Itron: Subtraction By Addition?

Summary

• Q4 results "beat" but raise earnings quality red flags, a recurring theme with ITRI.
• Strategic shift to growth through acquisitions raises risk profile.
• Legacy business showing negative organic growth.

Q4 Results Beat on Lumpy Revenue Recognition

Itron (NASDAQ:ITRI) recently reported its Q4 and full-year 2018 results. Revenue of $551 million exceeded consensus estimates calling for $533 million, driving adjusted non-GAAP EPS of $1.01 per share, which also exceeded consensus estimates of $0.93. The company also guided for FY 2018 revenue and non-GAAP EPS of $2.38 billion and $3.15, respectively, at the midpoint, relative to consensus estimates of $2.4 billion and $3.19, respectively, according to Seeking Alpha.

On the surface, the Q4 reported results seemed to constitute a pretty nice beat. But, as seems to be a recurring theme with ITRI, there were some red flags around the quality of earnings delivered in this report. The following chart depicts recent trending in Itron's revenue recognition dynamics: specifically, the relationship between the amount of revenue the company recognizes versus the amount it defers until future periods.

The table shows that in the most recently reported quarter, the amount of revenue deferred fell precipitously in relation to prior quarters. The less revenue that is deferred equates to more revenue recognized, and the impact to Q4 revenue easily accounts for the entire $18 million margin by which the company exceeded analysts' estimates for Q4 revenue.

Importantly, it is arguably not significant whether the company was intentionally 'massaging' this number, or if there is a legitimate shift in revenue recognition methodology, perhaps in connection with the recently enacted new accounting standard. The important thing is that this dynamic did not appear to be incorporated into analysts' estimates, and it served as a non-recurring benefit to boost Q4 reported results. This will only make for more difficult comps as we head into future quarters.

Acquisition Spree Amid Organic Stagnation

Amid the top line stagnation that ITRI has experienced over recent years, the company has embarked upon a course of external growth through acquisitions. As outlined in my prior note, ITRI acquired Comverge for $100 million in June 2017. Then in January 2018, the company closed the previously announced acquisition of Silver Spring Networks for $810 million. Using SEC filings and company presentations, the following table demonstrates the stagnation in ITRI's legacy business.

ITRI delivered FY 2018 guidance for revenue of $2.4 billion at the midpoint of the range given by management. The top section of the table shows that, even assuming zero growth in the newly acquired Comverge and Silver Spring businesses, management's guidance implies negative revenue growth in the legacy business. Note that the Comverge acquisition closed on June 1, 2017, so the FY 2018 revenue results will benefit from 5 months of Comverge revenue that did not exist in 2017.

The same phenomenon occurred in 2017. Excluding the newly acquired Comverge business in 2017, legacy ITRI revenue actually declined versus 2016. This demonstrates the elusiveness of sustainable growth opportunities in the space, and calls into question ITRI's rich valuation. The table below outlines the stock's current valuation multiple, in terms of EV to sales, giving effect to the financing transactions the company has announced in order to fund the Silver Spring acquisition. In connection with the closing of the acquisition in early January, Itron refinanced its credit facility, resulting in incremental floating rate debt of $330 million (assuming the new $650 million term loan proceeds were used to pay down existing term loan and revolver outstanding balances of $319 million), and has also issued $400 million of senior notes bearing interest at 5%. All in all, the additional debt is driving 2018 interest expense guidance of roughly $50 million, up from $11.6 million in 2017.

The 1.6x EV/Rev multiple exceeds ITRI's long-term average of 1.0x, which had remained fairly steady going all the way back to 2011, according to data from Morningstar. This 60% valuation premium warrants caution, especially for a company exhibiting negative organic growth, a leveraging balance sheet in a rising rate environment, and added execution and integration risk due to significant acquisitions.

The additional interest expense load of nearly $40 million annually should be put in the context of the "acquisition synergies" of $50 million touted by management as one of the main benefits of the Silver Spring acquisition. But importantly, these synergies are expected to take three years to finally build up to the $50 million per year run rate. The company seems to be trading an immediate and certain interest expense hit of about $40 million per year for an eventual and uncertain $50 million of cost synergies.

Conclusion

Following the Q4 earnings report and Silver Spring Networks acquisition, the operational and integration risks around ITRI's business appear as formidable as ever. Yet the stock still trades above $70 per share. Given the risk profile and earnings quality issues plaguing the company, the short-sell thesis for ITRI remains intact.

Analyst’s Disclosure: I am/we are short ITRI. 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.