or with respect to sites formerly or currently owned or operated by the Company, off-site disposal locations used by the Company, and property owned by third parties that is near such sites, could result in future costs to the Company and such amounts could be material. Expenditures for compliance with environmental control provisions and regulations during 2021 and the first two quarters of 2022 were not material.
See the “Special Note Regarding Forward Looking Statements” at the front of this Quarterly Report on Form 10-Q and Part I, Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 and Part II, Item 1A “Risk Factors” in this Quarterly Report on Form 10-Q for a discussion of risks and uncertainties that could impact the Company’s financial performance and results of operations.
Off-Balance Sheet Arrangements and Contractual Obligations
The Company’s off-balance sheet arrangements and contractual obligations are discussed in Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the headings “Off-Balance Sheet Arrangements” and “Contractual Obligations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2021 and have not materially changed since that report was filed unless otherwise indicated in this Quarterly Report on Form 10-Q.