Description

Investment Thesis – Badger Meter common stock is a short because:

■ Badger Meter is a “growth” company that has never actually grown and there is no reason to think it will grow in the furture. All growth is from acquisitions and the exit of a competitor in 2013. Aside from this growth is close to zero

■ BMI is an average-quality business - 13-year average ROIC is 11.7%

■ Despite being an average-quality business that is not growing, BMI trades at 58x 10 year average cash flow. Even if you use the highest cash flow BMI ever had, the stock still trades at 36x

■Fair value is 75% below the current price. Even if you assume BMI is able to grow profitably in the future (and there is no reason to expect this), the stock is still highly over-valued

This is a bit of a “valuation short” insomuch as there is nothing really wrong with the business, mgmt. etc. As such I don’t expect it to be a particularly popular idea. That said, the narrative management sells (and most seem to believe) is so far off base,  the valuation is so egregious and the risk of being really wrong is so small that I think its actually a pretty good short now.

Business Overview

Badger Meter manufactures products that measure and control the flow of various substances. Sales of water meters to U.S. utilities account for 71% of revenues. This is a competitive business selling a commoditized product into a market that is not growing (92% of sales are just replacing old meters). BMI is the second largest company in this market with 26% market share. The remaining 29% of company sales are from many products and end-uses. Outside of U.S. water utilities BMI’s market share of global flow instruments is only about 1%.

Badger Meter is an Average Quality Business

Badger sells a commoditized product in a competitive market. As far as I can tell, the company makes high-quality products but they are also slightly-more expensive than competitors. Management claims they have a technological advantage in radio meters, but I’m not sure this is really the case. Badger is one of five competitors in this market and market share is fairly stable. As such, it should not be surprising that this is a fairly average-quality business with long-term average ROIC at 11.7%.

Figure 1: BMI Long-Term ROIC

BMI’s End Market is Not Growing

Using data provided by the company we can see that the end market in BMI’s largest segment is not growing (even management doesn’t really dispute this point). This makes sense when we consider that 92% of sales are from replacing old meters. Meters generally last about 20 years before they need replacement.

Figure 2: Water Meter Market is Not Growing

Organic Growth is Essentially Zero

BMI is considered a “growth stock” yet somehow operating profit is the same as it was in 2008. Every year analysts forecast profit growth that never occurs – yet the stock seems to keep going up.

Figure 3: EBIT Growth is Zero

Management portrays Badger as a secularly growing company benefiting from the conversion of homes without water meters and the shift from traditional meters (which require manual reading) to radio meters (which can be read remotely). While there is some truth to this, if you actually look at the numbers organic top-line growth excluding acquisitions and the exit of a competitor is very small. Since 2009 BMI’s revenue has grown $127.4mm and the company has spent $117mm on 8 acquisitions.  For 4 of these the company provided the revenue contribution from the acquired company. Given that we do not have the revenue from the other 4 acquisitions its likely acquisitions contributed even more than shown In 2013, BMI’s competitor Elster was acquired and chose to exit the utility meter business. Due to an agreement Badger had with Elster to service customers after Elster’s exit, BMI was able to capture a significant amount of Elster’s business. Taken together, the acquisitions and the Elster exit account from almost all revenue growth over the last 6 years. As such, it seems reasonable to think that the only way BMI will grow in the future is via acquisitions.

Figure 4: Organic Growth is Very Slow

Acquisition Strategy is Flawed

About 40% of sales in the water business are via third party distributors. This is pretty common for industrial companies like this and in general OEMs are pretty happy with these types of relationships. Recently, BMI has started to acquire these distributors paying $21mm for National Meter and Automation in August 2014 and $3.3mm for United Utilities this past August. Badger justifies the strategy by touting the benefits of ‘being able to control the sales process’ because their products are increasingly complex and thus the sales cycle is more nuanced. As far as I can tell this is total BS. These products are not really that complex and industrial distributors in many other industries routinely handle much more difficult products / sales cycles. What really seems to be happing is that management needs to justify making some type of acquisitions so that BMI can keep growing.

Stock is Expensive Even if you Use the Best Year Badger ever Had

As shown below, despite being an average quality business that is not growing Badger trades at 57x 10-year average FCF! Even if you use the best year the company ever had (2009) the stock is still expensive at 36x.

Figure 5: BMI is Highly Over-Valued

Fair Value is Over 75% Below the Current Price

BMI’s average cash flow over the last 10 years is $17.2mm. If we round this up to $20mm and use a 9% cost of capital, this produces a fair value for the equity of $222mm or $76% below the current price.  We’ve also assumed that the value of growth is $0. This is a fair assumption considering that: A) there has been no growth and there is no reason to expect there will be, and B) even the company does grow, BMI’s return on capital is about equal to its cost of capital implying growth is value-neutral.

Figure 6: Fair Value is Over 75% Below the Current Price

BMI is Over-Valued Even in a “Best Case”

Lets assume that I’m totally wrong and that for unforeseen reasons the company’s end markets start to grow and BMI is able to gain share. Further, we assume this growth is higher quality than the current business and incremental EBIT margin is 30% (vs. 12 yr average of 23%) and lasts for the next 12 years. Even if this unreasonably bullish scenario, BMI is about 30% over-valued.

Figure 7: BMI is Over-Valued Even in a “Best Case”

Key Risk – I’ve thought a lot about how you can get hurt being short this and the best I can come up with is a possible acquisition. BMI is often mentioned as an acquisition target. This is likely because the company is small relative to other metering / industrial products companies. Even so, BMI has been public company since the mid-1980’s and has yet to be acquired. While an acquisition is a risk for any short, it is unlikely in this case given that BMI trades at a substantial premium to  both similar public companies and prior industry acquisitions despite being a lower-quality, slower-growing business

Catalyst

Never being able to come close to justifying current valuation