# BADGER METER INC (BMI) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from BADGER METER INC's 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/9092/000156459022006284/bmi-10k_20211231.htm
Accession: 0001564590-22-006284
Filing date: 2022-02-23
Report date: 2021-12-31
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/BMI/
All MD&A years: /company/BMI/mda/
Next year: /company/BMI/mda/fy2022/ (FY 2022)

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Current Business Trends – COVID-19

In December 2019, a novel coronavirus disease (“COVID-19”) was reported and in January 2020, the World Health Organization (“WHO”) declared it a Public Health Emergency of International Concern. On March 11, 2020, the WHO characterized COVID-19 as a pandemic.

Beginning in the second quarter of 2020, the Company implemented remote work arrangements for non-production personnel, adopted robust safety, social distancing and temperature screening protocols throughout its manufacturing sites and enacted other measures to be able to deliver products to meet customer orders on a timely basis.  While the pandemic has had varying levels of impact to demand trends since its inception, to date it has not materially affected our ability to maintain business operations, including the operation of financial reporting systems, internal control over financial reporting, and disclosure controls and procedures.

Throughout 2021, the Company continued to operate under various return-to-work protocols for non-production personnel and our manufacturing operations continued to follow safety and COVID-19 protocols. The introduction of vaccines in the Company’s primary geographic markets have aided its utility water and flow instrumentation customers in returning to more normal operations. On July 6, 2021, all US based non-production employees returned to the office on a hybrid basis following vaccination rollouts across the United States. Customer order rates have improved; however, global electronics and other component shortages, along with logistics constraints, have resulted in manufacturing interruptions which limited the Company’s output throughout 2021.  These varied and wide-spread component availability and supply chain issues continue to inhibit the Company’s ability to fully satisfy the increase in demand for certain products. In addition, cost inflation of materials and other expenses has become more pervasive.  The Company continues to pursue pricing initiatives to offset inflationary cost pressures where possible.  The Company’s primary competitors are also experiencing lead time extensions, inflation, and pricing dynamics, and therefore the Company 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 in 2021 and are likely to increase the unevenness of sales patterns in 2022.

It remains difficult to estimate the severity and duration of the impact of the COVID-19 pandemic 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, subsequent COVID-19 variants and their severity along with 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.

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 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 acquisitions of s::can and ATi, leading providers of water quality monitoring

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solutions, add real-time water quality parameters to the Company’s capabilities and enhances the scope of actionable data for its 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.  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.

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.    

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 for ATi, net of cash acquired, was $44.0 million. The Company's 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 3 “Acquisitions” in the Notes to Consolidated Financial Statements.

Effective November 2, 2020, the Company acquired 100% of the outstanding stock of s::can headquartered in Vienna, Austria.  s::can specializes in optical water quality sensing solutions that provide real-time measurement of a variety of parameters in water and wastewater utilizing in-line monitoring systems and other applications.

The total purchase consideration for s::can, net of cash acquired, was $30.5 million, inclusive of $1.3 million of working capital adjustments. The Company's allocation of the purchase price at December 31, 2021 included $2.6 million of receivables, $4.3 million of inventory, $1.2 million of other assets, $12.7 million of intangibles and $17.7 million of goodwill that is not deductible for tax purposes. The intangible assets acquired are primarily customer relationships and developed technology with an estimated average useful life of 12 years. The Company also assumed $3.5 million of accounts payable, $3.2 million of deferred tax liabilities and $1.3 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 3 “Acquisitions” in the Notes to Consolidated Financial Statements.

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RESULTS OF OPERATIONS

Net Sales

Net sales in 2021 increased $79.7 million, or 18.7%, to $505.2 million from $425.5 million in 2020.  Sales into the utility water market were $415.3 million, an increase of 20.6% over the prior year’s $344.3 million. The acquisitions of s::can and ATi increased sales $40.7 million compared to 2020. The remaining increase of $39.0 million was attributable to higher sales of the Company’s water meter, radio and software products including ORION Cellular endpoints as well as increased BEACON SaaS revenue associated with data collection and software analytics.  These favorable trends more than offset the supply chain shortages of certain components which limited sales of certain products throughout 2021 and contributed to the record backlog level throughout 2021.  Sales of products into the global flow instrumentation end markets were $89.9 million, 10.7% higher than the prior year’s $81.2 million due to the stabilization of industrial demand globally and across the array of end markets served.

Net sales in 2020 increased $0.9 million, or less than 1%, to $425.5 million from $424.6 million in 2019.  Sales into the utility water market were $344.3 million, an increase of 4% over the prior year’s $330.7 million. The increase was attributable to higher sales of advanced technology products including ORION Cellular endpoints, E-Series Ultrasonic water meters as well as increased BEACON SaaS revenue associated with data collection and software analytics.  It also included approximately $2.5 million of sales related to s::can, acquired on November 2, 2020.  These favorable trends more than offset the short term decline in orders that occurred in April and May 2020 from the stay-at-home orders throughout much of the United States in response to COVID-19.  Sales of products into the global flow instrumentation end markets were $81.2 million, 13.6% lower than the prior year’s $94.0 million due to significantly reduced activity across the array of industrial end markets served and also the result of widespread COVID-19 shelter-in-place and lockdown restrictions.

Operating Earnings

Operating earnings in 2021 were $78.7 million, or 15.6% of sales, compared to $65.2 million, or 15.3% of sales, in 2020.  Gross margin increased $37.2 million, and as a percent of sales increased from 39.5% in 2020 to 40.7% in 2021.  The gross margin improvement was due to higher volumes, improved sales mix as noted above, acquisition mix and strategic pricing actions that offset inflationary cost pressures from material input costs.  Selling, engineering and administration (“SEA”) expenses were $126.8 million or 25.1% of sales compared to $103.1 million or 24.2% of sales in the prior year.  The acquired businesses added $16.9 million of SEA expenses. The remaining $6.8 million increase was primarily due to higher personnel costs including increased headcount and higher incentive compensation and benefits.

Operating earnings in 2020 were $65.2 million, or 15.3% of sales, compared to $62.1 million, or 14.6% of sales, in 2019.  Gross margin increased $4.7 million, and as a percent of sales increased from 38.5% in 2019 to 39.5% in 2020.  The improvement was due to higher volumes and improved sales mix as noted above, along with favorable pricing actions.  These benefits were modestly offset by a net increase in warranty provisions year-over-year, including a $3.5 million cellular network sunset provision recorded in the fourth quarter of 2020.  Selling, engineering and administration (“SEA”) expenses were $103.1 million or 24.2% of sales compared to $101.4 million or 23.9% of sales in the comparable prior year period.  The increase was primarily due to higher personnel, research and development and business optimization investments, as well as the inclusion of s::can.  These increases were partially offset by the net benefit of COVID-19 cost reduction actions and lower pandemic-impacted expenses such as travel and convention costs.

Interest (Income) Expense, Net

Net interest income was less than $0.1 million in 2021, net interest expense was less than $0.1 million in 2020 and was $0.3 million in 2019. Changes in net interest (income) expense over these periods were due to the repayment of borrowings using cash from operations.  

Income Taxes

There were no significant variations in income taxes as a percentage of earnings before income taxes which were 22.6%, 24.1% and 23.4% for 2021, 2020 and 2019, respectively.  

Earnings and Diluted Earnings per Share

For 2021, the increase in operating earnings resulted in net earnings of $60.9 million compared to $49.3 million in 2020.  On a diluted basis, earnings per share were $2.08 in 2021 compared to $1.69 in 2020.

For 2020, the increase in operating earnings and lower interest expense, resulted in net earnings of $49.3 million compared to $47.2 million in 2019.  On a diluted basis, earnings per share were $1.69 in 2020 compared to $1.61 in 2019.  

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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

We use primary working capital (PWC) as a percentage of sales as a key metric for working capital efficiency. We define this metric as the sum of receivables and inventories less payables, divided by annual net sales. The following table shows the components of our PWC (in thousands):

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Overall, PWC increased $15.3 million compared to the previous year-end and includes the PWC acquired in connection with the ATi acquisition.  Receivables at December 31, 2021 were $65.9 million compared to $61.7 million at the end of 2020.  Excluding $3.9 million of ATi receivables, an increase of $0.3 million was due to robust collection efforts while growing sales.  The Company believes its receivables balance is fully collectible.  Inventories at December 31, 2021 were $99.6 million compared to $81.6 million at the end of 2020. Excluding $3.9 million of ATi inventory, inventory increased $14.1 million, due to component cost inflation and higher safety stock levels associated with varied component shortages. Payables at December 31, 2021 were $41.9 million compared to $34.9 million at the end of 2020. Excluding the impact of ATi payables, the remaining increase is attributed to payments timing and the increased inventory levels at year end.

Cash Provided by Operations

Cash provided by operations in 2021 was $87.5 million compared to $89.6 million in 2020.  The decrease from 2020 was driven primarily by increased operating earnings offset by increased working capital requirements as described above.  Operating cash flow was more than adequate to fund acquisitions ($45.3 million, net of cash acquired), capital expenditures of $6.7 million and dividends of $22.2 million.  

Cash provided by operations in 2020 was $89.6 million compared to $80.7 million in 2019.  The increase from 2019 was driven primarily by improved working capital management as well as higher operating earnings.  Operating cash flow was more than adequate to fund the acquisition of s::can ($29.1 million, net of cash acquired), capital expenditures of $9.1 million and dividends of $20.3 million and $3.1 million in share repurchases to partially offset equity compensation dilution.  The remaining cash flow was used to reduce short term borrowings and add to cash balances.

Capital expenditures were $6.7 million, $9.1 million and $7.5 million in fiscal 2021, 2020 and 2019, respectively.  Capital expenditures for fiscal 2022 are expected to be in the $9.0-11.0 million range, but could vary depending on timing of R&D projects, growth opportunities and the amount of assets purchased.

The Company had no short-term borrowings as of the end of 2021 or 2020. At the end of 2021, the Company was in a net cash position of $87.2 million.

The Company’s financial condition remains strong.  On July 8, 2021, the Company entered into a new credit agreement, replacing its prior facility which was set to expire in September 2021. 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 December 31, 2021. 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 $157.1 million of unused credit lines available at December 31, 2021.

CONTRACTUAL OBLIGATIONS

The Company's significant contractual obligations as of December 31, 2021 are discussed in Note 12 “Leases” in the Notes to Consolidated Financial Statements in Part II, Item 8 of this 2021 Annual Report on Form 10-K.  There are no material undisclosed guarantees.  As of December 31, 2021 the Company had no additional material purchase obligations other than those created in the

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ordinary course of business related to inventory and property, plant and equipment, which generally have terms of less than 90 days.  The Company also has long-term obligations related to its postretirement plans which are discussed in detail in Note 7 “Employee Benefit Plans” in the Notes to Consolidated Financial Statements in Part II, Item 8 of this 2021 Annual Report on Form 10-K.  Postretirement medical claims are paid by the Company as they are submitted, and they are anticipated to be $0.3 million in 2022 based on actuarial estimates; however, these amounts can vary significantly from year to year because the Company is self-insured.

APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

We believe the following accounting estimates are the most critical to the understanding of our financial statements as they could have the most significant effect on our reported results and require subjective or complex judgments by management. Accounting principles generally accepted in the United States require us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and revenues and expenses during the periods reported. These estimates are based on our best judgment about current and future conditions, but actual results could differ from those estimates. Refer to Note 1 in the Notes to Consolidated Financial Statements in Part II, Item 8 of this 2021 Annual Report on Form 10-K for information regarding our significant accounting policies.

Acquisition – Analytical Technology, Inc. (“ATi”)

The accounting for a business combination requires the purchase price for the acquisition to be allocated to the identifiable assets of the acquired entity at fair value. Any unallocated portion is recognized as goodwill. We engaged an independent third-party valuation specialist to assist with the fair value calculation of the intangible assets acquired, including trade names, customer relationships and technologies. This required the use of several assumptions and estimates including the projected financial and cash flow results of ATi, customer attrition rate, forecasted cash flows attributable to existing customers and the discount rate for intangible assets. Although we believe the assumptions and estimates made were reasonable and appropriate, these estimates require judgment and are based in part on historical experience and information obtained from management.  More information regarding this business combination is contained in Note 3 in the Consolidated Financial Statements.

Warranty and After-Sale Costs

Our products carry warranties that generally range from one to twenty years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. The introduction of additional technology, such as our ORION cellular radios, electronic meters and registration, have generally caused our annual warranty claims rates to increase over time.  While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. At December 31, 2021 and 2020, our reserve for product warranties was $12.9 million and $11.6 million, respectively.

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, 2020 and 2019 were not material.

See the “Special Note Regarding Forward Looking Statements” at the front of this Annual Report on Form 10-K and Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K for the year ended December 31, 2021 for a discussion of risks and uncertainties that could impact the Company's financial performance and results of operations.

MARKET RISKS

In the ordinary course of business, the Company is exposed to various market risks.  The Company operates in an environment where competition varies from moderate to strong.  The Company believes it currently provides the leading technology in water meters and radio systems for water utilities.  A number of the Company's competitors in certain markets have greater financial resources.  Competitors also include alliance partners that sell products that do or may compete with our products.  As the global water metering market begins to shift to adopt static metering technology, the number of competitors may increase.  We believe new static metering market entrants lack brand recognition and product breadth and do not have the appropriate utility sales channels to meaningfully compete in the North American market.  In addition, the market's level of acceptance of the Company's newer product offerings, including the BEACON AMA system, may have a significant effect on the Company's results of operations.  As a result of significant research and development activities, the Company enjoys favorable patent positions for several of its products.

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The Company's ability to generate operating income and to increase profitability depends somewhat on the general conditions of the United States and foreign economies, including to some extent such things as the length and severity of global economic downturns; the timing and size of governmental programs such as annual federal funding and periodic stimulus fund programs, as well as the impact of government budget cuts or partial shutdowns of governmental operations; international or civil conflicts that affect international trade; the ability of municipal water utility customers to authorize and finance purchases of the Company's products; the Company's ability to obtain financing; housing starts in the United States; and overall industrial activity.  In addition, changes in governmental laws and regulations, particularly laws dealing with the content or handling of materials, customs or trade practices, may impact the results of operations.  These factors are largely beyond the Company's control and depend on the economic condition and regulatory environment of the geographic region of the Company's operations.

The Company relies on single suppliers for certain castings and components in several of its product lines.  Although alternate sources of supply exist for these items, the loss of certain suppliers could temporarily disrupt operations in the short term.  The Company attempts to mitigate these risks by working closely with key suppliers, purchasing minimal amounts from alternative suppliers and by purchasing business interruption insurance where appropriate.

Raw materials used in the manufacture of the Company's products include purchased castings made of metal or alloys (such as brass, which uses copper as its main component, aluminum, stainless steel and cast iron), plastic resins, glass, microprocessors and other electronic subassemblies, and components.  The Company does not hold significant amounts of precious metals.  The price and availability of raw materials is influenced by economic and industry conditions, including supply and demand factors that are difficult to anticipate and cannot be controlled by the Company.  Commodity risk is managed by keeping abreast of economic conditions and locking in purchase prices for quantities that correspond to the Company's forecasted usage.

The Company's foreign currency risk relates to the sales of products to foreign customers and purchases of material from foreign vendors.  The Company uses lines of credit with U.S. and European banks to offset currency exposure related to European receivables and other monetary assets.  The Company believes the effect of a change in foreign currency rates will not have a material adverse effect on the Company's financial position or results of operations, either from a cash flow perspective or on the financial statements as a whole.

The Company typically does not hold or issue derivative instruments and has a policy specifically prohibiting the use of such instruments for trading purposes.