MWA:  03/15/2007

 

Current Price: @ 14.15

 

Mueller Water Products is a holding company based in the U.S. consisting of 3 water-infrastructure focused segments: Mueller, U.S. Pipe and Anvil.  Mueller deals primarily with hydrants and valves with a strong emphasis on municipal water systems; U.S Pipe focuses on ductile iron pressure pipe and related accessories; Anvil sells standardized connector parts like pipe fittings, nipples, hangers, couplings, etc.

 

Upside:

  • A possible Greenblatt spin-off special situation.  A leveraged spin-off with highly incentivized management and little Wall St. interest.  The newness of the company along with high debt load leaves a void right now to act if there is value in the company.
  • The main segment of the company (Mueller) has a narrow competitive advantage (moat) at the least due to the ubiquitous presence of its products in municipalities.  Municipalities are highly individualized in their specifications and the process to receive approval is daunting.  Mueller’s pre-established beach head in these markets puts them in prime position to benefit from increased water infrastructure investment – estimated to increase 11% this year.
  • Long-term story for water is compelling.  Population growth along with warmer climes and a deteriorating infrastructure makes the long case look good.  The American Society of Civil Engineers rated the U.S. water infrastructure as a D-.  Water is an essential resource and pretty inelastic in terms of demand.
  • Strong market position – they rank either 1st or 2nd in most of the markets they compete in (across all brands).  Also, branding is relatively strong.
  • Good margins and strong track record of raising prices each year, which suggests a good market position.
  • Leading market position, large installed base and moving toward minimizing production costs as a competitive advantage ala Wal-mart (e.g. lost foam casting process – reduces labor costs 15% in addition to materials cost).

 

Dangers

  • 40% exposure to residential investment (read housing) makes them susceptible to economic slowdown.  Already this year, revenues for their top two segments are down YOY.
  • Possible labor issues as 3 of their largest 8 plants have expiring contracts in 2007.
  • High debt loads and credit restrictions may hinder access to capital.
  • The Anvil segment, and to a lesser extent the U.S. Pipe segment, are basically commodities and thus the main competitive advantage on these products is pricing, which can hurt margins, especially from overseas competition.
  • Other than Canada, no international presence.

 

Management:

  • Integrity: B. Gregory Hyland, CEO: Hyland seems alright.  Doesn’t go out of the way to highlight risks or bad news but will be open and answer honestly if asked.  Consistent in his investor presentations.  Not overly familiar.
  • Past Performance: Inc.  Spin-off situation and recent merger makes it hard to gauge their performance.  However, margins are good; synergy realizations have been good (~$30 million so far); EBITDA margins rose last qtr despite falling revenues.  Looks good so far.

 

The Reasoning:

In a world of peak oil and global warming, water scarcity is perhaps the 800 lb gorilla of impending 21st century disasters.  No one can predict the future and so I try to base my macro-themes on solid research and verifiable evidence.  China’s breakneck growth is putting their water issues in stark relief.  Here in the U.S., you only need to look at California’s massive water system or Las Vegas sinking into the desert as it pumps its aquifer dry to realize that water is a big deal.  So that’s the big picture.

 

So what’s that got to do with Mueller Water?  It is extremely difficult to find good value right now in the water industry.  Mueller competes in a wide array of water infrastructure products and its spin-off situation makes it a possible good value situation.  According to the company’s estimates, Mueller-specific products have been approved in 90% of the major metropolitan areas.  Once, say a fire department, has outfitted all of their equipment to work with certain hydrants, valves, etc and all personnel have been trained to use this equipment, it is not advisable to change out specifications in such mission-critical areas (such as firefighting or water delivery).  One out of every two hydrants in this country is estimated to be Mueller or U.S. Pipe.

 

Discounted cash flow models based on adjusted income puts Mueller at about $20 - $25 per share meaning we have at least a 33% margin of safety right now.  The spin-off situation and one-off costs makes it a little harder to value MWA.  The company is already throwing off cash, even though revenues are down due to the construction slowdown. 

 

Management eats their own cooking.  CEO Greg Hyland has over 500,000 shares in the company and there’s been little insider selling.

 

While the wisest investors have stated that it is foolish to predict macro-economic movements to guide investment decisions, I can’t help but feel that a housing meltdown is under way which will significantly affect MWA.  That does not mean I am bearish on MWA.  However, it does mean that I want a higher risk premium, so I’m looking at $13.50 before accumulating shares and keep buying if it dips down.  A margin of safety of 50% would be ideal.

 

Risk Measurement @ $13.50 2 year outlook

    1. upside – 25% chance of going to $20+  = .25 * $6.5 = 1.625
    2. slight up – 30% chance of  $15 = .30 * $1.5  =  0.45
    3. flat – 20% chance of $13.50 = .20 * -$0.5 =  -0.30
    4. downside – 15% chance of going down to $11.00 = .15 * -$2.5 = -0.375
    5. slide to book – 8% chance of falling to $8 = .08 * -$5.50 =  -0.44
    6. zero – 2% chance of flatlining = .02 * -$13.50 =  -0.27

 

TOTAL:  +0.69

 

If the company is still around and in positive territory past 2 years, the risks should abate and MWA should be a long-term winner.