Seeking Small-Cap Moats: Badger Meter

This article is part of Todd's monthly series "Seeking Small Caps With Moats." The introductory article can be found here. New articles in the series are published on the fourth Wednesday of every month.

One of my favorite small-cap investing approaches comes from  Akre Focus Fund (AKREX) manager Chuck Akre, who searches for "three-legged stools"--that is, firms with high returns on capital and pricing power (economic moats), able management teams, and the ability to reinvest extra cash in high-return projects over long periods of time. Akre calls firms that pass all three tests "compounding machines," and the smaller the company and the longer its growth runway, the better, as this provides more time for compounding at high rates. 

As you might expect, "compounding machine" opportunities are quite rare. The forces of capitalism naturally yield relatively few durable competitive advantages, and of those select companies only a fraction are run by exemplary management teams and are blessed with long growth runways. 

A "compounding machine" candidate is $760 million Badger Meter (BMI), which has increased its book value per share at an impressive compounded growth rate of 12% between 2003 and the third quarter of 2013. Badger Meter is a flow measurement company that generates about 75% of its annual revenue from water applications (natural gas, food and beverage, and pharmaceutical applications constitute the remaining share) for both residential and commercial use. Badger Meter's water meter applications help utilities charge the right amount to each customer, alert the utility companies to system malfunctions, and manage water conservation programs. 

As you might imagine, accurately measuring water flow over a 15- to 20-year product life, often situated in challenging environments, across hundreds of thousands of miles of piping requires a bit of know-how, and Badger Meter has more than 100 years of experience in the field. Even so, the company continues to invest between 2.5% and 3% of its annual revenue on research and development to improve measurement accuracy and remote monitoring technology. 

Change occurs very slowly in the domestic water metering industry. To illustrate, even though radio meter monitoring technology (which allows utility companies to read each meter remotely instead of manually) has been around for 20 years, only about a third of water meters installed in the U.S. use radio monitoring solutions. As old meters come up for replacement, utility customers are replacing manual-read meters with new (higher margin) technology, but it's a slow and steady process. Still, a long growth runway is certainly present, as the U.S. Environmental Protection Agency estimates that replacing aging water infrastructure will cost between $300 billion and $1 trillion over the next 20 years. 

Further, about five companies including Badger Meter account for nearly all of the water meters installed in North America, and the relative market shares haven't changed much over the last 10 years, with Badger Meter holding a 30% market share today (roughly in line with top competitor, Neptune). The relative stability of the industry makes it conducive to value creation and speaks to the high barriers to entry that exist (more on those in a moment). In other words, would-be competitors aren't able to quickly enter this industry and seize on opportunities to generate high profit margins, and existing competitors aren't engaging in value-destructive trends like pricing wars. 

So at first glance, Badger Meter seems well poised to possess an economic moat, but let's take a closer look at the evidence before we make that conclusion.

	TTM	2012	2011	2010	2009	2008	2007	2006
Operating margin (%)	11.5	13.9	10.5	16.2	16.9	14.6	13.0	12.5
Net margin (%)	7.3	8.8	7.3	10.4	13.7	9.0	7.0	3.3
ROA (%)	7.8	11.0	8.8	14.1	17.7	14.5	11.4	5.3
ROIC (%)	9.7	13.4	10.5	17.2	23.7	19.8	15.4	6.8
ROE (%)	13.4	16.0	11.0	18.3	26.8	24.7	20.1	10.4

Source: Morningstar

The quantitative evidence suggests that Badger Meter has, at least historically, enjoyed a durable competitive advantage. Returns on invested capital and equity have on average been above the company's costs of capital and equity, and operating margins have held in a fairly tight range of 10.5% to 16.9%.

Before we can feel confident about Badger Meter possessing a moat, however, we need to answer the following question: From which of the five economic moat sources might the company derive a durable advantage?

It seems that Badger Meter's durable competitive advantages are largely due to the aforementioned favorable industry dynamics. Given that the North American water metering market is of limited size and has consistently been served by a small number of companies, and new entrants are discouraged by high capital costs and a long learning curve, the efficient-scale advantage is likely the primary moat source. There could also be some firm-specific benefits related to a strong reputation of reliability and accuracy and perhaps some switching-cost advantages derived from its large installed base of meters. 

Morningstar doesn’t have full analyst coverage on Badger Meter, and the company hasn’t been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, but after reviewing the evidence, it’s my opinion that Badger Meter has a narrow economic moat.

In regard to Badger Meter's stewardship, shareholders should be comfortable with management's track record of making smart capital-allocation decisions mainly through complementary bolt-on acquisitions. Badger Meter has shared its prosperity with shareholders, as well, having raised its dividend for 21 consecutive years. Though it infrequently employs share repurchases, it skillfully bought back $30 million worth of stock at attractive prices ($34 average) in 2012. Finally, as of the last proxy statement, insiders owned 5.5% of shares outstanding, which should align insiders' interests with those of minority shareholders. 

BMI Dividend data by YCharts

Badger Meter is a high-quality company and has historically traded at a premium to the S&P 500 on a price/earnings and price/cash flow basis. It's no different as of Jan. 14, with Badger Meter trading with a trailing price/earnings ratio of 32 times versus the market average near 19 times. In short, the stock isn't cheap right now. 

BMI Free Cash Flow Yield (TTM) data by YCharts

It's important to remember that long-term investors not only need to be patient after they buy, but also before they buy. The best time to buy premium companies like Badger Meter is when the market is not pricing in premium results as it is today. If you're interested in buying Badger Meter, I recommend waiting for a price in the mid-$40s. 

Other stocks highlighted in this series:
• John Bean Technologies
• Culp Inc. 

Todd Wenning owns shares of the Akre Focus Fund. You can follow him on Twitter @toddwenning.