2023-10-23 22:07:09 ET
Summary
- Robust water utility capex spending and improved component availability are fueling strong growth for Badger Meter in its smart metering business.
- The company's revenue grew 26% in the third quarter, driven by the municipal water business and strong sales of smart meters, cellular AMI network equipment, and software.
- I have concerns that PFAS monitoring, detection, and remediation capex spending will take some of the steam out of Badger's growth engine in the coming years.
- I believe advanced metering, edge monitoring, and software can support strong growth for a decade or more (high single-digit revenue/double-digit FCF growth), but the valuation already accounts for this.
Helped in no small part by federal funds directed towards water quality and reliability infrastructure, not to mention improved product availability now that chip shortages are largely in the past, water utilities are spending again and Badger Meter ( BMI ) is generating strong growth with its portfolio of smart meters, monitoring instruments, and software. Badger Meter shares are up over 40% since my last update , not only outperforming the broader industrial sector, but also outperforming peers/comps like Mueller ( MWA ) and Xylem ( XYL ) meaningfully over that time.
Badger’s business has definitely accelerated lately; 2022 results were basically as I expected, but 2023 has been quite a bit better and the shares have rerated substantially higher as well. There’s a lot to like here, including a long runway for revenue growth, already-good margins and returns (ROIC, et al), and technology that solves a lot of problems for its customers.
The question, as it so often is with growth companies/stocks is what constitutes a fair price. Badger’s shares already trade at almost 40x sell-side EPS estimates for 2024 and over 24x my 2024 EBITDA estimate. I know some readers will say that valuation doesn’t matter and the company’s growth will allow it to validate even higher multiples; if you’re comfortable with that approach, this may work for you, but water infrastructure stocks have shown in the past that multiples that shoot up can also come back down and utility spending may not be as durable as bulls hope.
Another Strong Quarter
It’s tough to fault the growth that Badger Meter has delivered so far this year. After revenue grew 12% in FY’22 (beating my expectations by 1%), the business has accelerated to a 25% year-over-year run-rate and third quarter earnings once again exceeded sell-side expectations.
Revenue rose 26% in the third quarter, beating expectations by around 4%. Gross margin improved modestly (up 20bp to 39.1%), but that was enough to drive 26% year-over-year EBITDA growth and 31% operating income growth, with operating margin improving 80bp to 16.9%, with an incremental margin in the mid-teens.
Growth was driven overwhelmingly by the municipal water business, with revenue up 31% on broad strength across smart meters, cellular AMI network equipment, and software (Beacon SaaS in particular). Flow instrumentation sales were up 2%, and management didn’t comment much on the discrepancy other than referring to past decisions to de-emphasize certain general industrial markets.
A Healthy Environment, But A Lot Of Mouths To Feed
Badger Meter is definitely benefiting from a more cooperative utility capex environment. Between backlogs generated when chip shortages prevented orders from shipping in a timely fashion, IRA-supported projects in drinking water capex, and other utility projects, spending has definitely picked up.
Looking at a host of publicly-traded water utilities, including American Water Works (AWK), American States Water (AWR), California Water Service (CWT), Essential Utilities (WTRG), and SJW Group (SWJ), capex spending has increased around 14% to 30% on a 1H’23/1H’22 basis. This is a rough measuring tool, but it does corroborate with the upturn Badger Meter has seen in recent quarters, and utilities by and large sound relatively bullish on the opportunity to get the rate support and project funding they need to move forward with infrastructure improvements.
Smart metering is nothing new, but it does still provide incremental opportunities for cost savings (through networking technologies and software). Likewise, ultrasonic metering offers utilities more tools to monitor water systems and detect potentially problematic leaks. As water waste (through leaks) is a major cost center for many utilities and a particular issue in areas where water availability is more limited, I expect ongoing interest in products that facilitate advanced leak detection.
Likewise, I still see ongoing opportunities in Badger Meter’s water quality monitoring businesses (ATi and s::can). Reagent-less sensors are a significant process improvement opportunity for water systems, as well as edge IoT systems (sensors, communications, and software) that actively monitor and report back to the utilities with much less active human labor involved.
One question I do have, though, is whether the upcoming surge in PFAS-related spending will shift budgets away from Badger’s core areas of strength. As far as I can tell, Badger’s monitoring technologies aren’t suited to PFAS (I can’t find any explicit mention of it, while I do find mention of chlorine, pH, and turbidity, and so I do have some concerns that spending on PFAS detection/monitoring and remediation may supersede metering, leak detection, and the like in a couple of years as PFAS spending really ramps.
The Outlook
To be clear, I don’t think PFAS spending, even if largely bypasses Badger Meter, is a major threat to the company. I still expect long-term revenue growth in the high single-digits on the back of ongoing spending on software, sensors, metering, and leak detection, and I’d argue the water utility industry is still “under-software’d” compared to many others. I’d likewise note that companies like Emerson ( EMR ) see at least some of the same opportunities, as this company has invested in further capabilities in areas like edge monitoring/reporting and software for the water utility industry.
As I said, I expect high single-digit revenue growth from Badger Meter after a sharp slowdown from 2023 to 2024 as backlog gets shipped out. On the margin side, I do expect ongoing uplift from mix shift toward more sophisticated meters, as well as more sensors and software content. With that, I expect mid-teens free cash flow margins over the next five years and high-teens margins over the longer term, supporting low double-digit annualized FCF growth.
Valuation is where things get challenging. As I said in the open, the cash flow I expect from Badger Meter, as well as the EBITDA and earnings per share, make it difficult to come up with a compelling fair value for the stock. Perhaps the company can continue double-digit growth for longer than I expect, but I’m concerned that this has become a revenue growth momentum story and when revenue growth normalizes, the music will stop.
The Bottom Line
Growth investors won’t care about that, and if you think there’s a case for persistent double-digit revenue growth (and/or that multiples/valuation just don’t matter), then have it. For me, this is a quality company serving a real (and growing) market opportunity that just trades beyond a price I can justify to myself. You may as well call that the “GARP Investor Blues”, but I’ve seen sharp deratings in other water equipment companies in the past and I’m not eager to court that risk with my own money.
For further details see:
Badger Meter: Thriving On Backlog Delivery And Healthy Capex Budgets, But Overvalued