2024-01-12 05:05:58 ET
Summary
- Badger Meter is a favorable investment with strong sales and earnings growth, compounding free cash flow, and exceptional economic characteristics.
- BMI offers differentiated exposure to our strategies and top-down views on utilities via its core products.
- We continue to advocate owning BMI for a long-term horizon, looking at 3-5 years due to starting valuations of 45x earnings.
- Net-net, rate buy, eyeing $193-$195/share price objective.
Investment Briefing
As a value investor, when owning the securities of listed corporations, I want to maximize our return on equity ("ROE") whilst minimizing the price paid relative to net assets ("price to book") and projected earnings ("price to earnings"). That is, maximise value relative to price. Too many investors think in opposition to this - ending on price relative to value instead.
Analysis is more cordial this way in our estimation. Business returns equal investor returns over the long run, and, when compared to the long bond yield, (or long-term market return of ~12%), or some other ERP, help us understand (i) is the compensation fair, and (ii) the market's expectations.
Sometimes, the market offers us investors the chance to buy shares of a company at truly extraordinary prices.
But more often than not, you'll have to pay a fair price to participate in the good fortunes of a firm, or the market in general.
So, pay a fair price we shall, especially when there is opportunity to own truly wonderful companies with exceptional economics that will continue to compound their intrinsic valuation over time. Because the market is a conduit between investors and their companies, we can count on it to transfer changes in earnings and asset growth over to changes in our net worth, thanks to mark-to-market accounting.
The question is where to start looking. Readers of mine will know our research pointed to basic materials, industrials and utilities as critical sectors that could provide asymmetrical investment returns in the coming 12 months, based on the composite of projected earnings growth and S&P 500 index weighting at the end of Q3 2023 (Figure 1, Figure 2).
For example, utilities held 2.4% notional value of the market-weighted S&P 500 index at the end of Q3, with 7.5% of the projected growth, whereas basic materials was 2.2% and 10.3% respectively. Comparing this axis by weighting growth relative to market value, these two sectors offer appealing upside potential for the next 12 months in our estimation, for the time being anyway (Figure 2).
Figure 1.
Figure 2.
Positioning against these sectors doesn't need to be so rudimentary as buying a basket of utilities names, for example. Positioning at multiple points along the value chain, in adjacent industries is an effective way to maintain market beta whilst participating in idiosyncratic industry growth.
Our August publication on Badger Meter ( BMI ) highlights this point exactly. Per the report, (which can be read by clicking here ):
BMI offers flow metering solutions for water management. Various industries are candidates for BMI's customer base, thus broadening the market opportunity. On the regulatory and sustainability level, corporations across the world are shifting focus to water management and efficient use of water. It is now a mainstream commodity, and no longer a simple utility. Being so engrained in our economic function, BMI's industry/market positioning is therefore favourable in my view.
At its core, BMI is an electronics equipment company, but its positioning relative to the adjacent industrials industry is critical to our buy thesis for the coming 1-3 years.
This report will unpack the latest updates for BMI and reiterate our buy rating on the company. We look to $193-$195.00/share as the next price objectives, in line with previous estimates. Net-net, reiterate buy.
Critical investment facts
The arguments for owning BMI over all investment horizons (short to long) are outlined below. Critically, there is support for buying BMI even at its extended multiples in our estimation.
- Investment returns next 12 months
Returns of marketable securities within the first 12 months after asset purchase are heavily dictated by starting multiples. In this vein, there is invariably price risk for BMI stockholders in coming year, as the company sells at 48.5x forward earnings and 27.5x cash flow as I write. I will demonstrate our position on the company over this duration, noting the dislocation in price to value apparent even at these multiples.
- Investment returns 1-3 years
BMI's investment outlook for the next 3 years is heavily dependent on fundamental drivers, scored through sales and earnings growth.
Crucially, consensus has the firm to grow sales 9-24% out to FY'25 on 11-38% earnings growth. These are above the company's 10-year CAGR for both sales and earnings, respectively, and well ahead of the sector's projected revenue and earnings growth for 2024.
This is also a firm compounding free cash flow spun off to shareholders at avg. 22% per year for the last 5 years, and 10% the last 10 years. It is effectively doubling owner earnings every 5-7 years at this rate. Estimates are for another 9-10% growth in FCF/share for '24 as well. This is a result of the company's capital-light model, so there are both profits and cash flows at the end of the year.
Such character was again exhibited by BMI in its Q3 '23 earnings, posted i n October last year. Quarterly sales were up 26% YoY to $186mm, on 31% growth in operating earnings and 44% earnings growth to $0.88/share.
The critical fact is this earnings growth will come with reduced drawdown risk in our opinion, thereby adding critical Sharpe to our strategies.
- Investment returns 3 years+
Long-term investment returns are clearly supported by the company's exceptional economic characteristics. This was discussed at lengths in my last BMI coverage (see: Section 2 - " Capital productivity, returns on capital deployed"). As a reminder of the drivers of value:
- Gross profitability of $0.35-$0.40 per $1 of assets each 12-month period,
- Low capital requirements to maintain competitive advantage and grow,
- Exceptional return on incremental capital, growing earnings 20-55% on average per $1 investment from 2021-2023,
- Critically, the company possesses pricing advantages that allow it to sell its offerings below industry averages, thereby increasing the sales produced per $1 of capital invested in the business.
Point (4) is encouraging to forward investor returns. Given BMI's mature phase and revenue model, predictability of future cash flows is reasonably high, along with capital requirements and business returns. For the last 5 years, each $1 of capital invested in BMI's business has produced $1.05-$1.20 in sales. This equates to revenues of $425mm on $393mm of investment in the 12 months to Q4 2020, to around $668mm on ~$650mm of capital invested into the business as I write.
Moving forward, these are exceptional economics to work off and are set to continue over the coming 3-5 years at least in our estimation.
Catalysts to drive investment returns above
The question is can BMI trade higher from here. I would draw readers to three critical points which evidence BMI's ability to unlock short-term, mid-term and long-term value.
1. Top-down drivers
First, the discussion on the growth value equation in the introduction is highly relevant, especially for utilities. Companies strategically positioned downstream from the utilities sector - as BMI is, with its offerings - offer differentiated exposure to this upside in our firm estimation.
To illustrate, the Vanguard Utilities Index Fund ETF Shares (VPU) has already caught a strong bid in the last 6 months since our original analysis, trading up from 25x pre-tax earnings to 30x within that time (Figure 3). It has also re-rated to the upper bound of 10-year price to book ("P/B") range, as seen in Figure 4.
Figure 3.
Figure 4.
2. Fair compensation for price
Second, critical distinctions must be made for the notion of value received at price. Think of this as "price vs returns", expanded to, "price paid relative to asset factors and earnings power".
Consider a firm selling at a P/B value equal to 1- this means you are paying fair value for the net capital employed in the company (paying $1Bn for $1Bn of equity).
Such a firm produces a return on equity ("ROE") equal to its cost of equity ("COE"). It has created no additional market value for its equity holders beyond the capital which has been employed in the business (i.e.: when P/B = 1; ROE = COE). But all of this of meaningless without the context of growth and returns. Sure, you can have high net asset value measured at accounting value. Is it valuable, though?
This really depends on what rate of earnings + growth the net assets produce, relative to the equity employed. Namely:
- High equity with < rate of return and < growth is not valuable.
- Smaller equity with > ROE and > growth arguably more valuable, and trades at higher multiples.
Ultimately, in the 2nd point, the P/B will likely be >1, because the firm's ROE is greater than the COE, thereby creating shareholder value.
Therefore, a critical distinction must be made for what value is received for the price paid, as mentioned. This is best summarised as:
- What I am paying (EV/IC; P/BOOK, P/E etc.), and what I am getting for that price (ROIC; ROE, growth).
- What growth are these asset factors producing? (Equity; invested capital) Note: we measure (2) via, sales + earnings growth per $1 capital, retained earnings ($1 retained $1 market value) and return on incremental equity.
As far as this price-value axis goes, BMI is tilted to the bullish side of the equation. Observe the following points in Figure 5, and relate them to the above:
- The stock trades at a substantial premium to industry peers - 48.5x earnings, 2.4x adj, growth, and 9x book value.
- Looking at both asset factors and earnings power, these are justified - it is clearly outperforming the industry median across business returns and capital productivity.
These findings demonstrate BMI is producing earnings above the cost of capital and throwing off plenty of cash to shareholders in doing so.
Figure 5.
The critical fact to know for long-term investment returns is that BMI produces a high rate of return on each $1 of capital (equity, debt) invested in the business. When you see earnings routinely produced at a rate of >12-15% relative to capital employed on the balance sheet - all equity mind you, no debt - this raises an eyebrow.
In our view, BMI is creating direct intrinsic value for its shareholders though its ability to generate profit with little capital involvement.
This manifests in four distinct ways:
(1). Return on shareholder equity (up from 14% to 17% in the TTM),
(2). Free cash flow per share (cumulative $21.80/share since '21),
(3). Economic earnings (returns above 12% opportunity cost),
(4). Dividends.
Consequently, we see BMI continuing along these lines into the coming 3 years, backed by our top-down analysis and the company's economics.
Figure 6.
3. Total shareholder return
As mentioned, BMI produces a high percentage of earnings relative to the capital required to conduct its business. It can therefore spin off as much cash to shareholders as possible without jeopardising its competitive advantage. Same goes for growth, provided there are opportunities to do so. In the absence of value-creating growth opportunities, the firm pays its dividend, which must be factored into the total shareholder return.
Mauboussin et al. (2023) illustrate TSR as: TSR = price appreciation + [(1 + price appreciation) × dividend yield]. It assumes all dividends are reinvested at the dividend yield, so it's basically impossible to achieve due to frictional costs.
Point is, BMI is compounding shareholder value in two ways:
(1). By increasing its intrinsic value, reinvesting capital at above-market rates of return to grow earnings and cash flows [capital appreciation],
(2). By paying investment income to its shareholders for the last 30 years, returning the surplus capital produced on its assets [dividends].
From January 2024 to the time of writing, investors realized a TSR of 533%, versus 470% capital appreciation through price return alone.
BMI has clearly demonstrated the propensity to compound shareholder value in this regard, through capital appreciation and dividends. An investor who bought BMI 5 years ago has realized 2% yield on cost with no dividend reinvestment, whilst the stock price has increased by 300% or ~$100 per share at the time of writing. Dividends, meanwhile, have continued to slope higher as well, providing an additional $1.08/share in forward income for shareholders (Figure 7a) off $0.40/share back in 2014/'15.
As a result of these economic factors, one can observe the company's equity line from the mid-80s to date in Figure 8, noting we are above trend in the current market cycle for BMI.
Most critically, we estimate this 'steady state' of value creation to continue for BMI into the coming 3+ years, as mentioned earlier.
Figure 7.
Figure 7a.
Figure 8.
Valuation and conclusion
My estimates of BMI's fair value since the August publication remain largely unchanged. What is pleasing to note is the correlation between BMI's directional movement and our implied intrinsic value model, also noted in last analysis (see: "Valuation-Figure 11" ). The model compounds a firm's intrinsic value at the function of its return on invested capital and reinvestment rates. I am still eyeing $5.5-$6Bn in market value for BMI at the time being, around $193-$195.00 per share, or 62x forward earnings, more than 38% upside potential from the c.45x earnings it currently sells at.
In addition, the company sells at ~40x trailing pre-tax earnings of $110mm as I write, at a $4.4Bn market value (40 x $110mm = $4.4Bn). Critically, BMI invested $19.60/share of shareholder capital in the 12 months to Q3 '23, and grew earnings $7.80/share, otherwise 40% incremental return on investment.
At the same 40x multiple, BMI is now worth $6.1Bn (40 x (110 x 1.4) = $6,160), also around 40% upside potential from the time of writing.
Consequently, I am reiterating BMI a buy for '24, reinstating our price objective of $5.5Bn-$6Bn or $193-$195 per share. Key risks include the following:
- Macro risks currently plaguing commodity markets. These cannot be ignored as the follow-through may shock equities.
- BMI may not hit the numbers forecast in this analysis. Should it not, it could nullify the thesis.
- The company may also incur legislative challenges around energy supply should the government continue to tighten up water markets.
Investors must know these risks in full before proceeding.
Figure 9.
For further details see:
Badger Meter: Continued Return Potential From ROE, FCF/Share, And Dividends