2023-08-22 22:31:53 ET
Summary
- Badger Meter has shown tremendous growth in the past year, with the ability to generate surplus cash and sustain growth rates.
- The company's position in the water management industry is favorable, as there is an increasing focus on water management and efficient use of water.
- BMI's financial performance and capital productivity make it an attractive investment, with strong returns on capital and the ability to generate sustainable earnings growth.
- Net-net, rate buy eyeing $193/share.
Investment Briefing
Those investors seeking long-term cash compounders with attractive economic characteristics will likely be drawn to the equity stock of Badger Meter (NYSE: BMI ). The company has caught a tremendous bud over the past 12 months without any significant external catalysts. Instead, its ability to throw off piles of surplus cash to shareholders, whilst compounding its intrinsic valuation as sustainable growth rates, are chief reasons behind the upside in my opinion.
In business for >118 years, 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.
This report will focus on the moving parts concerning the BMI investment debate and link this back to the company’s critical value drivers. The facts pattern clearly supports a bullish view in my opinion. Net-net, rate buy at $193/share initial price objective.
Figure 1.
Critical investment facts to buy thesis
For reference, the company books revenue on the sale of its products and delivery of services. These are derived from contractual agreements with customers. Said agreements include selling utility water and flow instrumentation products (such as flow meters and radios), quality and pressure sensing equipment, software access, and other ancillary water services.
The BEACON AMA software as a service ("SaaS"), along with training, certain installation, and other revenues, account for the majority of BMI's revenue recognized over time. But the majority of its top-line, recognized at a point in time , is derived from the sale of utility and flow instrumentation products.
1. Q2 Insights
BMI clipped sales of $175.9mm in Q2, up 28% YoY. This notches yet another quarterly sales record for the company. Growth was mixed from pricing and volume (demand), and was underscored by a book-to-bill ratio consistently >1 that's been in situ for the entirety of this YTD. For H1 FY'23, utility water market sales were up 26% to $283mm. This rise in utility water net sales owes itself to amplified turnover across the portfolio—including ultrasonic meters, ORION cellular endpoints, BEACON SaaS sales—and were propped via the firm's value-based pricing strategies.
The divisional breakdown of BMI's Q2 top line is as follows:
- Sales into its global flow instrumentation markets came to $25mm, a 560bps increase YoY. Growth in flow instrumentation sales was 1) driven organically via demand vs. pricing alone, and 2) underlined by robust order demand combined with growth in its underlying industrial markets. Availability of supply components also saw BMI push more inventories out the door in this segment as well.
- Total sales into its utility water product line were up 32% YoY to $150.9mm and were 14% higher sequentially from Q1. Intense order demands, improved supply chain dynamics, and the sustained impact of value-based pricing were the growth contributors, continuing favourable trends observed throughout H1 FY'23 in full. Notably, the surge in shipments was markedly evident in the further adoption of its cellular AMI solutions, ORION Cellular endpoints and BEACON SaaS segment.
The leverage BMI brings to its bottom-line fundamentals is observed in Figure 2. The TTM revenues and post-tax earnings per share are shown on a rolling basis, each quarter from Q4 2020—Q2 2023. Post-tax earnings are depicted as the net operating profit after tax divided by the basic weighted shares outstanding at the end of each period. Two facts are immediately observed:
- You're looking at sequential revenue upsides each quarter, driven by the same unit economics as described earlier. Revenues are up 47% cumulatively since 2020 and clipped $630mm in the TTM last period.
- On this, post-tax earnings per share have enjoyed the same upsides in sequential fashion. BMI has printed another $1/share since 2020, clipping $3.00 compared to $2.00 2.5 years ago. Hence, you're looking at a c.48% growth in revenues pulling to 50% growth in post-tax earnings per share, implying all revenue growth falls to the bottom line.
These are tremendously attractive economic characteristics that align with findings on BMI's capital productivity, discussed later.
Figure 2.
Shifting attention to margins, it pulled the $176mm in turnover to 39.5% gross. The firm also decompressed another 80bps off its quarterly operating margin of 16.8%. Critically, this marks another 100bps in margin loosening since 2020, where it's obtained 16.8% from 15% over the testing period. You'll note the growth in net earnings per share alongside this in Figure 3.
Figure 3.
2. Capital productivity, returns on capital deployed
It is within this portion of the analysis that I derive the most value for BMI and advocate for its inclusion as an investment grade company. Great detail will be spent on the firm's use of surplus capital, and how it is recycling this and profits earned back into creating additional value for shareholders. The following 5 facts explain this in further detail.
- One, treating gross profitability as a function of asset growth is telling. BMI returns ~$0.37—$0.39 in gross for every $1 tied up into its asset base [Figure 4, showing TTM values]. The assets are made up of core assets, including the firm's product lines and major offerings, and non-core assets, including investment in marketable securities and so forth. Acquisitions of business tuck-ins are recorded in the goodwill charge and PP&E additions post-deal. Critically, the growth in asset density hasn't dented its propensity to generate income. Gross earnings power is therefore attractive in this instance, in my view.
Figure 4.
- Two, the firm has low fixed capital and working capital requirements needed to maintain its growth operations. During the quarter, working capital accounted for 23.4% of sales, relatively flat compared to the 23.8% observed last year. This, as sales and post-tax earnings were up 28% and 14% respectively. Figure 5 captures the cash BMI has spun off to its shareholders from Q2 2022—'23, less dividends paid up, but including all cash paid to acquisitions (TTM values). Only changes in fixed capital above the maintenance capital charge are considered as growth investment. The rate of maintenance capital required to support BMI's steady–state operations is estimated to be roughly the depreciation+amortization charge each period. Thus, only changes in fixed assets above the maintenance capital charge are considered. What shows is 1) BMI isn't having to employ large sums of capital into its fixed capital base to grow, and 2) the majority of growth investment is therefore tied to working capital (inventory and the likes). In fact, since Q2 FY'21, whilst NWC density has crept up by ~83%, but for every $1 in sales growth, the firm was able to reduce its growth in fixed assets by ~$0.08.
Figure 5.
- Three, reconciling the capital attributed to BMI's owners (shareholders) to the owner earnings reveals tremendously attractive economic characteristics in my opinion. Around $88mm in post-tax earnings were produced on $522m of capital deployed into the business, 17% trailing return on capital deployed. Of this, $475mm has been provided—all equity financing. BMI has thus put ~110% of capital provided at risk to the business operations.
Figure 6.
- Four, reconciling the $522mm at risk—excluding acquisitions, as shown in Figure 5—in the 12 months to Q2 FY'23, BMI spun off ~$91mm to its shareholders in Q2, including all dividends paid up. Critically, it obtained this and the upsized dividend payout on just $23mm in new capital commitments into the business, otherwise a reinvestment of ~26%. Consequently, c.74% of the post-tax income was available for distribution, and the company still managed to his record revenues and sustained growth in earnings. Hence, you've got a firm that 1) is growing sales/earnings without additional capital requirements, 2) can spin off ~60–90% of its after-tax earnings to shareholders without jeopardizing growth, and 3) continues returning capital to its owners by way of dividends in the process.
Figure 7.
- Five, and perhaps most critically to this analysis, the firm has grown the returns on the capital it has committed to risk in the business. As mentioned, it has deployed ~$522mm, 110% of what's been provided by equity holders. This $522mm generates ~$88mm in earnings after-tax, ~17% return on capital deployed. Excluding the goodwill charge you're looking at 21.5%. Equally as important, these numbers are above the market return on capital—benchmarked as 12% here. As a reminder, a positive spread in a company's ROIC and the opportunity cost of capital is absolutely fundamental as an indicator of value creation. That BMI is growing the profits off its capital base is conducive to the growth in economic earnings, those profits earned above the cost of capital. You can see below these have scaled from $12mm in 2020 to $25.1mm last period, using TTM values. The goodwill charge has penalized the firm's economic profitability by ~$13.7mm. However, as a firm can compound its intrinsic value at the function of its incremental return on capital and the amount it reinvests at these rates, BMI has pushed its intrinsic value in mid-single digits in each period over the testing period (note, the intrinsic value shown is a sequential growth, i.e., from quarter to quarter, and not a YoY sequence).
- As a final point, you can see BMI’s value driver is in the turnover of its invested capital, rather than growth at the margin. It makes perfect sense, because the firm’s capital produces the profits, and it employs a cost leadership strategy as evidenced by the 1.2x turns of capital last period, up from 1.08x in 2020. This means it is pricing its offerings below industry averages. This also speaks to its capital efficiency, where each unit tied up in capital employed into the business (mostly inventories here) is driving additional profits down the line. A full rundown of this data is observed in Appendix 1.
Figure 8.
Market—generated data
Given the recent consolidation in price trend a look at what the market’s saying is required. The daily and weekly cloud charts in Figures 9 through 11 do a great job in doing this (I’ll refer to them as chart 9, 10 and 11 for simplicity). Starting with chart 9, that looks to the coming weeks, both the price and lagging lines are positioned well above the cloud. Two critical observations were made. The first is that, even with the price risk, there’s still scope for a further consolidation, and for BMI to remain on bullish trend. Second, you can see BMI testing the cloud top 4 or 5 times over the run from February to date. Empirically, this serves as good evidence for a potential roll down and bounce from the support level shown.
Figure 9.
Chart 10 is the weekly cloud and looks to the coming months. Here the same observations are made with respect to trend positioning and price risk. The chart shows a move down to $140 by December and still remain on trend, and around $130 by November for the same. To me this supports a bullish view and corroborates the buy thesis.
Figure 10.
Finally, in chart 11, one can observe the weekly money flows into/out of BMI’s equity stock over the last 3 years. Critically, for the bulk of FY’23, flows have remained positive and at magnitude—even with the latest price action. This also adds to the bullish weight of the risk/reward calculus from a sentiment level. For those strong hands long of the stock, adding on the weakness is a potential sign of conviction, and evidences that there’s demand at each weaker price point.
Figure 10.
Valuation
For those managers/investors tied to a benchmark, relative valuations are less attractive on price multiples. The stock sells at 53x forward earnings , and 32x forward EBITDA. But BMI he created more than $9 in net asset value for every $1 in market value. I would argue that you’re buying BMI as a function of its capital productivity. This fits with my core investment tenets, which takes value investing to a more targeted strategy—one that seeks to buy productive companies and sell (or at least hold off buying) unproductive companies, where productivity is measured in returns on capital and profitability. As such, a firm can compound its intrinsic value as a function of the incremental returns on capital employed, and how much it reinvests at these rates. Free cash flow and dividends are also considered in this approach.
Applying this calculus to BMI’s implied equity value you can see the market has been a fairly good judge of fair value over the last 2 years. I’ve got it trading at around fair value as I write, and projecting the calculus 12 months out, gets me to $5.6Bn in implied value, or $193/share, 21% value gap. This supports a bullish view. Further, on my FY’23 post-tax estimates of $95–$98mm, this gets me to ~56x forward P/E, more than justifying where it sells today.
Figure 11.
In short
BMI presents with the kind of economic characteristics that I like to position against within our equity risk budget. In particular, capital efficiency and productivity are the standouts to me. You’re looking at 17–18% returns on capital that’s at risk in the business, producing sustainable earnings growth whilst still spinning off cash to shareholders (dividends included). In that vein, multiples are well supported even with conservative forward estimates. I’m eyeing $193/share into the coming 6-12 months. Net-net, rate buy.
Appendix 1.
For further details see:
Badger Meter: Exceptional Capital Productivity, Compounding Intrinsic Value At Attractive Rates