Badger Meter In The Right Water Markets, Steep Stock Valuation (NYSE:BMI)

For some time now, my refrain on water-leveraged industrials has been iterations of “yes, this is a good sector to be in long term, but the valuation more than reflects that”, and the sector has definitely pulled back and derated recently. Badger Meter (NYSE:BMI) has been caught up in that, with the shares underperforming since my last update; underperforming the broader industrial space by about 15%, as well as other water plays like Mueller (MWA) and Franklin (FELE), though outperforming Xylem (XYL).

As I’ve said in other articles, I don’t believe that all water exposure is equal, and I think Badger is in some of the best places to be, including water quality and loss mitigation. Even so, I can’t make the valuation work at this level and it’s hard to recommend this name over some other companies in the water space with more reasonable valuations.

Water Quality Is A Significant Growth Opportunity

Management has been using M&A to build its water quality business, and I like the prospects for this business. It was about 9% of total sales in FY’21, growing at an organic rate of 9% and generating mid-teens margins. I think there’s a lot more potential here.

First, I really like the leverage here to remote reagent-less sensors and edge IoT functionality. Unlike the water quality testing offered by companies like Danaher (DHR), which is usually lab-based testing of periodic samples, Badger can offer real-time monitoring of multiple parameters, letting utilities more quickly detect and respond to any water quality issues. Given the focus in the infrastructure bill on drinking water quality assurance, I think a lot of utilities might start taking a serious look at this technology.

Second, I like the applicability of this technology outside of utility water. The technology used to monitor the contents and quality of water intended for drinking can also be used to monitor the contents of industrial discharge water, helping companies comply with increasingly rigorous environmental standards. As this technology/capability becomes better known, I think it’s at least plausible that more companies could be required to implement it as a means of ensuring compliance with various national and state regulations.

Water Supply / Loss Mitigation Also A Meaningful Opportunity

The core of Badger’s business is its municipal water meter operations. This is primarily a replacement market today (around 80% of sales), but that doesn’t mean that it doesn’t offer growth potential – with that potential tied to operational efficiency and increasingly on loss mitigation.

Badger introduced the first ultrasonic meters some time ago, and with the enhanced accuracy of these meters, it’s easier to monitor unusual activity that may be indicative of leaks. That potential grows when coupled with smart communication capabilities and analytical software. While there’s a labor-saving angle to meters with communication capabilities (they can “radio in” usage information instead of requiring workers driving around in trucks), as part of an integrated, real-time network with smart capabilities layered on the top (the analytics), they can more easily spot leaks or other system problems. As undetected/unrepaired leaks are a significant source of loss to water utilities, I believe this too is a growth opportunity for Badger over time.

The Outlook

The biggest issue with all of the above is that it’s already reflected in the share price. The positive qualities of Badger are already pretty well-known. It’s the largest player in water metering in the U.S., with the top three companies (including Xylem’s Sensus and Roper’s (ROP) Neptune businesses) holding around 85% share. It also produces healthy margins and strong ROICs, and the capital intensity (capex/revenue) is quite low at just over 2%.

I do believe there are opportunities for Badger to exceed expectations on revenue. While the U.S. water metering market is predominantly a replacement market, those replacement sales can come with ASPs that are double what the old units carried. As more utilities look to reduce loss from leakage, the argument for more sophisticated metering and analytics could become stronger (if you have to replace your meters, why not add leak detection capabilities?) and drive higher-value and higher-margin sales, not to mention recurring revenue from the software/analytics side.

Likewise with water quality monitoring. I think the arguments for continuous real-time remote monitoring are compelling, even if utilities will still need/want to corroborate those readings with lab-based periodic testing. If the industrial water monitoring side takes off, that’s even more upside, and it could be particularly attractive given the edge IoT/analytics element to it.

I’ve boosted my long-term revenue growth outlook to over 7% over the next 10 years, and while my FY’23 estimate is already above the Street-high estimate, I expect acceleration beyond that as spending related to the infrastructure bill kicks in. I’d also note that that 7% growth rate is about two points higher than the trailing growth rate.

I do expect some supply chain pressures on Badger’s margins in the near term, but I think EBITDA margins should accelerate in 2023 and beyond, particularly if and when sales of higher-value meters, remote monitoring, and software/analytics accelerate. Long term, I believe Badger’s FCF margins can move from a historical average in the low double-digits to close to 20%, driving nearly double-digit annualized growth.

The Bottom Line

The “but” is that all of that is in the share price today. I only get a mid-single-digit expected total long-term annualized return with those assumptions, and even 10% revenue growth would only get me to where the shares are today. Margin/return-based EV/EBITDA is likewise no help, even factoring in Badger’s above-average growth potential, margins, capital intensity, ROIC, and so on.

In fact, even if I treat Badger as one of the elite “compounders” (a group that includes companies like AMETEK (AME), IDEX (IEX), Rockwell (ROK), and Roper (ROP)) and use a low-20s forward multiple (which is actually above where this subgroup trades now), that only gets me into the $80s.

So, I’m left where I’ve been in the past with Badger – I like the story and I like the company’s leverage to attractive opportunities within the larger water market, but the valuation wouldn’t seem to leave much upside, even considering the possibility of better growth.