Badger Meter: Things Are Getting Difficult

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About: Badger Meter, Inc. (BMI), Includes: HON, ITRI, MLI, XYL
by: Darspal S Mann
Summary

The great run of the last few years, which was helped by a favorable macro setting, seems to be coming to an end.

Consolidation in the space, weak top-line growth and potential margin pressure will make things difficult for the business.

The space seems to be ready for a re-rating downwards.

Badger Meter (NYSE:BMI), like some of the other flow metering equipment names, benefited from strong demand over the last few years coming from the water and utility companies, but things seem to be changing fast, and the trend going forward may not be as supportive. In the meantime, the market, having high hopes from the potential infrastructure upgrade cycle, continues to give a liberal valuation to the stock, and the space to some extent.

The rich valuation in the space, including names like Itron (NASDAQ:ITRI) and Mueller (NYSE:MLI), suggests the market is offering a slight consolidation premium, but the fundamentals suggest revenue softness may precede any such moves. Since reported sale efforts by the company do not seem to have yielded much luck, investors might be served better by following the fundamentals.

Headwinds, both macro and company specific, are gaining strength, even though the long-term opportunity for the business to further penetrate and expand into the $9 billion flow metering market with varied end-markets from a leading market position in utility water metering products remains as relevant today as it was a few years ago. Recently, pricing discipline, focus on larger orders and initiatives to move up the product sophistication index seem to have helped the margins as well, even though the efforts may not be enough to correct the possible deceleration at the top line or lumpiness inherent in the business model itself.

Favorable long-term setting, but headwinds that can't be ignored anymore

With 75% revenue from water utility instrumentation & connectivity products and 25% from flow & industrial instrumentation, the business is clearly skewed towards the water utility markets where the company has a leading market share, but this also limits BMI's ability to grow beyond the North American utility water metering market, which is barely 9% of the global flow metering market. The shift from mechanical to electronic meters clearly favors the company, especially given the global water meter market is still dominated by the single, multi-jet and turbine meters.

The biggest concern for the stock is the near-term outlook, considering the influence of economic trends on the business and consolidation in the industry, somewhat on expected lines for an industrial sector ahead of a slowdown. There is usually a lag between economic slowdown and the utility business. Early signs of weakness are already visible in the flow instrumentation business, which trends more closely to the economy, and the impact on the majority utility business may get pronounced over the coming months. The replacement demand for meters is still small, thanks to improving durability of the products.

Source: Badger Meter

Consolidation, both actual and expected, in the industry may act as a headwind for fundamentals, contrary to the usual equity market reaction. The North American water meter market is relatively concentrated, as the chart above shows, and customers tend to hesitate on any sign of shakeup, as was evident from Badger Meter experiencing delays in orders due to rumors about the business sale. Recently, Xylem (NYSE:XYL), which has a significant presence in wastewater and water treatment systems, acquired Sensus, and before that, Honeywell (NYSE:HON) acquired Elster. Worth noting that both these businesses have been acquired by deep-pocketed names, increasing the competitive concerns for Badger Meter.

Problems have started to show up

During the previous quarter, revenues declined at a low-single-digit rate for both municipal water and flow instrumentation products. The weakness was visible all around, be it residential or commercial water meters. The BEACON product that was already experiencing weak order flows due to some software interface issues continues to pose problems.

Source: Badger Meter

Gross margins did improve during the latest quarter, almost 380 basis points over last year, partly at the cost of top-line growth, but maintaining margins may also get difficult as competition intensifies and some of the favorable commodity-related tailwinds ease out, as the chart above shows.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.