imaginima
From time to time I like to address investment philosophies that are repeated virtually to the point of cliché, and that brings me to Itron (NASDAQ:ITRI) and “buy the dip”. As I’ve said in the past, while buying the dips in good companies with strong long-term prospects can generate excellent returns, it can be tough to discern what’s really a dip (a temporary recoverable issue) and what’s the first stumble down a longer staircase.
Itron shares have gotten hammered since my last update, falling over 40% as the company has seen significant hits to the business from supply chain issues and demand disruptions. At the same time, though, the Device Solutions has structural issues that won’t vanish quickly and there are large players in the company’s more attractive markets to challenge their share/revenue growth in the coming years.
I’ve cut back my modeling assumptions substantially since my last update, and as much as I’m concerned that I’m getting pulled into a bull trap, long-term core revenue and FCF growth of 3% and 10% from the 2019 peak can still support an attractive return from here.
Still Leveraged To Grid Modernization
The main long-term drivers for Itron are still largely in place – namely that utilities need to strengthen, modernize, and automate their grids to meet the needs and challenges of an evolving energy generation and distribution world. Itron can address many of these challenges, but the question still remains as to whether utility clients will opt for Itron’s automation, IoT/smart device, and management solutions.
The recently-passed Inflation Reduction Act will likely have only a modest positive impact on Itron’s near-term fortunes. Incentives for increased clean energy generation and energy storage will help some, but I’d say that Itron’s exposure here is more derivative than direct.
Still, the underlying drivers are legitimate. Adding renewables to grids complicates the management of those grids and significantly strengthens the argument for automation, as does integration with distributed generation. Likewise, the growing electrification of many industries that once relied on fossil fuels, the future growth of applications like EV charging, and further climate volatility will increase the importance of demand response capabilities.
Weak Current Results, But With A Few Brighter Spots
Itron’s earnings reports over the past four quarters have been varying shades of awful, with the company hit hard by component shortages as well as deferred orders as customers try to navigate this more challenging period.
Revenue in the second quarter declined 12% as reported and 8% in constant currency, continuing a weak trend that saw Q1’22 revenue down 9%, Q4’21 revenue down 8%, and Q3’21 revenue down 10%. With these declines, Itron’s revenue has fallen from a peak of $2.5B for the full year of 2019 to $1.7B on an annualized Q2’22 basis.
Second quarter revenue missed expectations by 11% even after multiple downward revisions in sell-side estimates. Device Solutions led the decline with a 36% reported revenue decline (27% in constant currency), missing by 27%, while Networked Solutions rose 2% (missing by 6%) and Outcomes declined 6% as reported and 3% in constant currency (missing by 9%).
Gross margin declined 140bp year-over-year to 29.2%, with Device Solutions down 550bp to 13.2%, Networked Solutions down 280bp to 33.4%, and Outcomes actually up 50bp to 38.7%. EBITDA fell 51% and missed by 24%, while adjusted operating earnings fell 66% and missed by 40%. By segment, Device Solutions profits were down 73% (margin down 710bp to 5.2%), Networked Solutions profits were down 4% (margin down 130bp to 23.1%) and Outcomes profits were down 27% (with margin down 460bp to 15.8%).
Clearly there are ongoing issues at Itron’s Device Solutions business (which focuses largely on legacy metering products), and management has acknowledged as much. The company has sold the C&I gas business and is looking to further prune the portfolio in an attempt to minimize the damage from a business that is in secular decline in most of its markets. Frankly, it’s a business that I think the company might be better served by either closing down or selling, provided that a wind-down wouldn’t damage existing customer relationships that extend into the more promising Networked Solutions and Outcomes business.
Considering the Networked Solutions business, revenue has fallen by about 25% since Q2’19, with operating margins down 440bp. Outcomes has seen revenue down 5% with operating margin down 760bp. That’s disappointing in the context of what should be growth markets, but I do think component availability has had a significant impact here, as semiconductor shortages have hit the company hard.
Orders grew 47% qoq in the second quarter, with a book-to-bill of 1.4x, and the backlog has grown 17% yoy (and 5% qoq) to $4.1B, or more than two years’ revenue, while the 12-month backlog has grown 21% yoy and 6% qoq to $1.7B.
The Outlook
Management’s commentary on the second quarter sounded to me as though they believe conditions have bottomed, and I believe that’s likely true. While I think Device Solutions is a low-prospect business now, margins should still improve as supply chain pressures ease. As component availability improves, Networked Solutions should recover more significantly, and improved incentives for utilities should help the Outcomes business.
Again, the main drivers here tie back to further capacity increases in renewable energy sources (which contribute to grid complexity), enhancements to grid resiliency (including demand response) and security, and further automation. Only about one-third of utilities use advanced distribution management software today, and I think it’s a “when, not if” question for the remainder adopting these platforms.
After three straight years of year-over-year revenue declines, I expect Itron to rebound with low double-digit (12.5%) revenue growth in FY’23 and 10% growth in FY’24. Relative to the 2019 peak, I expect long-term growth from Itron through 2031 of 3% to 4%.
I’ve cut back my margin assumptions due to the declines in the Device Solutions business and slower/weaker ramps in the other businesses. I still expect double-digit FCF margins over time, with the company hitting 8% in FY’26, and I’m looking for about 10% annualized growth from 2019 to 2031.
The Bottom Line
With growth and theme investors bailing out of Itron, discounted cash flow and margin/return-driven EV/EBTIDA are more useful now than in the past. On a discounted cash flow model (with a double-digit discount rate to reflect increased execution risk), I see low double-digit total annualized return potential, while an 11.25x multiple on my FY’24 EBITDA estimate ($300M) discounted back gives me a $60 fair value.
I can understand why some investors want nothing more to do with Itron. It clearly got overhyped as a play on the utility modernization trend, and recent results have not been good. That said, I still think the company is legitimate play on automation demand growth in the utility/distribution sector and the growing need to make grids more flexible and more resilient. As a beaten-up former growth darling, I think it’s worth a look today.
Be the first to comment