Badger Meter In The Right Water Markets, But The Valuation Is Steep

For some time now, my refrain on water-leveraged industrials has been iterations of “yes, this is a good sector to be in long term, but the valuation more than reflects that”, and the sector has definitely pulled back and derated recently. Badger Meter (NYSE:BMI) has been caught up in that, with the shares underperforming since my last update; underperforming the broader industrial space by about 15%, as well as other water plays like Mueller (MWA) and Franklin (FELE), though outperforming Xylem (XYL).

As I’ve said in other articles, I don’t believe that all water exposure is equal, and I think Badger is in some of the best places to be, including water quality and loss mitigation. Even so, I can’t make the valuation work at this level and it’s hard to recommend this name over some other companies in the water space with more reasonable valuations.

 

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Badger Meter In The Right Water Markets, But The Valuation Is Steep

Badger Meter - A Quality Water Name That Is Priced Accordingly

Badger Meter (BMI) is a great example of why I say that valuation in and of itself isn’t really a driver of future performance – these shares have been “expensive” for a long time, and yet they’ve beaten the S&P for five years in a row (by double digits in three of those years) and generated an annualized average return of over 18% over the last decade, outperforming both the S&P 500 and its water sector peers.

Badger Meter is still expensive, but it also still has leading share in the almost-oligopolistic U.S. water meter market, a market where there is still meaningful growth potential in remote metering, and a growing technology suite that addresses water quality issues. I can’t make the numbers work on the basis of the growth and margins I expect, but Badger has good margins, good ROIC, healthy markets, growth opportunities, and strong ESG credentials, so I wouldn’t call it a promising short candidate either.

 

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Badger Meter - A Quality Water Name That Is Priced Accordingly

Mueller Looks Hard-Pressed To Reward The Market's Rediscovered Optimism

One of the ongoing mysteries of the market that I have yet to solve is the almost evergreen enthusiasm that investors have for water-related companies. While stocks like Mueller Water Products (NYSE:MWA) and Xylem (NYSE:XYL) do have their periods of relative underperformance, it seems like there's a strong "will to believe" behind this sector that doesn't seem related to the actual underlying long-term free cash flow growth or ROIC prospects.

Be that as it may, I'm not going to look a gift horse in the mouth - I thought Mueller looked undervalued earlier this year and the 50% move in the stock since then is definitely more than I'd expected. It's also more than I think is merited by the fundamentals. I understand that housing activity and municipal spending are both looking better, and this company has been doing well with margins in its core business, but even my expectations for almost a decade of sustained double-digit FCF margins (something the company hasn't achieved before) and solid mid-single-digit revenue growth isn't enough to generate a fair value above today's stock price.

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Mueller Looks Hard-Pressed To Reward The Market's Rediscovered Optimism

Seeking Alpha: Mueller Water Tapped Into Wall Street's Housing Hopes

Investors are clearly expecting improvements in the housing market to continue, and that enthusiasm is helping to push Mueller Water Products (MWA) to a new 52-week high. I don't consider this altogether surprising, as I wrote about six months ago that Wall Street would likely stay on this name so long as the prospects for improved revenue growth and margin leverage remained tenable. While it is harder and harder to see long-term intrinsic value in the shares unless the housing recovery really surprises to the good, momentum and near-term profit growth prospects could take these shares into the low to mid teens.

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Mueller Water Tapped Into Wall Street's Housing Hopes

Seeking Alpha: Wall Street Betting That Mueller's Profits Will Start To Flow

The markets have long loved water/fluid-management stories like Xylem (XYL), ITT (ITT), and Franklin Electric (FELE), and if you can add a residential construction rebound, you have an even better story in the making. That has certainly worked for Mueller Water (MWA), as shares have risen more than 75% over the past year, 235% over the past two years, and about 300% over the all-time low set in November of 2011.

Not surprisingly, it looks like the market has put a definite premium on the recovery potential here. I do believe that residential construction is on its way back, and I also believe that Mueller's investment in advanced products like advanced metering (AMI), leak detection, and pressure monitoring will provide a nice kicker to its growth in valves and hydrants. Mueller shares do look pricey on a cash flow basis, and could be vulnerable if the residential recovery proves shallower than expected, but I won't ignore the possibility that strong leverage could lead to significant profit growth and even higher multiples.

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Wall Street Betting That Mueller's Profits Will Start To Flow

Investopedia: Itron's Path Won't Be Smooth, But The Growth Couuld Be There

Smart metering company Itron (Nasdaq:ITRI) is not exactly a secret anymore. The bull story on water has been droning on for nearly a decade now, and Itron is followed by over 20 sell-side analysts. Unfortunately, the project-oriented nature of the business means that there's a fair bit of unpredictability in the model and ample opportunity for above/below-consensus expectation. So while Itron still has solid growth possibilities before it, investors should expect a bumpy ride along the way.

Mixed Messages in Fourth Quarter Results
Fourth quarter results from Itron offer a sense of some of the challenges at the company. Sales were substantially higher than expected, but up about 4% in reported terms and 5% in constant currency. North American and International results were similar on a reported basis, with international sales offering a little more momentum on a constant currency basis.


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Investopedia: Layne Christensen Could Be Better

Combining municipal construction operations with mineral exploration sounds like it should be something out of a Dickens novel ("It was the best of times ..."), but that's the basic story at Layne Christensen (Nasdaq:LAYN). While mineral exploration activity continues at a strong pace, municipalities are spending less on water projects. While Layne Christensen has an interesting mix of businesses and seems undervalued today, management must prove that it can consistently deliver free cash flow, if this stock is going to work.

A Disappointing Result 

Layne Christensen did not post an especially strong third quarter. Though this relatively under-followed company beat the revenue expectation and posted 9.3% top line growth, margins and earnings were disappointing.

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A.O. Smith Gets Out While The Getting Is Good

It looks like ABB (NYSE: ABB) has managed to shake up the electrical motors business. In the press release announcing a deal whereby A.O. Smith (NYSE: AOS) will sell its motors business to Regal-Beloit (NYSE: RBC), AOS tacitly acknowledged that industry consolidation, and this recent deal between ABB and Baldor Electric (NYSE: BEZ), has made it too difficult to continue on with their own efforts. Facing up to reality and making the best of the situation, AOS is getting a pretty decent going-away prize for this business.

The two companies announced that Regal-Beloit would buy AOS's motors business for $875 million in a combination of cash ($700 million) and stock ($175 million). That is a healthy multiple (1.4x trailing sales) for a business that was the #4 player behind Emerson (NYSE: EMR), Regal-Beloit, and Beldor and relied heavily upon replacement sales (75%) for its business. By comparison, Beldor sold out for about 1.9x sales - Beldor was far larger, more diversified, more leveraged to growth opportunities, and filled a key gap in ABB's motors business.

A.O. Smith management was a little cagey about their plans for the proceeds - talking about using the capital to expand the water products business into new markets and perhaps acquire other products/technologies in that sector. That's almost certainly not enough money to acquire Franklin Electric's (Nasdaq: FELE) water pumps business, but maybe the company would think of taking a run at a large target like Badger Meter (NYSE: BMI) if management felt especially ambitious. What is much more likely, though, is that AOS would target one or more of the numerous small private companies that are involved in heaters, boilers, or tanks - particularly those that have a good business in emerging markets like China or Brazil.

I give AOS management a lot of credit for having the humility and rationality to realize that ABB was putting them in a box that would make their business increasingly nonviable and unlikely to earn attractive returns on capital. That does not mean that it's an awful deal for Regal-Beloit. Quite the opposite actually. Regal-Beloit has the scale that AOS lacked (especially with this deal) and does not seem to be overpaying for what should be a leveragable business. I would expect RBC to able to integrate this deal fairly easily and make it accretive in relatively short order.

Win-win deals are not that common, and certainly seldom come from a major rival getting more active in the space. Nevertheless, ABB's efforts to grow its North American motor business may just end up helping these two companies out if A.O. Smith can put the capital to good use and Regal-Beloit can avoid the footfalls of the new giant.

Danaher Assimilates Another Company

Scarcely any organization outside of Star Trek's Borg have taken the route of growth-by-acquisition quite like Danaher (NYSE:DHR). Fortunately, Danaher is quite a bit friendlier in its approach and typically makes very fair offers to the shareholders of the targeted company. They are at it once again, though, announcing on Wednesday that they would acquire electronic test equipment specialist Keithley Instruments (NYSE:KEI) for $21.60 in cash.  

What Danaher Is Getting?
In paying a net value of about $300 million, Danaher is acquiring a leading niche electronics company with trailing revenue of over $100 million. That is a pretty good premium for Keithley shareholders, at least relative to the current valuation of others in the "scientific equipment" space like Agilent (NYSE:A). Although some shareholders may lament that the company sold itself just as business seemed to be recovering, Danaher is giving them an exit price that has not been seen since 2004. It is entirely possible that Keithley might have had another run in it, but Danaher is offering a risk-free price that should satisfy almost any shareholder. 


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