Description

Badger Meter, Inc. (BMI)

Overview

• Highly valued industrial company faces potential sea change in competitive environment; appears that new competitive threat may already be showing up in reported numbers; shares face meaningful revaluation to extent growth trajectory reorients downward

Business

• Company designs, manufactures, and sells water meters, valves, and related technologies to municipal water utilities and industrial users
• Sales breakdown
  • ~75% to municipal water system; primarily meters
  • ~25% to industrial customers
• Meters business
  • Estimated 20% market share in U.S.
  • 85% of units are mechanical, 15% are solid state
  • 70% of meter revenue comes from mechanical units, with 30% attributable to solid state
• Geographic split
  • ~85% (revs) U.S.
  • Balance is well diversified across >5 countries/regions

Thesis

• BMI has historically enjoyed a strong position in sale of mechanical water meters to US utilities
  • Standards for US water meters are set by the American Water Works Association (AWWA); for the last couple of decades, in part due to heavy lobbying from incumbents (including BMI), the AWWA has stuck to a required mechanical standard
  • The mechanical standard has been sustained despite ample evidence that mechanical meters are less accurate, and less reliable, than competing ultrasonic (i.e. electronic) meters over the life of the meter
    • Mechanical meters are incapable of reading very low flow volumes (less than ~1/4 gallon/min); ultrasonic meters can typically read down to 1/8 gallon/min; this means that utilities can capture higher levels of customer revenue on low flow homes (for instance, those with slow leaks) using ultrasonic technology
    • Mechanical meters lose accuracy over time as the physical components wear
    • Mechanical meters lose accuracy as fluid flow becomes restricted due to buildup inside the pipe; ultrasonic meters do not suffer from this shortcoming
    • Mechanical meters are more subject to failure in locations where the water includes suspended solids (i.e. sand, sediment, minerals)
  • In late 2018, the AWWA finally reworked its standards, and has now approved the use of ultrasonic meters
  • Cozy oligopoly of US mechanical meter manufacturers (BMI, Xylem/Sensus, Roper/Neptune, Mueller/Hersey) controls 90% of domestic market; is now subject to potentially material new competition from foreign manufacturers of ultrasonic meters; many foreign locales have allowed ultrasonic meters for years so the foreign manufacturers have extensive development and manufacturing experience
  • For larger pipes (2” → 6”) not subject to AWWA residential standards; 80% of current sales volume is ultrasonic vs. mechanical; this share shift is a potential precursor of what may happen in the residential market now that ultrasonic has been approved
• Water meter market is largely a replacement market as older meters are replaced due to age; as such, the pie is not expanding rapidly and competitors must drive growth primarily through market share gains; market share shifts do NOT favor BMI
• BMI is poorly positioned among domestic legacy competitors
  • Only 15% of BMI current sales volume is ultrasonic (85% mechanical)
  • Compare this to domestic competitor Xylem/Sensus, which saw the writing on the wall and pivoted aggressively to ultrasonic much earlier; Xylem is reportedly already running at 65% ultrasonic volume
  • BMI (along w/Mueller) has historically targeted the low (price conscious) end of the market; its current AMI infrastructure (“Beacon”) piggybacks on the Verizon wireless network
    • The Beacon value proposition is theoretically attractive to price conscious customers, as it does not require installation of wireless sensor infrastructure to receive signals from meters
    • However, monthly charges to Verizon have negated much/most of this advantage
    • Customer feedback has been poor to-date
• Potential new competitors have already begun making aggressive moves in the US market
  • Itron
    • Itron is a US-based diversified manufacturer of metering equipment and technology
    • #1 in the US in gas/electric metering, so have experience (and necessary relationships) selling to U.S. utilities
    • Have been selling water meters into European markets for several years now
    • Has not historically sold a standalone water metering solution in the US; however, has provided components to other meter manufacturers
    • Have been major supplier of connectivity solutions for BMI meters (anecdotal estimate of 60% share on BMI connected meters); BMI has been an Itron reseller for years; Itron potentially has important insight into BMI details (customer data, reliability, etc.)
    • Anecdotal evidence that Itron is specifically targeting BMI customers for displacement
    • Itron is known as the low-cost competitor; this will put BMI squarely into Itron’s sites
    • Itron has reportedly already displaced BMI with Philadelphia Water, and has impending BMI displacements in NM and TX
  • Kamstrup (European meter manufacturer); privately held
    • Opened first US meter manufacturing facility in early 2018 (Atlanta)
    • Have hired numerous BMI personnel, including former head of sales and multiple former BMI sales reps
  • Diehl; European; have recently been marketing in the US at trade shows
• BMI drastically underperformed competitors in the most recent quarter (2Q); possibly a precursor of things to come
  • BMI municipal water sales down ~10% Y2Y
    • Explained shortfall as result of “innovation delay” as customers await roll-out of next generation of wireless technology
  • 2Q shortfall vs. consensus: 12% revenue shortfall, 13% EPS shortfall
  • However, all public competitors posted Y2Y gains in their meter businesses
    • Xylem/Sensus: meter business posted “solid double digit” growth that was “almost 20%”
      • Notwithstanding the impressive growth, management called out “competitive replacement market dynamics”
    • Roper/Neptune: 2Q was a “record quarter” with “systematic market share gains”
    • Mueller/Hersey: metrology business grew in 2Q
• Upfront cost advantage of mechanical meters is likely to be whittled away/negated
  • Ultrasonic meters currently sell for a 30-40% premium upfront versus mechanical meters, they also likely have a shorter effective life due to need for battery replacement after 10+ years (although this has not yet been tested given relative newness of the ultrasonic market)
  • Despite this higher upfront cost (and shorter lifespan), total cost of ownership is reportedly materially lower over the life of the meter due to improved revenue generation and higher accuracy
  • This upfront cost advantage has left a natural constituency for mechanical meters in the near-term; i.e. smaller utilities that are unwilling to foot the bill for a higher upfront cost versus lower cost of ownership over the life of the meter
  • The upfront premium is likely to narrow materially going forward as the ultrasonic cost curve gets forced down and unit sales increase; there are virtually no electronic devices whose prices increase over time (functionality held constant)
  • Mechanical meters cost advantage is also being negated (particularly for larger installations) by growing presence of performance monitoring companies like Siemens and Johnson Controls; these integrators guaranteed a return on the upfront cost of ultrasonic systems in exchange for a piece of the savings on the back end
• Growth and valuation
  • Current trading multiples
    • 18x and 17x 2019 and 2020 EV/EBITDA, respectively
    • 34x and 32x 2019 and 2020 EPS, respectively
    • This for a company that has grown revenue and EPS at 5% and 7% CAGR, respectively from 2012-18
    • Moreover, this tepid growth has not all been organic; mgmt has reinvested ~55% of its OCF into acquisitions
    • The company has consistently bought-in its distributors, possibly to ward off potential competitive inroads
  • Shares trade above LT averages on an absolute basis, despite 2Q earnings miss and new competitive headwinds
  • Material potential downside if market decides this is no longer a growth company
• Failed auction process was run in 2016; several competitors (incl Itron and Kamstrup) were interested but balked at valn; other parties (XYL, Honeywell) ended up buying competitors
• Consistent insider selling
• CEO has only been on board since Apr 2018, CFO and Treasurer have both been on board for ~6 mos; could senior mgmt retirements be related to materially worsening competitive envionment?
• Significant working capital requirements; net working capital >25% of revs
• Short interest = 7%, 9 days

Upside/Downside

• P/E-based target multiples, given lack of leverage
• 20x target multiple is 7-yr low; last time shares traded at 20x EPS growth was negative; possibility of that happening if back half rebound 2019 does not materialize
• 2.5x favorable skew
• Note: financial below are consensus

Catalyst

 Loss of share to ultrasonic, downward revenue inflection, revaluation