Q3 2023 Badger Meter Inc Earnings Call
Participants
Karen Bauer; VP of IR, Corporate Strategy & Treasurer; Badger Meter, Inc.
Kenneth C. Bockhorst; Chairman, President & CEO; Badger Meter, Inc.
Robert A. Wrocklage; Senior VP & CFO; Badger Meter, Inc.
Adam Michael Farley; Analyst ; Stifel, Nicolaus & Company, Incorporated, Research Division
Andrew Jon Krill; Research Associate; Deutsche Bank AG, Research Division
Robert W. Mason; Senior Research Analyst; Robert W. Baird & Co. Incorporated, Research Division
Tate H. Sullivan; MD & Senior Industrials Analyst; Maxim Group LLC, Research Division
Presentation
Operator
Ladies and gentlemen, welcome to the Third Quarter 2023 Badger Meter Earnings Conference Call. (Operator Instructions) 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.
Karen Bauer
Good morning, and thank you for joining the Badger Meter Third Quarter 2023 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.
Kenneth C. Bockhorst
Thanks, Karen, and thank you for joining our third quarter earnings call. The Badger Meter team delivered another record quarter with continued strong sales, operating profit and EPS growth year-over-year. Demand for our differentiated and tailorable digital smart water solutions remains robust and improving supply chain dynamics allowed us to make modest headway into the elevated backlog.
I want to thank all of our employees for their focused efforts in serving our customers. I'll provide an update on the macro environment and market outlook later in the call.
For now, I'll turn it over to Bob to go through the details of the quarter.
Robert A. Wrocklage
Thanks, Ken, and good morning, everyone. Turning to Slide 4. Our total sales in the third quarter reached yet another record at $186.2 million, an increase of 26% compared to $148 million in the same period last year. This increase was on top of 15% year-over-year growth in Q3 last year and 13% in the prior year.
To put our multiyear organic sales trend line into perspective, third quarter 2023 sales are more than 60% above pre-COVID-19 -- 2019 levels, which equates to about 13% compounded annual growth on an organic basis. Total utility water product line sales increased 31% year-over-year with broad-based growth across the portfolio of utility smart water solution offerings.
Continued robust order demand and normalization of supply chain conditions resulted in strong manufacturing output. Similar to last quarter, we delivered on meaningfully higher cellular AMI demand, including ORION Cellular endpoints, E-Series Ultrasonic meters and BEACON Software as a Service revenues.
Additionally, water quality and pressure monitoring sales contributed to the top line growth. Sales for the flow instrumentation product line increased 2% year-over-year with solid demand in water-related markets, partially offset by modestly lower sales associated with deemphasized general industrial applications.
Turning to margins. Solid execution at both the gross margin and SEA lines contributed to the 80 basis point increase in operating margins in the quarter, reaching 16.9% versus 16.1% last year. Gross profit dollars increased $15.2 million year-over-year and as a percent of sales increased 20 basis points to 39.1% versus 38.9% last year with higher volumes and favorable product mix contributing to the improvement.
We were pleased with overall gross margins again in the upper half of our normalized range. SEA expenses in the third quarter were $41.3 million, an increase of $7.6 million year-over-year, which included higher personnel-related costs such as headcount, salaries and variable compensation as well as R&D expenses.
The addition of Syrinix with its related intangible asset amortization also contributed to the dollar increase. Despite the higher spend levels to support growth, SEA as a percent of sales declined 50 basis points to 22.2% from 22.7% in the comparable prior year quarter.
While operating income grew 31%, we increased EPS an exceptional 44% to $0.88 in the third quarter compared to $0.61 in the prior year quarter. The delta includes the benefit from interest income earned on our increasing cash balance. And in addition, the quarter's 20.3% income tax rate benefited from discrete equity compensation transactions occurring in the quarter. We continue to expect our normalized effective income tax rate to be plus or minus 25%.
Working capital as a percent of sales was 22.7% compared sequentially to 23.4% last quarter end. While overall working capital, including inventory, has increased in total dollars to support growth, we did see an improvement in inventory as a percent of sales and continue to expect modest inventory reductions as we move forward.
Free cash flow of $28.4 million improved from a year ago, primarily on higher earnings. We remain on track for 100% plus free cash flow conversion of net earnings for the full year.
With that, I'll turn the call back over to Ken.
Kenneth C. Bockhorst
Thanks, Bob. Turning to Slide 5. As Bob mentioned earlier, we've delivered meaningful growth over the past several years, leveraging our expanding portfolio of digital water -- digital smart water solutions to solve our customers' evolving water challenges. While the word meter is a part of the Badger Meter name and remains a prominent element of our offering, the growth that we've had and will continue to deliver goes far beyond the meter.
As the macro challenges of labor shortages, aging infrastructure, water conservation and climate events continue to drive much needed investment into critical water systems, Badger Meter's broad portfolio of customizable solutions, spanning metering, sensors, instruments, communication, software and support offerings is uniquely positioned to serve the evolving needs of our utility and other customers.
The total available market globally is valued at approximately $20 billion, giving Badger Meter ample opportunity to continue to grow and expand these offerings in the U.S. and other select regional markets. It also gives us ample opportunity to add to our portfolio of solutions and other sensors and hardware-enabled software via organic and disciplined M&A investments. We've demonstrated our ability to capitalize on these growth opportunities and we remain well positioned to further build on our track record of value creation.
Looking ahead, we have a constructive outlook for the remainder of the year and see a solid foundation for profitable growth in 2024. As noted in the release, as we close out 2023, we continue to expect solid year-over-year sales growth, taking into account the fewer operating days in the fourth quarter with U.S. holidays.
As supply chain dynamics improved, we've been able to begin improving lead times. These improving dynamics have also aided manufacturing efficiencies, benefiting the gradual margin expansion we've consistently discussed.
One additional item to note, we're monitoring the evolving conflict in the Middle East and its potential impact related to partners in the region. Awards, orders and bid funnel activity remains strong, supported by the well-understood macro drivers facing the water industry. The replacement-driven underlying demand activity as well as our ability to leverage our water-related hardware and communication offerings to accelerate software and data analytics across the water ecosystem position us well for future growth.
With that, operator, please open the line for questions.
Question and Answer Session
Operator
(Operator Instructions) Our first question today comes from Rob Mason from Baird.
Robert W. Mason
It sounded like you made the comment, you were able to work backlog down a little bit, but you characterize as it's still elevated. I'm just curious within that higher backlog, is there any portion of that, that you would think is in the delinquent category or there's an accelerated need to work the backlog down?
Kenneth C. Bockhorst
Yes. So Rob, as we've discussed before, so when we talk about backlog, what we're talking about is what we have [POs] for that customers are interested in getting right now. So in our backlog, we don't talk about the 2-, 3-, 5-year longer-term AMI deployments that we book.
So as we think about backlog, I don't think about it in past due. I just think about this, these are things that customers are looking for us to provide. So as we start to improve lead times and eat into that actionable right in front of us today backlog, that's actually a good thing for customers. And if we continue to improve lead times and eat that down a bit, I would feel happy about that. Overall, we're extremely excited about order rates. So that optimism has not changed on that time.
Robert W. Mason
Understood. Understood. Ken, could you just characterize what the pricing environment looks like now that some of the supply chain headwinds that had been out there and commodity costs as well have settled down. Just give us maybe a framework for what you're seeing, either on list prices or in particular, just how the RFP and bidding process is playing out with respect to pricing?
Kenneth C. Bockhorst
Yes. It's remaining largely unchanged from what we've talked about in the other quarters. While some things are moderating, inflation is still real. There are parts of the economy that still certainly aren't great as we talked about inflation and interest rates and other things that are out there. But for the most part, the work that we did 3 years ago and really embarking on a value creation, value pricing model has certainly paid dividends for us throughout a difficult operating environment, but largely pricing dynamics haven't changed.
Robert W. Mason
If I could just sneak one last one in. This is just a comment on the slide presentation, which is certainly appreciated. I did notice in the slide deck where you referenced ASPs around some of your solutions, broad ASPs, I understand. But just on the manual meter side, around $70 pricing. If I'm not mistaken, that was back in January, that was at a $50 to $60 range. Can you just speak to what the dynamic is pushing that up, whether that's all price? Or does that include some blended mix between mechanical and e-meters or just kind of the underlying movement in that number.
Robert A. Wrocklage
Yes. So I would say, again, I don't know how great we are at keeping those numbers current, but there's probably a bit of price increase that's occurred over multiple time frames between those being updated. I think also, likewise, you've got kind of core meter [bare] meter plus registration being included in that. So I think if that's your specific question, that reflects kind of whatever was in the market at that point in time.
Operator
The next question comes from Nathan Jones from Stifel.
Adam Michael Farley
This is Adam Farley on for Nathan. A quick one on the fewer selling days in 4Q. Should we be expecting a sequential decline in 4Q revenue?
Robert A. Wrocklage
Yes. So we don't give guidance, but I think you're walking away with an obvious takeaway, which is with fewer working days, likelihood that that's a potential. That's, I think, effectively what we're saying.
Adam Michael Farley
All right. Okay. Fair enough. And then shifting gears, could you talk about strategic investments and how we should think about that driving revenue growth?
Kenneth C. Bockhorst
Yes. So I think if you just look at our history in totality, the strategic investments are what have brought us to the point that we're at, whether that was being first in our market with ultrasonic meters or first in our market with cellular radios or bringing the water quality portfolio and developing our own software.
In many cases, it's continuing to invest in keeping and advancing our lead in cellular, keeping or advancing our lead in Software as a Service, our software offering, continuing to integrate water quality and Syrinix into the broader portfolio on cross-selling. So the long answer is yes. The short answer is yes.
I mean we continue to follow our capital allocation priorities of number one, R&D investment and priding ourselves and keeping our innovation leader status, increasing dividends annually in line with earnings and disciplined M&A. So that hasn't changed. That's the same as it back.
Robert A. Wrocklage
I think I just -- I'd [augment] kind of that first capital allocation priority of organic investment in the business. Everyone always thinks of innovation as being R&D, but we equally think of innovation in the space of operational efficiency and capacity expansion. And so we've been investing over the last several years to be able to drive higher capacity and output, which, of course, allows us to then deliver on those higher order rates and higher growth numbers that you're asking about.
So it's equal parts -- I don't know the equal parts, but it's contributory from innovation as well as operational efficiency focus and capital investment to support capacity.
Operator
The next question comes from Andrew Krill from Deutsche Bank.
Andrew Jon Krill
I ask first, sales have been very strong for several quarters in a row. And I think you're on track for strong double-digit growth in 2023, and that's on top of basically double-digit growth on prior 2 years. So I am just wondering, is the kind of historical like mid- to high single-digit growth rate for this industry. Is that -- do you think it's structurally moved higher? Or should we expect to kind of go back towards that range again?
Kenneth C. Bockhorst
Yes. So if you went -- if you rewound a couple of years ago, we used to refer to it as mid-single digit. So we have changed into that high single-digit mode. And as you know, we don't provide guidance in the quarter or the annual basis. Things can tend to be uneven at times, but for the most part, through the strategic cycle, we're really comfortable thinking in the high single-digit range year-over-year.
Robert A. Wrocklage
And so when we say high single digit over the strategic cycle, we're talking 5 or 10-year cycle. So to get a compounded annual growth rate of high single digit, there may be years that are up 15%, 16% and there may be years that are only up 5%. So we're simply talking about that kind of trend line over a CAGR style.
So I do think, again, we don't guide obviously, but I think the ability to sustain double-digit growth even in this market, it's not doable, repeatable every year annually over that strategic cycle.
Andrew Jon Krill
Makes sense. And just next, just on like capital allocation, any update on how you're thinking about your approach there just as your cash balance continues to grow and maybe an update on like the deal pipeline or anything you're looking at?
Kenneth C. Bockhorst
Sure. Yes. So the deal pipeline remains strong. We have -- as we've always maintained over the last several years, a really healthy target-rich environment of companies that are in this water quality space, we'd be certainly interested in building that out more software side, anything that has global footprints in the select regional markets that we're looking at, similar to what [ATi] and Syrinix have brought to us.
So good funnel. We remain disciplined. We think we have a really good idea of where value does get driven within our industry, and that's where we'll continue to look for value creation opportunities in M&A.
Andrew Jon Krill
Okay. Great. And if I could sneak one last quick one. I think last quarter, you noted that book-to-bill was over 1. Can you give an update on that for the third quarter?
Kenneth C. Bockhorst
Well, yes, so as I talked about with that improving lead time situation, we had a really strong order period that we're really proud of. We just had an exceptionally strong shipment period that was slightly better and I do mean slightly.
Operator
(Operator Instructions) The next question comes from Tate Sullivan from Maxim Group.
Tate H. Sullivan
A couple of things, I mean, impressive expense control. I mean your revenue growth exceeded my expectations that expenses were under. Can you just talk about maybe the composition in selling and administration expenses? I mean is R&D at higher levels than historically to enter more water quality -- real water quality markets and any integration expenses? I mean it's just -- I continue to expect you to have more expenses, but it seems like you managed it quite well.
Robert A. Wrocklage
Yes. I certainly won't dissect the $41 million of SEA, but I think the way to think about that, Tate, is exactly what we've been saying for the last 4 years is that SEA leverage because of our -- I'm going to say a term I hate to say, growth algorithm, because of our growth algorithm, we believe, while still being an innovator and doing the things that you talked about, R&D, integrating new businesses that we've acquired, et cetera. We can still do all those great things but grow SEA at a rate slower than sales, and that creates automatic SEA leverage.
I mean we're not more than 3 years removed from a time when we were running at 25%, 26% SEA as a percent of sales. And we just closed the quarter at 22.2%. And I think for the full year, we're in that kind of high 22% range.
So the story of SEA leverage is real improvement over the last 3 years, and we believe to continue that while being steadfast and being invested in organic investment as our capital allocation priority #1. We continue to gain that leverage as a point of operating and EBITDA margin expansion. So there's nothing unique in the third quarter. It's more the continuation of that trend that we've been talking about over the last 3 years.
Tate H. Sullivan
Great. And then the addressable market slide, thank you for including it. I mean -- and I want to understand the meter market part of that, I mean I would -- if it's fair to categorize mostly the replacement market, how much of the $20 billion -- remaining $20 billion market, I mean, I thought maybe you're creating, so to speak, I mean, are you creating some of the real-time water quality markets and the software markets? Are you replacing existing solutions? Can you talk more about the pie chart in there?
Kenneth C. Bockhorst
Yes. What's exciting to us, and I know sometimes the acquisitions that we've done can appear small, but given our brand name, our 118-year history, things we've done in the water market, when we add these companies like ATi, [s::can] and Syrinix, it opens up these much larger markets to us. And as we continue to integrate and develop software, it opens up these other markets to us.
We do tend to enjoy and look for niche opportunities within these spaces. We're not looking to follow some of the giants in some of these spaces that have established markets that are more difficult to get into, we're -- for example, in water quality. (inaudible) is a really strong, great business and there's -- but there's room for several other technologies and everyone to be successful in a wonderfully large growth market.
Operator
(Operator Instructions) As we have no further questions, I'll hand the call back to Karen Bauer for any concluding remarks.
Karen Bauer
Thank you, operator. Thanks, everyone, for joining our call today. For your planning purposes, our year-end call is tentatively scheduled for January 26, 2024. I'll be around all day to take any follow-up questions you have. Have a great day.
Operator
This concludes today's call. Thank you very much for your attendance. You may now disconnect your lines.
