Badger Meter Stock: Filing This One Away For A Big Drop (NYSE:BMI)

Meter Reading

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Badger Meter (NYSE:BMI) is an experienced competitor in the water measurement and quality industry. They have been providing solutions and expanding capabilities for over 100 years. Badger Meter primarily sells various types of water meters that are focused on serving various water utilities.

Badger Meter is also largely aimed at the United States market which represented around 86% of sales through the first two quarters of 2022. Management has targeted international expansion by expanding into the Middle East, Mexico, Europe, Canada, and Asia.

To go along with the meters, Badger Meter also offers software solutions that aid utilities in leak detection as well as more visibility into the water usage and demands throughout the distribution networks. Additionally the software suite allows for utility customers to view an manage their water usage.

In addition to various flow meters, Badger Meter also serves industrial customers with their real-time water quality and flow measurement solutions.

Badger Meter isn’t exactly a glamorous business; however, it’s proven to have staying power while continuing to expand their offerings through their expertise and relationships with their customers.

Dividend History

Dividend growth investing is the strategy that I gravitated towards when first began investing in individual companies. I’m always on the lookout for new potential businesses that can be added to my portfolio and one of the first things I check is whether a company has a history of both paying and growing their dividends.

Badger Meter Dividend History

Badger Meter Dividend History (BMI Investor Relations)

According to the CCC list, Badger Meter is a Dividend Champion with 30 consecutive years of dividend growth. That’s an impressive feat for a company that dates back over 100 years. While dividend growth in any given year has waxed and waned, over longer periods of time dividend growth has been relatively consistent.

Since 2003 Badger Meter has given year over year dividend growth ranging from 3.8% to 17.6% with an average of 10.3% and a median of 10.0%.

Over that same time there’s been 15 rolling 5-year periods with annualized dividend growth spanning from 7.5% to 14.2% with an average of 10.9% and a median of 11.6%.

There’s also been 10 rolling 10-year periods with Badger Meter’s annualized dividend growth coming in between 9.7% to 11.2% with an average of 10.5% and a median of 10.4%.

The rolling 1-, 3-, 5-, and 10-year annualized dividend growth rates from Badger Meter since 2003 can be found in the following table.

Year Annual Dividend 1 Year 3 Year 5 Year 10 Year
2003 $0.1325
2004 $0.1375 3.77%
2005 $0.1450 5.45%
2006 $0.1550 6.90% 5.37%
2007 $0.1700 9.68% 7.33%
2008 $0.2000 17.65% 11.32% 8.58%
2009 $0.2300 15.00% 14.06% 10.84%
2010 $0.2600 13.04% 15.21% 12.39%
2011 $0.3000 15.38% 14.47% 14.12%
2012 $0.3300 10.00% 12.79% 14.19%
2013 $0.3500 6.06% 10.42% 11.84% 10.20%
2014 $0.3700 5.71% 7.24% 9.98% 10.41%
2015 $0.3900 5.41% 5.73% 8.45% 10.40%
2016 $0.4300 10.26% 7.10% 7.47% 10.74%
2017 $0.4900 13.95% 9.82% 8.23% 11.17%
2018 $0.5600 14.29% 12.82% 9.86% 10.84%
2019 $0.6400 14.29% 14.17% 11.58% 10.78%
2020 $0.7000 9.38% 12.62% 12.41% 10.41%
2021 $0.7600 8.57% 10.72% 12.06% 9.74%
2022* $0.8500 11.84% 9.92% 11.65% 9.92%

Source: Author; Data Source: Badger Meter Investor Relations

*Assumes a 4Q payment of $0.225 per share.

For dividend growth investors, the dividend payout ratio is one of the more vital metrics to track. A dividend payout ratio that is flat over time tells you that dividends have been growing in line with profits or cash flow. All else being equal the lower the payout ratio the better as there’s the possibility for the payout ratio, and in turn the dividend, to rise as the business matures.

BMI Dividend Payout Ratios

BMI Dividend Payout Ratios (BMI SEC filings)

Over the last decade Badger Meter’s net income payout ratio has averaged 40.9% and for the last 5 years the average is 43.3%. Similarly, the average free cash flow payout ratios are 37.8% and 30.1%, respectively. Badger Meter’s dividend has been well covered by both earnings and free cash flow over the last decade.

Quantitative Quality

It’s the business quality that ultimately dictates the bulk of returns that investors will earn. That doesn’t mean that investors should eschew valuation; however, identifying a quality business should be the first goal. As such I examine a variety of financial metrics to become familiar with the business and whether I believe it should continue to do well.

BMI Revenue Profits and Cash Flow

BMI Revenue Profits and Cash Flow (BMI SEC filings)

Between FY 2012 and FY 2021 Badger Meter’s revenues grew by 58.0% in total or 5.2% annualized. Gross profits rose by 68.2% or 5.9% annualized over that same period.

Operating profits improved by 72.7% or 6.3% annualized with operating cash flow rising an impressive 151.4% or 10.8% annualized. Most importantly Badger Meter’s free cash flow increased by a stunning 203.8% or 13.1% annualized.

My expectation is that good businesses will be able to defend their competitive positioning over time as evidenced by stable or rising margins. I prefer to see a free cash flow margin greater than 10%; however, the trajectory of margins is more important.

BMI Margins

BMI Margins (BMI SEC filings)

Badger Meter’s free cash flow margin really started showing improvements since 2015. The 10-year average free cash flow margin for Badger Meter is 10.9% with the 5-year average up to 14.5%. While Badger Meter has only surpassed the 10% threshold in 5 of the years since 2012, they have managed to exceed that mark in 5 of the last 6 years.

An alternative measure of profitability can be quantified by comparing the free cash flow versus some measure of assets or capital base. By looking at profitability this way we can see how efficient the business is at generating cash from the chosen capital measure. I want to see a free cash flow return on invested capital, FCF ROIC, greater than 10% and preferably one that is rising over time.

BMI Free Cash Flow Returns

BMI Free Cash Flow Returns (BMI SEC filings)

Once again we see solid improvement in Badger Meter’s free cash flow returns beginning in FY 2016. Badger Meter has earned a FCF ROIC greater than 10% in 7 of the last 10 years. The 10-year average FCF ROIC is 13.9% with the 5-year average up to 18.2%.

To understand how Badger Meter uses its free cash flow I calculate three variations of the metric, defined below:

  1. Free Cash Flow, FCF: Operating cash flow less capital expenditures
  2. Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
  3. Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less net cash used on share repurchases

BMI Free Cash Flows

BMI Free Cash Flows (BMI SEC filings)

Over the last 10 years, Badger Meter has generated a total of $453.1 M in FCF. They have also paid out a dividend each year sending out a total of $145.5 M to shareholders in dividend payments. That puts the cumulative FCFaD for that period at $307.6 M.

Additionally, Badger Meter has only spent a net total of $31.4 M on share repurchases over that time which brings the cumulative FCFaDB for the last decade to $276.2 M.

Badger Meter has not heavily utilized share repurchases as a means to return excess cash to investors. In total, between FY 2012 and FY 2021 Badger Meter used ~$4.63 on dividends for every $1.00 used on net buybacks.

BMI Shares Outstanding

BMI Shares Outstanding (BMI SEC Filings)

While Badger Meter hasn’t committed much capital to share repurchases, that hasn’t been necessary as there’s been effectively no dilution either. As such the share count is effectively flat with just a 1.7% increase between FY 2012 and FY 2021 or a 0.2% annualized rate.

When I choose to make an investment in a business my aim is to be holding my stake for years and potentially decades. With a long-term mindset that means I want to avoid companies that are heavily leveraged as that places what I believe is an unnecessary risk to my equity investment.

BMI Debt to Capitalization

BMI Debt to Capitalization (BMI SEC Filings)

Badger Meter’s debt-to-capitalization ratio has been heading in the right direction over the last 10 years. Even at its peak the debt-to-capitalization ratio was only around 28.0% and currently sits at 0.0%. The 10-year average if 14% with the 5-year average at just 4%. When you don’t owe anyone anything the underlying business has a lot more leeway in tough times.

How Did We Get Here?

From December 31, 2012 through December 31, 2021 Badger Meter’s share price has risen 349.5% which is good for a 16.2% annualized rate. Add in the 1.4% trailing dividend yield at the beginning of the period and Badger Meter’s shares have a CAGR around 17.6% for that timeframe. Until approximately mid-2018 Badger Meter had, for the most part, tracked along with the S&P 500. Since then Badger Meter has significantly outpaced the S&P 500.

Chart
Data by YCharts

While Badger Meter has handily beat the S&P 500 over that time that doesn’t mean that all of the returns were justified by improvements in the underlying business. The best source of returns is growth of the business with the least sustainable coming from valuation changes. As such I try to break down the returns from that period into three components.

  • Business Returns: Measured by revenue growth and change in net profit margin
  • Capital Allocation Returns: Measured by dividends and annualized change due to share repurchases
  • Sentiment Changes: Measured by the change in P/E multiple from the beginning and end of the period

As we saw earlier Badger Meter’s revenues grew at a 5.2% annualized rate. Their net profit margin rose from 8.8% to 12.1% which represents a 37.6% improvement or ~3.6% annualized changed. That brings the total business return contribution to +8.8% annualized.

We saw that the share count has risen by 0.2% annualized during that same time which is a drag on the returns. Added with the initial yield of 1.4% brings the capital allocation return contribution to +1.2%.

The P/E multiple based on FY 2012’s EPS of $0.97 works out to 24.4x and by the end of the period it had risen to 51.3x. That’s a huge 110.3% increase in the P/E multiple off of an arguably expensive base which puts the sentiment change returns at +7.7% annualized.

Annualized Returns % of Returns
Business Returns 8.8% 50%
Capital Allocation Returns 1.2% 7%
Sentiment Change 7.7% 43%
Total Annualized Returns 17.6%

Source: Author

Combined the business and capital allocation returns worked out to a 10.0% annualized rate which represents ~57% of the return investors saw over that period. Multiple expansion accounted for the remaining 43% of the returns.

BMI Return Breakdown

BMI Return Breakdown (BMI SEC filings)

Valuation

While a great business will eventually bail you out of paying a seemingly rich valuation if given enough time. However, I aim to avoid those situations by utilizing several valuation methods in order to get an idea of what the business could be worth. The valuation methods that I use are dividend yield theory, a reverse discounted cash flow analysis, and a minimum acceptable rate of return, “MARR”, analysis.

Dividend yield theory is a simple valuation method that works off of reversion to the mean. The idea is that over time investors, collectively, will value a business such that it offers a dividend yield around a normal level. For Badger Meter I’ll use the 5-year average forward dividend yield as a proxy for fair value.

Badger Meter Dividend Yield Theory

Badger Meter Dividend Yield Theory (BMI Investor Relations and Google Finance)

Since around 2014 Badger Meter has rarely offered a dividend yield approaching the 10% undervalued level. More typically it has traded such that its yield is between roughly the 5-year average forward yield and the 20% overvalued level.

Badger Meter currently offers a forward dividend yield of 0.99% compared to the 5-year average forward dividend yield of 1.01%.

A reverse discounted cash flow analysis can be used to decipher what expectations are built into the current market valuation. In other words, you work backwards from the current market valuation and see what kind of growth and free cash flow generation the business must achieve in order to support the market price.

I use a simplified DCF model built on revenue growth, an initial free cash flow margin of 12.4% that improves to 17.0% during the forecast period. The terminal growth rate is estimated at 3.5%.

With a 10% return target, Badger Meter needs to grow revenues at a 13.2% annualized rate through the forecast period in order to generate the cash flows necessary to support the current valuation. Lowering the return target to 8% drops the required revenue growth to 7.2% annualized during the forecast period.

The MARR analysis entails estimating the future earnings and dividends that a business will produce during a given period of time. You then apply a reasonable expected multiple on those future earnings to determine a potential future share price and calculate the expected return. If the expected return is greater than your threshold for investment then you can feel free to invest.

Analysts expect Badger Meter to report FY 2022 EPS of $2.26 and FY 2023 EPS of $2.45. They also expect Badger Meter to be able to grow EPS at a 10.25% annualized rate over the next 5 years. I then assumed that earnings growth would slow to 5.0% annually for the following 5 years. Dividends are assumed to target a 38% payout ratio.

Over the last decade, Badger Meter has traded at a premium multiple based on TTM EPS. The TTM P/E has ranged from ~25x to ~45x. For the MARR analysis I’ll examine multiples spanning from 15x to 40x.

Chart
Data by YCharts

The following table shows the potential internal rates of return that an investment in Badger Meter could generate provided the assumptions laid out above prove to be reasonably accurate. The MARR analysis assumes that dividends are paid and increased along the timeline that Badger Meter has usually followed. Returns assume that shares are purchased at $91.05, Friday’s closing price.

IRR
P/E Level 5 Year 10 Year
40 9.4% 7.8%
35 6.7% 6.5%
30 3.7% 5.0%
25 0.2% 3.3%
20 -3.8% 1.2%
15 -8.7% -1.3%

Source: Author

Alternatively I use the forecast growth for Badger Meter to work backwards and determine the maximum price I could pay for shares given the varying terminal multiples. My base hurdle rate is a 10% IRR and for Badger Meter I’ll also examine 12% and 8% return targets.

Purchase Price Targets
10% Return Target 12% Return Target 8% Return Target
P/E Level 5 Year 10 Year 5 Year 10 Year 5 Year 10 Year
40 $89 $76 $82 $64 $98 $90
35 $79 $67 $72 $57 $86 $80
30 $68 $59 $62 $50 $75 $70
25 $58 $51 $53 $43 $63 $60
20 $47 $42 $43 $36 $51 $50
15 $36 $34 $33 $29 $40 $40

Source: Author

Conclusion

Badger Meter is one of those nice, boring businesses that should continue to do well no matter what the macro economy throws at it. Badger Meter has a 100+ year history which is quite impressive. Badger Meter’s margins have shown great improvement during the last decade. Badger Meter has been able to maintain strong FCF returns as well with their return on assets now well over 10% for each of the last 4 years and 5 of the last 6.

Dividend yield theory suggests that Badger Meter is fairly valued. The fair value range from DYT comes to $81 to $99 based on the recently increased payout to $0.225 per share.

The reverse DCF analysis implies that Badger Meter is quite expensive here and not likely to be able to grow its way into the current valuation such that it offers 10% or even 8% returns. Of course there’s the possibility that margins could drastically improve; however, the spread appears quite large.

Likewise, the MARR analysis suggests that Badger Meter is quite expensive at current levels unless you believe they are deserving of a huge premium multiple compared to the market as a whole. Based on a 10% IRR 5 years out and a terminal multiple between 20x and 25x the fair value range is just $47 to $58 meaning shares are worth at best around 2/3 of the current share price.

Share repurchases could be a potential future boost to returns. Based on the 3-year average FCFaD of $57.8 M and current market cap around $2,700 M they could repurchase ~2.0% of shares annually and that’s with what I consider to be a very rich valuation. Given the expensive valuation I would prefer to see special dividends over repurchases, although it’s interesting to see that Badger Meter could transition to a share cannibal which would go that much further should market prices fall.

Management seems to be in agreement that Badger Meter is likely expensive, and has been for a while now. In February 2020 they authorized the repurchase of up to 400,000 shares with the authorization terminating in February 2023. Since then Badger Meter has only repurchased 60,322 shares or roughly 15% of the authorized amount.

Badger Meter has an enviable balance sheet carrying no debt especially given the trajectory of rates thus far in 2022. That should allow them the opportunity to make continued bolt-on acquisitions.

Badger Meter is primarily focused on the United States where they generate the bulk of their sales predominantly from various water utilities. So the international market is a potential avenue for Badger to move into.

However, through Q2 FY 2022 vs FY 2021 international sales declined by ~5%. No doubt that was at least partially due to the rising US dollar and FX headwinds. Badger Meter has made inroads in the Middle East region which did show an increase over that period despite the strong dollar.

Even though dividend yield theory shows that shares are fairly valued, both the MARR analysis and reverse DCF model require pretty optimistic assumptions in order to generate adequate returns.

Badger Meter is a fine business and one that I’d be interested in at the right price. However, at this time there seems to be a whole lot of optimism and growth baked into the current market valuation.

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