Ladies and gentlemen, welcome to the Badger Meter Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' remarks, there will be a question-and-answer session. As a reminder, today's conference is being recorded. It is now my pleasure to turn the conference over to, Karen Bauer, Vice President of Investor Relations, Corporate Strategy and Treasurer. Please go ahead, Ms. Bauer.

Good morning and thank you for joining the Badger Meter Second Quarter 2021 Earnings Conference Call. On the call with me today are Ken Bockhorst, Chairman, President and Chief Executive Officer; and Bob Wrocklage, Chief Financial Officer. The earnings release and related slide presentation are available on our website. Quickly, I will 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. On today's call, we will refer to certain non-GAAP financial metrics. Our earnings slides provide a reconciliation of the GAAP to non-GAAP financial metrics used. Finally, during this call, we will refer to core results for various financial metrics. For example, core utility water sales. Core means, a designated financial metric excluding the impact of the recent s::can and ATi acquisitions. We believe this reference point is important for year-over-year comparability. With that, I'll turn the call over to Ken.

Thanks, Karen, and thank you for joining our second quarter earnings call. I couldn't be more pleased with the dedication and execution demonstrated by our team, supporting our customers and delivering record sales in the face of widespread supply chain, inflation and logistics challenges. Our strong order momentum from the first quarter continued into the second. And even with that strong execution, our backlog reached another record high, as we exited the second quarter. Our two water quality acquisitions, s::can and ATi, delivered strong topline performance above our expectations, with solid EPS accretion. Overall, it was a great quarter, due in large part to the activity in the trenches day in and day out. I'll talk about the current environment and our outlook later in the call. But for now, let me turn the call over to Bob to go through the details of the quarter.

Thanks, Ken, and good morning everyone. As you can see on slide 4, total sales for the second quarter were $122.9 million, compared to the coronavirus-impacted trough of $91.1 million in the same period last year, an increase of 35%. Overall, utility water sales increased 38%. Excluding the approximately $12 million of sales from s::can and ATi acquisitions, core utility water revenues increased 22% year-over-year. Comparing back to the pre-COVID impacted second quarter of 2019, core utility water sales increased 11%. As Ken noted, we continue to experience robust orders. However, supplier allocations of certain electronics and other components, along with logistics challenges, again limited manufacturing output and deliveries. We did experience growth in overall meter sales and BEACON Software-as-a-Service revenue, and we benefited from strategic value-based pricing actions. We exited the quarter with another record high backlog, which bodes well for our sales expectations moving forward. As anticipated, the flow instrumentation product line sales rate of change returned to growth, with a 22% year-over-year improvement. Stabilizing demand trends across the majority of global end markets and applications, as well as an easier comp influenced the increase. We were pleased with the operating profit margins generated in the quarter, in light of the significant and varied inflationary forces. The quarter's operating margin was 15.2%, an increase of 130 basis points year-over-year. Gross margin for the quarter was 40.8%, an increase of 150 basis points year-over-year. Margins benefited from favorable acquisition mix, as well as the higher volumes and positive product sales mix, namely higher SaaS revenues, along with favorable value-based pricing realization. Combined, these drivers tempered the cost headwinds from higher brass and other component and logistics inflation. Taking a closer look at copper. Prices have settled back down into the $4.30 range, after escalating to about $4.80 earlier in the quarter. This is generally in line with our most recent year-over-year headwind estimate, which was approximately $7 million to $8 million on a full year basis unmitigated. As our margins demonstrate, we have executed well in implementing appropriate pricing mechanisms to offset this inflation, and we will continue to actively monitor pricing in light of the inflationary pressures. Turning to SEA expenses. The second quarter spend of $31.4 million was sequentially in line with the $31.6 million from Q1 2021 and represents an increase of $8.2 million from the prior year. You may recall the prior year included the benefit of various cost reduction actions taken at the onset of COVID-19 including temporary furloughs. The SEA run rate includes both the s::can and ATi along with the higher level of acquired intangible asset amortization and is in line with our ongoing expectations of normalized SEA leverage in the 25% to 26% range over time. The income tax provision in the second quarter of 2021 was 25%, slightly higher than the prior year's 24.3% rate. In summary, EPS was $0.48 in the second quarter of 2021, an increase of 45% from the prior year's EPS of $0.33. Working capital as a percent of sales was 24.3% on par with the prior quarter end. Inventory increased due to the manufacturing output constraints as well as commodity inflation as described earlier. Free cash flow of $11.9 million was lower than the prior year, the result of higher cash tax payments and the increase in inventory. On a year-to-date basis, free cash flow conversion of net earnings is sitting at 147%. As we noted in the press release and in our 8-K a few weeks back, we entered into a new five-year credit facility in advance of the September 30 expiration of the prior facility. We took the opportunity to upsize the facility to $150 million and to add additional flexibility in the form of leverage covenants and an accordion feature among others. Our strong cash flow combined with our borrowing capacity provides us with ample liquidity to fund our ongoing capital allocation priorities. With that, I'll turn the call back over to Ken.

Thanks, Bob. Turning to slide 5. We updated the chart we introduced last quarter with actual second quarter data. Given the number of different variables at play in both the current year and prior year comparables, we think this chart can be helpful in understanding the uneven results we have and will continue to see in our sales. The robust growth rate we experienced this quarter, excluding the acquisitions, was the result of continued strong order rates as well as the record high backlog with which we started the quarter. Not surprisingly, it was also due in part to the easier comp from the most significantly COVID-19 impact at second quarter last year. As we enter the back half of the year, the strong order momentum and record high backlog will be supportive of our growth outlook. The third quarter will see a difficult comp both in terms of sales and profitability based on the post-COVID lockdown recovery in both manufacturing output and orders last year. Our supply chain team continues to work tirelessly at playing whack-a-mole with the varied electronic and other component shortages. While we don't expect to be back to normal, we do expect further backlog conversion as the year moves ahead. We are very pleased with the results from the last two water quality acquisitions this quarter contributing just over $12 million of revenue in the quarter, a pro forma growth rate in the double-digits. Their underlying performance along with the integration work underway to establish and cross-train sales resources and harmonized product offerings within water quality validates our confidence in the underlying strategy of combining water quantity with quality in order to accelerate our customers' digital transformations. In summary here on slide 6, the step-change in order rates of the past several quarters confirms the fundamental market demand for intelligent water solutions to monitor, manage and support operational efficiencies throughout the water distribution system. We are uniquely positioned with a full line of smart water offerings encompassing both water quantity and quality to serve utility and industrial customers alike. A record backlog is one of those good problems to have and the challenge we expect will persist for some time as we migrate through the second half of the year and beyond. Electronic and other component suppliers are making good progress in restoring and building capacity. However, the rate of recovery is fluid and will continue to be uneven until inventory levels are able to be fully meet demand. Despite the component availability inflation and logistics challenges, our teams are working hard to build supply chain resiliency and actively communicate to suppliers and customers to proactively manage expectations. Our effective sourcing strategies, market-driven innovation and operational agility are supporting Badger Meter's profitable business growth and delivering value for shareholders. Finally, I want to highlight several additional ESG-related disclosures that we've added to our website. One is an outline of how Badger Meter works to align our ESG efforts with the United Nations Sustainable Development Goals, notably Goal 6, 3 and 11 that focus on water, health and safety and sustainable cities. The second is a stand-alone SASB-focused report providing annual metrics and other information for 2020, which is cross-referenced to GRI. Badger Meter continues to advance its ESG journey as we work to understand and mitigate the most material and impactful risks of climate change and preserve and protect the world's most precious resource. To close out our prepared remarks, I want to welcome back to the office many of our remote work employees who returned this month, adding to the teams of dedicated employees in production in our support staff, who never left. I want to thank all of our colleagues for their agility, and consistent and dedicated efforts to serve our customers. With that operator, please open the line for questions.

Thank you. Our first question comes from the line of Nathan Jones with Stifel. Your line is open.

Good morning everyone.

Hi Nathan.

Good morning, Nathan.

I guess I'll start off by digging a bit further into the supply chain and logistics challenges. I think you guys commented that it deferred some sales out of this quarter that's sitting in backlog now. Can you talk about just how much revenue you think got deferred out of the second quarter into the back half, and what your expectations are for catching that up completely?

Yeah, Nathan, as you know the supply chain situation and logistics certainly are not confined to just us; it's pretty dynamic all the way across. And we don't typically size backlog. Obviously, we've talked about it the last couple of quarters, because we find it significant enough that we should mention it. But we're not going to size that out. The bottom line is supply chain challenges are going to continue to persist. Our team is doing a great job. We think this will continue to be a challenge throughout the year, but we do expect that we will perform very well throughout the cycle.

So, do you think that you'll have caught up with all of these backlog by the end of the year, or do you think this is something that's going to carry over into next year?

I think there's a chance that this issue will extend into next year. We observe larger companies, like GM, halting production for two weeks, and while we're not facing that kind of situation, I would prefer to be more optimistic. However, I feel it's more realistic to suggest that the challenges will likely continue into next year.

It’s always better to prepare for the worst while hoping for the best, right? What are the main challenges? Is it related to the electronic components? Is it about the availability of trucks or shipping? What are the significant difficulties for Badger with the current tight supply chain situation?

Yeah. Well, it can depend on the day. Sometimes it's logistics, because COVID is still an issue in several parts of the world in trying to move products and manufacturing challenges. At times, it's been plastics when you have the deep freeze in Texas. At times, it's semiconductor chips. At times, it's electronics. So that's why we're being somewhat cautious with the commentary; it's not one specific supply chain or logistics challenge. It's pretty wide-ranging.

Okay. Fair enough. I’ll pass it on next. Thanks.

We have our next question coming from the line of Andrew Buscaglia. Your line is open.

Hey guys. Thanks for taking my question.

You bet.

Ken, can you discuss the impact of supply chain challenges in the quarter? Would your revenue have been higher, and if so, by how much?

Certainly, I won't disclose specific figures, but I can say that we experienced strong sequential and year-over-year growth. We made a point to mention that we built upon an already record backlog, which indicates that we could have achieved even more if it weren't for the supply chain challenges. However, I won't provide a specific estimate.

I think the story coming out of Q2 is very similar to the story coming out of Q1, which is very much record order intake. But supply chain challenges impacting that backlog. We didn't size kind of the carryover from Q1 to Q2, or Q1 into later years. But you guys had a pretty darn good job predicting where we'd come in at from a consensus standpoint. So, we're not going to size it. But yeah, your conclusion is accurate. We could have done better were it not for those things. And really the dynamics are very similar where we sit at June as where we sat at the end of March.

Yeah. Yeah it still exceeded what I was estimating. And I think that well going forward is the issue more that, having each sales on the table, sort of, or is it more navigating these costs as they come back, or I guess what is your bigger problem here, or both?

I believe it’s a combination of both, but I would prioritize addressing the supply chain challenges that are constantly changing. If you were to ask me if I feel more at ease now in mid-July compared to our conversation in April, I would say yes. However, the situation is evolving daily and weekly due to various contributing factors. It's not limited to one supply component or a single supplier; it encompasses a wide range of elements. The upcoming six months will focus on navigating these challenges. This also brings the issue of costs. We've certainly experienced this from the copper side, as I've mentioned, but it applies to other cost categories as well, such as resins and logistics. We are actively working to mitigate these issues every day, and I believe our margin performance over the last two quarters reflects that effort. However, we have not yet fully absorbed the peak costs associated with copper or the recent rise in resin in our profit and loss statement. While we're optimistic about the outlook for the second half, we are being realistically cautious in this inflationary environment, as we haven't accounted for the peak costs in our financial results, so it's not all positive.

Yes. Okay. Maybe just one last broad question given the challenging environment and everything you've mentioned. Now that you're progressing with the M&A, it actually exceeded my expectations in terms of revenue contribution. Are you still open to pursuing more M&A and possibly adding some leverage considering the current rates to facilitate a larger deal, or will this environment hinder those plans for the time being?

Well, financially we're in great shape to be able to advance any of our M&A strategies. And organizationally I couldn't be more pleased with how we've gone through the acquisitions of s::can and ATi. I mean, obviously, our funneling process found two extremely great assets, great companies throughout the diligence process. Our Badger Meter employees in combination with s::can and ATi have done a great job on the integration. The performance is there. So from a financial point of view and from an organizational point of view, I feel really good about our opportunities to execute our M&A strategy. So I wouldn't say that we're paused. But at the same time, we've got a disciplined process and we'll make the right M&A decisions at the right time.

I think to the leverage question no question the word on the Street. And as we talk about it with investors is we have a comfort level that's much higher than the leverage ratio that we sit at now. We always talk about 1.5 times to 2 times or two type of leverage ratio comfort level. It's just more about timing and pacing. I think if you look at the debt agreement that we just signed recently, it signals all the right things in terms of expanding the facility having a leverage covenant that's a notch higher than where it was historically. And I think that should signal realign and align with that philosophy.

All right. Thanks, guys.

We have our next question coming from the line of Connor Lynagh with Morgan Stanley. Your line is open.

Yes. Thanks. I was hoping maybe you could provide a little bit more context on the orders you're seeing certainly sounds like pretty robust across the board. But I'm curious if you could frame if there were any meaningful changes versus say, pre-COVID or just versus history in general that would suggest any notable mix shift within your customer base. Any sort of changes in customer sourcing strategies as a result of the pandemic?

I wouldn't say that there've been any significant shifts. I mean, we're seeing it broad-based across the portfolio. It's just a really strong environment. We're executing really well and the profile is primarily the same.

Okay. That's helpful. On another note, you've faced some supply chain constraints that have impacted shipments. Are these constraints affecting certain products more than others? Essentially, I'm trying to understand if there's a mix effect we should consider for margins as the supply chain improves and you can ship more widely.

Yes. Without getting specific into which products it was more impactful in the utility product line than it was in flow instrumentation.

Okay. Fair. Maybe just one last one to pivot to the higher level a little bit here. There was some concern, more so, I would say, last year around municipal budgets. Certainly, you've had support from the government. Things are looking better. But I'm just curious, if you could give any high-level thoughts around customer sentiment and how you think budgets are likely to evolve over the next couple of years here.

Yes. I want to express how proud I am of our sales and marketing teams for their close engagement with customers to understand budget developments. We maintained a more optimistic view than many in the market regarding navigating budget cycles, anticipating strong spending rather than declines. As we entered July 2020, we found that budgets remained stable, and this continued through January with the arrival of new budgets. We are hopeful that as we approach another significant budget cycle in July 2021, we will see similar stability. From a budget perspective, we have consistently held an optimistic outlook, and I believe we have been validated in that perspective from the beginning.

I think the other encouraging factor is the order rate or the demand environment that we saw in Q1 and we're certainly happy with and then now in Q2, even stronger. That's happening in an environment with a rumored infrastructure plan on the sideline. And so, I think, we're very encouraged by the fact that, that to us is a signal that budgets are healthier than maybe some expected a year ago. And even with the rumor of money falling from the sky, people are still spending money. So that's encouraging as well.

Yes. And if I could add to that, it also speaks to the point that we talk about often on how smart metering is so critical to the water distribution that our customers spend on that throughout cycles.

Yes, it makes sense. Thanks for all the color.

We have our next question coming from the line of Hasan Doza with Water Asset Management. Your line is open.

Good morning, gentlemen. A couple of questions. Wanted to start with on the inventory. Can you give an update as much as possible as to what is causing the buildup of inventories? Is it likely the finished goods? Is it work in progress? Is it raw materials? Just wanted to get a color on the inventory side.

Yes. So, Hasan, first, if it was finished goods, we would have shipped them. So we're more in the mode of, as we're trying to play through, as I've referred to with the whack-a-mole analogy is, you get some buildup, because you might have built up your components to build an assembly or package of sorts and then you don't get a component. So that inventory build is there. I'll let Bob talk more about the copper step-up and it's also an issue.

Yes. I believe the increases in the current quarter are mainly due to timing. Copper prices have risen significantly, which is a major component of our inventory, contributing to the inflated costs. As Ken mentioned earlier, we are working to stay ahead of supply chain challenges. If one component is delaying others, it doesn’t stop us from purchasing the other necessary items, which explains the increase in inventory this quarter. Looking ahead, we anticipate needing higher working capital to meet the increased demand indicated by our order trends. Consequently, I expect that in the second half, working capital may create challenges for free cash flow, but we have been signaling this for some time.

Okay. My next question is, Ken or Bob, your primary facility, manufacturing-wise, is in Mexico and has that facility been impacted by any chance in terms of work interruptions or anything else from COVID? I just wanted to get an update on that factory in Mexico.

Well, so a year ago, right, we had several challenges as everyone did, when COVID was really raging throughout the U.S. and Mexico. But, certainly, we're not seeing any impacts currently at all on that front.

Okay. When you discuss value-based pricing, you've already outlined the cost aspect. Can you provide some details on how much of a price increase you've been able to implement? While I don't need an exact figure, other companies have shared approximate ranges. For instance, is the increase in the mid-single digits, single digits, or high single digits? I'm looking to understand the extent of price increases you have successfully passed on to customers so far this year.

I appreciate the effort, but I'm sure, you knew, I wouldn't answer that. So from a pricing point of view, what I think you need to understand is this is not a pricing initiative. What we're talking about here is business excellence process is like anything else. So we're doing, I think a very effective job at understanding the value that we provide for customers and getting the right amount of price for it. There's a second lever to getting business excellence around pricing, and it's also winning at least our fair share of new business. So for us, it's a two-factor, right? It's making sure that we both grow and grow profitably. So I'm really proud of the work that's been done. As we've said in other quarters, it's not a copper surcharge, if anything else it's just the way that we do business. So we're proud of what we've put through. But no, I mean, we're not going to size it out in percent or anything, because it's – frankly, it's not that simple. It's not like this is a price increase that you're spreading peanut butter across product lines.

We have our next question coming from the line of Robert Mason with Baird. Your line is open.

Yes. Good morning. Bob, you'd made the comment just in discussing some of the inflationary impacts you've not yet absorbed or seen the peak yet in some of those. When might you expect to see that? Do you have a time frame in mind, or…

Yeah. So I would think of those very much – I would – so, when I say that, I'm not trying to predict forward. Look I'm talking about what's occurred in the history and how that is realized in our P&L. So I think you can expect that – I'll use copper as an example. Copper hit $4.80 I think in the May timeframe. So I would expect that to come flowing through the P&L in the third quarter. So when I make that statement, we haven't seen that peak, I'm primarily speaking to copper and resins and that's more of a third quarter event.

I see. And then I just had a question on the acquisition performance. I mean, we were pleased as well, a little bit above our expectations. And Ken, you noted, those growing double digits. Is that kind of growth rate – I mean, can we hang our hat on that going forward, or how comfortable are you around that kind of a double-digit growth rate, or is there some seasonality in that business as well that we need to be aware of as those drop into the P&L?

Well, I'll go first, but I can see Bob wants to get in on this one too. But the first thing, I'd caution you still is it is kind of the law of small numbers. I mean, it can move pretty quickly when you're talking about percents of growth. We're absolutely bullish that these businesses were growing high single digits before we acquired them. We believe in the synergy aspects of bringing them together. We're extremely pleased with the first six and eight months of having these two companies here, and we think they'll perform in that high single digits, some quarters maybe a little higher, some quarters maybe a little lower. But through the cycle, we feel really good about it.

Yeah. The only thing I would add is, with respect to the second quarter results as a whole related to the acquisitions, I would just caution you there is a bit of backlog timing, and as again, on a relatively small basis, but a discrete project. So I would expect that level – the absolute level of revenue dollars to moderate in quarters going forward. But still very little seasonality and I would think of it as high single-digit growth that you could bake in going forward.

Okay. Very good. And is it fair to assume that those businesses relative to your other utility businesses would be less exposed to some of the supply chain challenges as well, or is that a fair statement?

It's not a fair statement. I mean, we've seen challenges there as well. Yeah, again, I think it's pretty broad-based. I'd be surprised, if other people you're following aren't talking about it too.

No, they definitely are.

All right. All right.

Very good. Thank you. Thanks very much.

Yeah. Thanks.

Our next question comes from Ryan Connors with Boenning and Scattergood. Your line is open.

Hey. Great. Thanks for taking my question and congrats on a great result.

Thanks, Ryan.

One thing that was not mentioned much in your prepared remarks and was only briefly touched upon in the Q&A, yet has been significant over the past year, is the infrastructure stimulus package. I assume this is partly because the current market does not seem to require federal support. What is your perspective on this? Bob, you spoke about money potentially coming in from the government, and it appears that may happen based on recent news. How would that impact the market? Are we looking at a potential overheating situation? Would you and your peers need to build new factories in that scenario? What is your stance on stimulus, and do you desire it or find it necessary at this moment?

So I'll go first and then I'm sure Bob will have some thoughts on this too. So if you recall, it may have been end of Q2 early Q3, the things that I thought were really important were vaccination and we're there for people to be able to actually go out and do the work and low interest rates I thought would be really positive. Stimulus for us can only be positive, right, unless that condition we've talked about before where it's just rumored and it doesn't happen that could sometimes be a delay, but that wasn't even the case this time. We've seen really robust order growth for the last three quarters, while people knew there would be infrastructure. So for us, we sit here and think about $55 billion for water infrastructure in the bipartisan bill still again we believe in the fact that AMI is a really strong proposition for using those funds. Shovel-ready projects are usually priority with our infrastructure-free AMI. We feel really strong about that. Water quality delivering clean safe drinking water is a big deal. That's why we wanted to get into it. We think we could see some positivity there. So it isn't that we don't want it. We wouldn't have to build factories. I mean, we've got a very strong manufacturing model. Supply chain challenges I can't imagine would get easier, if we keep throwing money into the market, but in terms of manufacturing capacity we're fine.

Okay. I have another question that looks at the bigger picture. You’ve covered a lot during the call, but I want to discuss price and price expectations in the market. There’s been considerable discussion about inflation, with both consumers and businesses recognizing we are in an inflationary environment and anticipating price increases. As a result, they may be more willing to accept these price hikes than in the past. Is there any indication that customer expectations have shifted, making them more accommodating to price increases than before?

Well, so two things on that. I mean, I want to be clear, when we're talking about value-based pricing, we're not trying to go out and grab every nickel that we can. The affordability of water to us is still an important thing on our minds, as we talk to our customers. They are accepting. The market is still rational. So that's why I try to use the word value-based pricing rather than pricing initiative, because that's really what we're doing here. But the market is still rational and understanding of the challenges that are driving the cost out.

Got it. Thanks again for your time.

Yes. Thanks, Ryan.

Thank you. There are no further questions at this time. I will now turn the call back over to Karen Bauer.

Thanks everyone for joining our call today. For your planning purposes, our third quarter call is tentatively scheduled for Friday, October 15. I'll be around all day to take any follow-up questions you have, and good luck to our Milwaukee Bucks tonight. Cheer the Deer. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect.