Description

In a nutshell MLI is:
A water infrastructure play A material, margin expansion story
A copper play An imminent, likely, major capital return to shareholder story
A starkly mispriced, undervaluation story
A “hidden gem, little public market exposure” story where higher market recognition is almost inevitable
A situation where the valuation seems highly likely to keep on accreting or a takeout by either a strategic or PE seems highly possible if not likely

Background on Mueller Industries and MLI as a Water Infrastructure Play
Mueller is a 100+ year old company based outside of Memphis, Tennessee that has three business segments:

Piping Systems – the manufacture and distribution of copper tube, fittings, line sets, pipe nipples, and re-sale of steel pipe, brass and plastic plumbing valves, malleable iron fittings and faucets, and plumbing specialties. The Company is a market leader in the air-conditioning and refrigeration service tube markets and also supplies a variety of water tube in straight lengths and coils used for plumbing applications in virtually every type of construction project.

Industrial Metals – the manufacture and distribution of a broad range of brass rod, copper bar, and copper alloy shapes, as well as a wide variety of end products including plumbing brass, valves, and fittings sold primarily to OEMs in the industrial, HVAC, plumbing, and refrigeration industries. Additionally, businesses in this segment manufacture cold-form aluminum and copper products for automotive, industrial, and recreational components, as well as highvolume machining of aluminum, steel, brass, and cast-iron impacts, and castings for automotive applications. Further, businesses in this segment manufacture brass and aluminum forgings; brass, aluminum, and stainless-steel valves; fluid control solutions; and gas train assembles used in a wide variety of products, including automotive components, brass fittings, industrial machinery, valve bodies, gear blanks, and computer hardware. 

Climate – the design and manufacture of valves, protection devices, and brass fittings for various OEMs in the commercial HVAC and refrigeration markets as well as the manufacture of tubular assemblies and fabrications for OEMs in the HVAC and refrigeration markets. 

Catalyst

At the heart of it, Mueller has an excellent reputation for making what sound like unsexy, but highly necessary tubes, valves, coils and other parts for the plumbing, HVAC, transportation, industrial and automotive industries. As stated in MLI’s public filings “new housing starts and commercial construction are important determinants of our sales to the heating, ventilation, and air-conditioning, refrigeration, and plumbing markets because the principal end use of a significant portion of our products is in the construction of single and multi-family housing and commercial buildings. Repairs and remodeling projects are also important drivers of underlying demand for these products.” The biggest part of the story is the Piping Systems business per the table on the following page. ~70% of revenues and currently almost 75% of operating profit is being generated by the piping systems business. This is a water infrastructure business that is highly leveraged to three things: residential and commercial construction activity, copper prices and, interestingly enough, seaborne shipping rates.

A Material Margin Expansion and a Copper Play Story
Operating profit margin for the piping systems and climate segment are bolded in the above table to emphasize the marked growth in margins for both segments. There are a few contributing drivers:
- Copper prices – per a conversation with the Company, 70-80% of COGS for the piping systems segment is the cost of copper. As shown on the next page (pulled from MLI’s most recent 10-Q), copper prices have increased >60% since the onset of Covid. MLI has been passing through (and then some) price increases so that its increased copper costs (and then some) are covered.
- Supply chain issues have been a huge boon to MLI’s business. China was one of the biggest exporters and manufacturers of products competitive with MLI’s offerings. With seaborne shipping rates particularly high coming out of China and China conducting various degrees of brown outs (to lessen expensive power usage and pollutant emissions), there has been less competition for MLI in the North American market.
- MLI’s CFO has a penchant for saying “we measure costs in half pennies around here.” When I first heard him say it, it couldn’t help but resonate with my frugal, Yankee sensibility. MLI has made a concerted effort over the last five years to improve its margins through cost restructuring and adjustments to its business mix through generally small divestitures and acquisitions. MLI took a particular hard paring to the expenses during the initial onset of Covid as like many companies, it didn’t know where things would end up. Those efforts to reduce costs have paid off handsomely in terms of margin expansion. With the lowest starting margins structure in its peer group (see the table on page one), MLI’s efforts have led to a dramatic increase in margins (a near doubling of EBIT% or a 650bps increase vs. its prior 5-year median EBIT% vs. a 100bps increase for its peer group). 

The above chart comes from p.29 of MLI’s most recent 10-Q. The Company presents an updated version of the above chart in each 10-Q and 10-K filing as the cost of copper is so critical to its business. Obtaining attractive price increases and growing expenses less than top line has led to a material improvement in margins. Excellent expense management has brought MLI’s EBIT% in line with its comparable companies (see table on page one). The copper and supply chain tailwinds aspect of the margin expansion story beg the questions, “how long will copper prices stay elevated? And how long will supply chain challenges persist?” Well, if Goldman Sachs’s forecast is to be believed ( https://markets.businessinsider.com/news/s tocks/copper-price-outlook-demand-rise-goldman-sachs-sustainability-commodities-2021- 4 (https://markets.businessinsider.com/news/stocks/copper-price-outlook-demand-rise-gold man-sachs-sustainability-commodities-2021-4) ), we could have a decade long bull run in copper ahead of us with copper going to $15,000 per ton by just 2025 (vs. the current spot price of $9,500). Goldman stated in that report that Copper “is the new oil.” Goldman cites woefully insufficient investment in new copper mining projects, accelerating demand (could be up 900% by 2030 if green technologies are adopted en masse). It’s also well recognized that miners have learned from the episode a decade ago when they overinvested in significant new capacity and copper prices collapsed. With ESG forces at work (making mining projects harder) and scars from the 2011 pricing collapse episode that run deep, it’s becoming increasingly recognized that miners are not investing in enough capacity given the demand trends ahead for copper. BoA has also been pounding this drum (https://www.marketwatch.com/story/the-world-risks-runningout-of-copper-and-heres-how-high-prices-may-rise-as-the-economy-reopens-bofa-warns -11620073503 (https://www.marketwatch.com/story/the-world-risks-running-out-of-copper -and-heres-how-high-prices-may-rise-as-the-economy-reopens-bofa-warns-1162007350 3)). In terms of the supply challenges, while we may be past the peak demand season, generally speaking supply chain challenges are only worsening particularly when it comes to ocean borne freight out of China. L.A.’s port Chief (LA being the biggest port system in the US and one of the top few in the world) was quoted in a Bloomberg article on December 8 saying “I see this going to the end of at least 2022, but we’re making small, incremental gains.” China’s “zero Covid policy” is wreaking havoc on transpacific ocean borne freight https://www.bloomberg.com/new s/articles/2021-11-24/china-s-seven-week-port-quarantine-is-blocking-shipping-recovery (https://www.bloomberg.com/news/articles/2021-11-24/china-s-seven-week-port-quarantine-i s-blocking-shipping-recovery) and on top of that there’s the trucker shortage in the US, the lack of warehouse space in LA, the lack of chassis, etc. It goes on-and-on. In short, it is hard to see until the world has come to accept Covid that supply chain issues (particularly going from China to the US) will meaningfully ameliorate. This dynamic is very good for MLI because it materially reduces competition.
On top of all this, it also needs to be appreciated that demand for MLI’s products is high (hence why customers are willing to pay 50%+ more for them). This all feeds into one of the most tantalizing sentences that I read in any earnings report of the Q3 2021 earnings season. In a quarter where MLI’s normalized earnings (earnings ex the $0.71 per share one-time gain on the sale of small sub) were up over 200% vs. Q3 2020 ($2.30 vs $0.76) and in a quarter where annualizing those earnings ($9.20 per share) suggests that MLI is trading at ~6x earnings, the earnings press release stated: “We anticipate that current market conditions will continue for the foreseeable future.” What’s crystal clear to this analyst is that MLI is going to be putting up stellar results for what’s likely to be a period extending at least thru 2022. And while the stock has made a strong 50% move in 2021, it’s not even close to trading at where it should be given the metamorphosis of the business, how it should trade relative to its most comparable peers and what’s likely to be an imminent, material action on the shareholder payout front.

An imminent, likely, major capital return to shareholder story
Approximately every five years, MLI does something big for shareholders. In January 2017, MLI declared a $5.00 per share special dividend when the stock was trading at $40. In 2012, MLI repurchased 10.4mm shares that were owned at the time by Leucadia National. That 10.4mm share buyback represented approximately 27% of shares outstanding. In 2004, MLI delivered a $7.50 (split-adjusted) special dividend when the stock was trading in the low $20s (splitadjusted). So why do I think that another major stock repurchase or special dividend is imminent? Four reasons: It’s been about five years since the last major payout. With the explosion in MLI’s profitability and FCF generation, since Q1 of 2020 MLI has reduced its gross debt by ~$350mm and its net debt by ~$300mm. If MLI so chooses, given anticipated Q4 results/FCF generation MLI could be debt free by year end with a $100+mm cash position to boot. Point is FCF is exploding and there’s no more debt to pay down. Time to focus back on shareholders. Buying back stock when that stock is trading at ~6x annualized earnings is not only incredibly accretive, it’s incredibly low risk vs. doing a major acquisition. Also, it should flatter executive comp (and the value of employee stock holdings). That said, I also wouldn’t be surprised by another significant special dividend (or special dividend and buyback). MLI has an outstanding authorization to buy back over 13mm shares of stock (or 23% of shares outstanding). Both MLI’s CEO and CFO have been at MLI since before the 2012 and 2017 major payouts. It would be more surprising if they didn’t do a major special dividend or meaningful ratchet up of share repurchase activity than if they did.

A starkly mispriced, undervaluation story
So, head back to page one of this write up and you’ll see that MLI trades at a ~70% (on P/E or EV/EBITDA multiple bases) to a ~90% discount (on PEG) to its best peers. How can this gap exist? A few thoughts:
- With a management team that does no earnings calls, does not present at investor conferences and has only one sell-side firm that covers them (Boenning & Scattergood – a firm I’d never heard of before reading Greg Royce’s piece on MLI published on SumZero on 6/23/21), it’s hard to find MLI’s footprints in the market. One of the biggest challenges is that with the “measuring everything in half pennies” sensibility pervasive at the Company, management is a small group. It has a lot on its plate and hasn’t prioritized investor outreach/education. The CFO is also the Treasurer and de facto heads of IR and business development. That is four real and important jobs under one position for a ~$3bn in sales and market cap company. In my conversation with the Company, I strongly advocated that they incur the expense of a full-time IR person (that it would be likely to more than pay for itself in terms of higher valuation for the Company). Management conceded the past philosophy of “MLI will let its operational performance speak for itself” is increasingly coming into question and that they need to be getting out there more on the investor education/outreach front. That said, this will probably take a while to come to fruition. 
- There are probably plenty of investors that looked at MLI at some point in the 2016-2021 period and concluded that it was, and forever will be, a low-quality business because its margins were so much weaker than peers. Go back to the table on page one and digest the forces (discussed in the margin growth section) that have driven the enormous margin growth for MLI. MLI’s margins are now in-line with its peer group despite being 40%+ lower just a few years ago. Not only is MLI’s profitability now comparable to peers, its ability to drive dramatically superior EPS growth through stock repurchases is unparalleled as compared to peers (that all have valuations that are dramatically higher than MLI). 
- Investors are probably concerned that we’re at peak earnings for MLI. Well to this I’d point the skeptical investor to a) the quote from the earnings call of “we anticipate that current market conditions will continue for the foreseeable future” b) the quote from the LA Port Chief highlighted earlier c) the recognition of all the other forces at play and actions taken by management that should lead to sustained and potentially growing stellar financial performance from current levels and d) with management’s ability to drive major accretion through share repurchase, I could easily see EPS performance improving markedly from current levels.
- Despite being as “Watery” as anyone (per the B&S analyst), MLI has yet to gain the attention of some of the major ESG investors that are heavily invested in peers. Impax (a major ESG shop) is a top five holder in MWA, BMI, WTS and PNR but they own no MLI. Franklin Resources owns 3% or more of MLI’s best peers, while it only owns approximately half that amount of MLI. Invesco (the 2 largest ESG ETF provider) is a top 10 holder (owning 2-4%) of three of the four best peers for MLI, it’s the 11 largest holder of MLI (1.7%). Why haven’t the ESG acolytes dived in, it probably goes back to reason “1” above. Or maybe it’s because MLI is just too cheap!

A “hidden gem, little public market exposure” story where higher market recognition seems almost inevitable
First up, if MLI keeps on performing the way it has operationally and the way I think it will, it is inevitable that the stock will gain more of the market’s attention if by the fundamental quants if no one else. Further, if the company engages in either a major special dividend or significant stock repurchase effort, that should also garner significant attention. Management, as highlighted earlier, has indicated a growing understanding internally that it should greatly benefit the stock if they were to have a more public face with the market. Finally, there are anywhere between three (for Badger Meter) and nine (for Pentair) sell-side analysts that cover MLI’s best comparables. Might one or two sell-side analysts that have been shadowing MLI decide to initiate given how much better MLI is doing than peers (in terms of operational improvements and stock performance)? Crazier things have happened.

A situation where the valuation seems highly likely to keep on accreting or a takeout by either a strategic or PE seems highly possible if not likely
Entering the confessional, I do subscribe to the belief that if a company delivers stellar results, has an excellent outlook and trades ridiculously cheaply, that its valuation is likely to accrete higher. But I also fully concede that this type of investing can, at times, take a perplexingly long time to come around to the desired outcome. What I also take stock in is that there are strategics and PE types that find situations like this as attractive as I do. As is clear by some past ownership by Leucadia, PE/financial types have been involved in MLI in the past. MWA was previously owned by PE, but with its focus more on municipalities and inconsistent operating performance, I believe it to be an inferior asset to MLI. The point is ultimately this, MLI is trading at about 6x earnings (my 2022 earnings estimate) right now and is going to be increasingly flush with cash. It’s a very attractive size for a PE takeout and the Watery/ESG element should be highly attractive to a large swath of potential suitors. 

In conclusion, arriving at a warranted valuation for MLI
MLI’s peers trade for between 20x-50x 2022 earnings. I see no real reason why MLI shouldn’t trade at 20x. Then the question is where should earnings come out for 2022? While the B&S analyst has forecast $6.60 for 2022, based on its YTD ex-special items EPS of $5.40 and “current market conditions are likely to persist for the foreseeable future” guidance from the last earnings release, I think it likely that MLI will deliver $7.25 or better for full-year 2021 (vs. the $6.25 forecast by B&S). With smart capital allocation (estimating that MLI uses half of free cash flow to buyback 4mm shares ratably in 2022) and the strong trends underlying its business, I can see MLI delivering $9.12 in 2022 earnings. At 20x that arrives at a warranted value of $182. Discount that warranted TP by 15% for the sake of conservatism and that arrives at a warranted TP of $155 (or ~170%+ from current). Get watery with MLI.