Ladies and gentlemen, welcome to the Second Quarter 2022 Badger Meter Earnings Conference Call. 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 thanks for joining Badger Meter's second quarter 2022 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. With that, I'll turn the call over to Ken.

Thanks, Karen, and thank you for joining our second quarter earnings call. In the second quarter, we bolstered our track record of strong performance by delivering 12% revenue growth and an 18% increase in operating profit and a 19% increase in EPS year-over-year. For the past three quarters, we've delivered double-digit organic sales growth, including mid-teens core growth in utility water revenues. Over the same period, gross profit margins have been within our tightened to normalized range of 38% to 40% even with supply chain shortages and significant economic impacts from inflation, COVID shutdowns, and the ongoing war in Ukraine. Our focus on delivering the widest choice of smart water solutions across the water ecosystem and our operating execution illustrate that we are well positioned to weather macroeconomic challenges that may lie ahead. I'll talk about the current environment and our market outlook later in the call, but for now, I'll turn the call over to Bob to go through the details of the quarter.

Thanks, Ken, and good morning, everyone. Turning to Slide 4, our total sales for the second quarter were $137.8 million, a quarterly record and a 12.2% increase over the $122.9 million in the same period last year. The stronger U.S. dollar did reduce sales by approximately $2 million or about 1.5 percentage points in the quarter. Total utility product line sales increased 14.1% year-over-year. Strong order demand coupled with modestly improving production output and ongoing price realization efforts helped to offset continued sporadic supply chain challenges. Sales growth in the quarter was most notable in ultrasonic meters, ORION Cellular radio endpoints, and BEACON software as a service sales. Order rates continued at a strong pace showing no inflection from the higher interest rate environment or potential macroeconomic softening. Even with the mid-teen sales growth, we exited the quarter with yet another record high utility water backlog. Sales for the flow instrumentation product line increased 3.8% year-over-year, led by double-digit sales growth in North America as the stronger U.S. dollar offset the organic sales increase outside of the U.S. Solid demand trends across the majority of end markets and applications were partially offset by supply constraints which limited production. Turning to margins, we were pleased with the operating margin improvement of 80 basis points year-over-year to 16% from 15.2% in the comparable quarter last year. Gross profit as a percent of sales in the second quarter of 39.7% was at the high end of our normalized range and improved 140 basis points sequentially from the first quarter of 2022. This was due to higher manufacturing output and the improving pace of price cost dynamics. As anticipated, despite continued favorable product mix trends, gross profit was down on a year-over-year basis due to widespread inflation across nearly every element of our cost structure. We maintained our value-based pricing rigor which partially offset these inflationary pressures. We remain confident in the margin resiliency of our business model. SEA expenses in the second quarter were $32.7 million, an increase of $1.3 million year-over-year due primarily to higher personnel and travel costs and other growth investments. As a percent of sales, SEA was 23.7%, a 190 basis point improvement from the 25.6% in the comparable prior-year quarter. We remain disciplined in our spending, while simultaneously supporting the strong demand environment and our ongoing innovation focus. The past two quarters clearly illustrate the SEA sales leverage potential inherent in our business model. The income tax provision in the second quarter of 2022 was 24.4%, a modest reduction from the prior year's 25%. In summary, EPS was $0.57 in the second quarter of 2022, up 18.8% from $0.48 in the prior-year comparable quarter. Free cash flow of $18.1 million was $6.2 million higher than the prior year's $11.9 million due to higher earnings and working capital timing between years. Working capital as a percent of sales was 23.8%, a 100 basis point improvement from the prior quarter end. We continue to invest in working capital, most notably inventory, to ensure we have the best levels of availability for our customers during this time of supply chain challenges. This investment has supported our exceptional growth and generated strong overall returns on capital. We continue to take a disciplined approach to cash generation and deployment, which remains a core element of our business model and incentive compensation structure. With that, I'll turn the call back over to Ken.

Thanks, Bob. Turning to Slide 5, I wanted to spend a bit of time today on water quality monitoring to help investors visualize better the variety of challenges across the water cycle that our solutions help to solve. Water quality is a topic of great interest for our customers and investors and some of you that visited our booth at ACE. This slide walks you through four example applications utilizing real deployments to illustrate just a few of the ways in which real-time water quality monitoring is being used across the water cycle today. Let's take source water monitoring on the left. Having insight into real-time levels of nitrates in the source water supply, especially after rains which can cause increased levels of common agriculture fertilizer, enables this city in Ohio to more effectively dial-in their treatment dosing to ensure safe drinking water quality for residents and optimize treatment related costs. Within water production and water delivery, our chemical-free chlorine monitoring solution allows this U.K. utility to provide safe drinking water to residents while saving labor, eliminating the use of reagent chemicals, and reducing costs. Turning to an industrial example, our solutions enable a Canadian brewery to meet requirements for discharge monitoring without the expense and time delay that comes with manually collecting and testing samples. It also serves to provide an early warning to the unintentional discharge of beer, which we all know is of course very important. Finally, the Public Works Department in Memphis, Tennessee actively monitors the discharge from local industries into the wastewater system. This compliance step protects the city's infrastructure from pH corrosion and increases the efficiency and effectiveness of the wastewater treatment process. These application examples provide you with a sense of the breadth and scope of industries, customers, and regions that can benefit both from a financial and regulatory standpoint across the water ecosystem. We remain extremely excited about the water quality growth opportunities ahead. Turning to the current environment and outlook here on Slide 6, in summary, our backlog order rates and bid funnel remain supportive of durable, long-term growth for Badger Meter. This momentum is the direct result of the consistent execution of our growth strategies, combined with our customer focus and operational agility, which has differentiated our performance. There is increasing market-wide concern about the potential for U.S. recession and rising interest rates to potentially dampen demand. Yet, the industry fundamentals that have proven to be resilient for Badger Meter in the past during downturn still exist and have only strengthened in recent years. These include the critical nature of metering infrastructure, replacement-driven demand, customers' long-term investment mindset, and more recently, stable SaaS revenue. The water industry's secular tailwinds including demographic shifts in utility staffing and retirements, climate-related weather events and droughts, aging water infrastructure and technology adoption, all continue to support the dependable demand environment. These tailwinds, coupled with our innovative solutions in water quantity and quality, choice matters portfolio, and advancements in software and digital solutions that drive operational efficiency and sustainability for our customers, give us confidence in our ability to weather economic uncertainty ahead. In the near term, we will continue to manage the macro challenges of inflation and periodic supply chain interruptions in support of our customers. We will be disciplined in our capital allocation, utilizing our strong balance sheet to invest in production capacity and organic and acquisition-driven growth strategies, delivering value for shareholders. We published our bi-annual Sustainability Report last month, which serves to communicate the progress on our ESG-related goals and priorities, including minimizing the environmental impact of our operations and fostering a culture that is safe, inclusive and engaging for our employees. The report also showcases how our products create a positive impact by preserving and protecting the world's most precious resource, water. Finally, I want to highlight that Badger Meter has been selected to receive the 2022 Manufacturing Industry Top Workplaces Award. This award was based on the results of our first employee engagement survey conducted this past fall and is a testament to the strong culture and dedication of our employees worldwide. I want to express my appreciation for the team's hard work and dedication to serving customers globally. With that, operator, please open the line for questions.

Our first question is going to come from Nathan Jones from Stifel. Nathan, your line is now open.

Good morning, everyone.

Hi, Nathan.

Hi, Nathan.

Good morning. I'll begin with the noticeable decline we've observed in copper prices over the last couple of months. While copper has become a smaller part of our overall mix as we've increased our ultrasonic meters, radios, and SaaS revenue, could you share your insights on inflation at this point? Is inflation starting to level off for you with copper at these current prices? Are your overall costs increasing, stabilizing, or decreasing?

Well, let's focus on copper for a moment. It's clearly experienced significant fluctuations over the past three months. The recovery mentioned began in late June and it hasn't influenced our Q2 results. As we've mentioned previously, alongside your points about reduced sensitivity to copper exposure, we talk about a one quarter lag in how changes in copper prices affect our financials. Therefore, we anticipate any positive effects from copper to be more apparent in Q4 than in Q3. Regarding other costs, we are still facing elevated levels and are certainly experiencing inflationary pressures like many others in the industry. This provides context for the specific areas related to your question. I just wanted to highlight that the impact of copper on our financials is more gradual and will be seen later than some might expect.

Understood. When you look at the overall cost picture for you, including this rapid decline that we've seen in copper and understanding the lag, are you still seeing or will you continue to see further inflation, or have those things started to flatten out now with other input costs, obviously, copper going down, and will you need to continue to push pricing to cover any inflation?

In my opinion, we are not done with inflation by any means, particularly regarding electronics and transportation. We expect to see inflationary pressures continue, and we will maintain our approach from the past two years, which includes a combination of value-based pricing strategies and, in some cases, commodity-based price increases. It will be business as usual, and we will continue to experience both leading and lagging effects as we have discussed over the last two years.

Yes. And I think the key point there is, when we embarked on value-based pricing a couple of years ago, it wasn't a project. It was embedding that methodology into the business to make sure that we're dynamic and reacting to the trends. I'm really proud of how we've managed through the most difficult inflationary period of my career for sure and feel really confident in the process to be able to do a great job throughout the cycle regardless of where it goes.

Yes. So industry rebound in gross margins within the quarter for sure. Utility budgets are probably getting set right about now. There is likely to be some money coming from the U.S. government through the infrastructure bill. Do you have any insights into what utility budgets look like for fiscal '23? Where do you think there's going to be more funding available just to utilities in general and then for your business specifically?

Yes. So, we look at this in a couple of ways. One is, we're always looking at the full pipeline of what's happening, and RFPs are still continuing at a very hot pace. Orders, even though we've shipped mid-teens revenue in the last three quarters, have continued to outpace that really exciting growth that we've shipped out the door. When utilities are continuing to order at that rate, obviously, they're very confident in their metering and water quality needs. Other statistics the AWWA put out in a report a couple of weeks ago about the bullish nature of the industry, and I think they pointed out roughly 72% of all utilities are looking at implementing rate increases in the upcoming year. So all the things that we look at in terms of real activity that are specific to Badger Meter and/or market reports from reputable sources continue to indicate that the space in which we operate is going to be very, very resilient.

Thank you very much for the color. I'll pass it on.

Yes, thanks.

Our next question comes from Andrew Buscaglia from Berenberg Capital Markets. Andrew, your line is now open.

Good morning, guys.

Good morning, Andrew.

Hi, Andrew.

So, maybe just following up on the last question, if we're looking out into the next several quarters potentially recessionary scenario, when you guys look past into how utilities act in these scenarios, what have you come up with in terms of how demand will ebb and flow? And I guess with that, you have the dynamic of infrastructure stimulus. So I guess what are you guys thinking with, I guess, longer term through like a worst-case scenario?

Certainly. I would like to share a specific example. We spend a considerable amount of time contemplating the questions you raised. In May, I was at a major utility customer, and I posed the question about their plans for managing the next cycle in a potential recession or higher interest rate environment. Their response was clear: if budget issues arise, they would redirect funds to continue their AMI projects. This is very reassuring. Our conversations with customers reaffirm the critical role that AMI plays in the resilience and future of their water systems. At the ACE show, we conducted several interviews with industry consultants and spoke with various customers. The strong drivers behind AMI that emerged during the COVID period have been further validated in nearly every discussion we've had since then.

Okay, interesting. Switching gears to your free cash flow, it's been a really strong quarter and a nice recovery from the hold in Q1. What are the dynamics in your working capital or inventory management that could affect the rest of the year? What targets are you expecting this year?

So, I think very consistent with what we said in the first quarter. There really isn't a structural change by any means to our working capital philosophy, other than perhaps a temporarily elevated inventory balance to service customers in this supply-constrained environment. I think over the long term, no real fundamental change to primary working capital management, and at the end of the first quarter, we talked about how clearly we thought the first half free cash flow would be weaker than the second half based primarily on some timing aspects, and I would argue that holds true. I think the one, I guess, maybe modest change to that philosophy, not necessarily primary working capital related, but CapEx related is, with our sustained success, with our strong demand environment, and with our elevated backlog, largely caused by supply chain shortages, we are thinking a bit more about capacity expansion, more so than we have in the past. That is not a signal of anything other than there may be some capacity expansion projects on the horizon, which would be great in terms of investing in the business and supporting future growth, but may serve as a temporary free cash flow headwind. But no real structural change to our primary working capital philosophy.

Okay, great. Thank you, guys.

Thank you. Our next question is from Tate Sullivan from Maxim Group. Your line is now open, Tate.

Hi, thank you and thank you Ken, for the comments on the water quality monitoring opportunity in Slide five. Can you give an update to an integrating or do you have an effort to integrate BEACON into the water quality monitoring businesses and customers?

Absolutely we do. So we were proud to launch that at the ACE trade show in San Antonio, the largest trade show in our industry. So a lot of great customer feedback on it. Yes. Our integration efforts have really been outstanding. The team has done a great job. We're really excited, and that's why we wanted to share on this call just some of the real examples that we've already had, and we're certainly seeing positivity from many of these customers that Badger Meter had for so long on metering, absolutely showing interest in our water quality offering.

And is BEACON part of those already installed in some of those projects that you mentioned, or part of those projects?

Not yet. That is future goodness.

I was reviewing my notes from previous years and you mentioned the percentage of SaaS revenue relative to total revenue. Can you provide any updates on its current status and your long-term goals for SaaS revenue? Can we assume it has accelerated since you mentioned it being accretive?

Well, it's interesting that we talk about this as a percent and it's clearly our overall goal to get that to at least double digits, to get that up to 10%. It's been really difficult to grow it as a percent of revenue when the rest of the revenue has been growing so well, so strongly as well. So it continues to grow sequentially. It continues to grow year-over-year. We're really excited with it. It remains at about the same percentage level that it was before. So there is nothing new in terms of where it is, but it's been growing the way that we're expecting.

Okay, thank you. And last for me, please on the water quality, the projects you mentioned, are those new projects, sort of new installed equipment since your acquisition, more than a year ago now?

We have several more examples to share since the acquisition. Many of these have been established for a while. ATI, in particular, has maintained a strong, long-standing relationship with most of the U.K. facilities, s::can, and various other countries. We have additional examples with existing customers that we could discuss, but we felt these four provided a nice broad overview of our current activities.

And further, it's not like these water quality options are one and done. These are relationships much like the utility industry where they are established over time. You start with an initial sale and then as that technology proves itself, there are add-on sales along. So it's not a black and white line. These are relationships that have been around, and sales and transactions that have occurred pre and post-acquisition.

Excellent. Okay, thank you.

Great, thanks, Tate.

We now have a question from Thomas Johnson from Morgan Stanley. Your line is now open, Thomas.

Hi, congrats on the strong quarter, yet again. I guess, it would be helpful if we could go back to the comments on capacity expansion for production. Maybe just if you could go into detail there about where that planned expansion would be and time frame for that? I guess, it would be helpful if we could kind of frame this up, just in terms of 2023 revenue potential and potential constraints to revenue without that capacity expansion. Thanks.

So, I think we'll keep it very general. The thought process here is, as we've been successful in the market and we've grown at mid-single-digit utility water growth for the last three quarters as we continue to aspire for international growth with the development and launch of our international meters as well as just the backlog that we have today. It's simply a signal that we're thinking about capacity expansion more so than we have in the past. There are no finite plans. There is no specific facility targeted. There is no dollar amount that I can quantify for you. Just signaling that, that is a potential forthcoming use of cash. That's different than perhaps the level of CapEx that we've seen in recent years. So, that's about as specific as we'll get on that today.

Yes. And I just think to add a little bit to that to keep in mind, it isn't that we haven't invested in any capacity for several years and all of a sudden we find ourselves jammed up. We have continued to increase capacity on specific product lines over the past several years. So it's just an ongoing extension and really the fact that we get asked all the time, when are you going to start chewing into the backlog, and the great news is, we keep shipping mid-teens shipments and growing the backlog and with the positive sentiment from our customers. I guess to Bob's point, it signals that clearly we're optimistic about the future and looking more closely at our production capacity.

Okay, great, thanks. That's very helpful. Maybe just one question on the backlog, since that seems to be a focus here. Some peers have expressed varying strategies around pricing in the backlog. So I guess it would be helpful for us if you could kind of comment on the margin profile of your backlog; should we assume that is kind of in line with current margins or could that be possibly accretive and just possible shift in product mix in the backlog versus what you've been doing in recent quarters? Thanks.

Yes. So immediately, we don't even disclose backlog in total. So I don't think we're going to go very deep into the margin profile or mix of that backlog. The way to think about it from a pricing and pacing standpoint is to really look at how the gross margin performance performed over the back half of last year and now the first half of this year. Obviously, the inflationary pressures increased in the back half of last year, which narrowed our gross margin profile relative to the first half of 2021. We implemented some pricing actions in late 2021 that as we have not acknowledged in the first quarter of this year, take some time to manifest themselves in the P&L. We saw a lower-than-normal still within our tightened band of 38% to 40%. But on the lower end of that gross margin performance in the first quarter. Here in the second quarter, you see that margin rebounding to a certain extent. I would tell you, as we talked about in the release, price-cost is a huge dynamic in driving our current margin profile. I would say as we chew through that backlog, we have seen a modest improvement in the margins that are realized in the second quarter results. You can infer what you want to from that, but that's about the extent that we'll talk about the different profiles. We don't necessarily have great authority, if you will, or practice to reprice backlog. We take every price increase individually. It depends on who the customer is and how much is in backlog and what future orders will be. So there is some degree of influence there, but in large part, price increases are effective as of a certain date; those play out over time and as we've mentioned in the first quarter, it takes some time to hit the P&L.

Understood, thanks. I'll pass it back.

We now have a question from Rob Mason from Baird. Rob, your line is now open.

Yes, good morning. I just wanted to note that it depends on who the customer is, how much backlog exists, and what future orders are anticipated. There is some influence there, but primarily, price increases become effective from a specific date and take time to reflect in the financial results.

Hi, Rob.

Ken and Bob, hi. I wanted to ask a couple of times during the commentary you noted the sporadic production interruptions that are still present in the operation. I'm just curious if you could speak to those and how much they might be holding back revenue, if there's a way to quantify that for the second quarter. Are they getting marginally better or holding steady as we've gone through the year? Additionally, I'd like an update on the supply constraints you're dealing with and how that dynamic may be trending for you into the second half of the year.

I thought you might be separating the two aspects. When we talk about production, it actually pertains to supply chain issues. We've previously mentioned the ongoing challenges with electronic components that are critical for many of our advanced radios and E-Series meters. This situation has certainly seen improvement. Last quarter, I mentioned that we were feeling better than we had since these challenges began, and I feel even more optimistic this quarter. Our supply chain team wouldn't claim that the industry or global economy is completely past the supply chain difficulties, but there has been noticeable progress. This has been the main factor limiting our ability to do more, rather than production itself.

Understood. Anyway to quantify how much that is limiting you or would have limited you in the quarter?

So typically, we don't disclose that. One of the things that we typically didn't either was the backlog, and the reason we keep telling you that is because we think it's important for you to understand that our growth isn't being driven by chewing down that backlog. So it's meaningful enough that we're talking about this for a few quarters in a row that we've never talked about before.

Yes, how the step up in gross margin sequentially was fairly noticeable? How much of that increase versus the first quarter? It appeared your sales mix was very similar, at least in terms of the products that you called out as being contributing to the quarter's growth? How much of that step up and change in gross margin quarter-to-quarter? Would you attribute to more narrowing of the price cost gap versus just again, your better supply, fewer interruptions, I guess in your production operations? Yes, it's a mix of a couple of things. The areas that we called out as our leading growth areas are, of course, the things that our best margin. So radios, E-Series, and BEACON are some of the best margin lines that we have. So recovery there and growth there is helpful, combined with, of course, some of the price actions that we've taken coming through in the quarter. It's a combination of multiple factors that I think the team has managed really well in difficult times.

Very good. I guess, I can infer as you've come through the quarter that the supply, you said, supply gets a little bit better as you come into the second half of the year versus perhaps where you finished the quarter; is that fair?

That is correct. That is correct.

Okay, very good. I'll hop back in the queue. Thank you.

All right, thanks.

We now have a question from Bob Chernow from RBC. Bob, your line is now open.

Thank you. I have two questions. First, there is significant drought occurring in the United States. I believe that a campaign encouraging the use of water meters would be beneficial for both the country and Badger Meter. Could you share what efforts you are making, either individually or through the organizations you collaborate with? Secondly, I haven't heard much about the Finnish acquisition you completed a couple of years ago. Could you provide some insights on that?

Sure. Yes. Thanks, Bob. Yes. So on the drought conditions, one of the things that we called out in the prepared comments was the severe weather events. What we have from a product and service offering that's been really well adopted here is our cellular AMI. The fact that we have with that, also our EyeOnWater app, which gives all the individual users the ability to manage and understand how much water they actually use has leak alerts and interaction that allows the utility to interact directly with individual water users within their community. That's one of the examples of R&D where we've been out in front in our AMI offering with cellular as well as our developing software BEACON platform to really enable communities to do a much better job with their water use. There are independent studies that show that when people know how much water they use and they have access to that information, they naturally reduce consumption by roughly 20%, and we're on the forefront of giving people that real-time information to do that. Secondly, regarding the Swedish acquisition of D-Flow, that's been a really nice addition for us. It's allowed us to build out our ultrasonic line. Since we've acquired it, we released the larger, commercial ultrasonic meters, the three, four, six, and eight, and we continue to build that up. We've incorporated that technology into some of our residential meters and continue to go forward with that. It's been a source of stability for us as we've gone through supply chain challenges to own our own intellectual property on ultrasonic. Overall, it's also been a very successful acquisition added to AquaCUE before that and s::can and ATI now. Those are, in fact, the types of companies that are in our funnel that we're excited about.

Let me come back to the drought area, if I may. The kind of equipment that we have is very useful if people actually have your product or similar products. But many places, for example, in California are not metered. What efforts are you making to ensure that all these communities are metered?

We are doing everything possible through our marketing efforts and campaigns, in addition to engaging with all the utilities, to ensure that people are aware of the technology that can help them improve their operations. We've noticed a significant increase in the RFP funnel and orders. Much of the growth we are experiencing is related to AMI. The information is spreading. Currently, about 7% of households in the U.S. are not metered, but that gap is decreasing. We are particularly observing the adoption of technology among the 30% of the market that lacks any type of communication technology. This is where we are seeing substantial growth, and we expect this trend to continue accelerating.

Thank you.

Thanks, Bob.

That concludes the Q&A session for today. I will now refer you back to Karen Bauer for further remarks.

Well, thank you, everyone, for joining our call today. For your planning purposes, our third quarter 2022 call is tentatively scheduled for October 19. I'll be around all day to take any follow-up questions you might have. Have a great day.

That concludes the second quarter 2020 Badger Meter earnings conference call. Thank you for your participation. You may now disconnect your lines.