Description

We believe Mueller Industries, Inc. (NYSE:MLI) represents a compelling opportunity to short a secularly challenged pandemic beneficiary that in our view is significantly overearning and faces an imminent deterioration in market structure, a resurgence in competitive imports from East Asia, and cyclically-declining demand, amplified by excess distributor inventories. We believe a major new source of domestic supply from the company’s largest international competitor, Zhejiang Hailiang Co., Ltd., is entering production in the next several weeks. MLI trades today at roughly 35x pre-pandemic earnings, which reflected a much more benign competitive environment than the one currently emerging. We believe a realistic underwriting of the likely path forward yields fair value 37%-59% below current within 12 months.

Company overview:

• Mueller is a manufacturer of copper tubes and fittings for the plumbing and HVAC end-markets (reported within the Piping Systems segment; 69% of revenues and 79% of EBITDA before eliminations), brass rods & forgings for industrial OEMs (reported within the Industrial Metals segment; 17% of revenues and 10% of EBITDA), and residential HVAC components (mostly flex duct, reported within the Climate segment; 15% of revenues and 20% of EBITDA).

• The company derives 75% of revenues from the US, 12% from Canada and 9% from EMEA, with small contributions from Asia and Mexico. Plumbing accounts for 48% of revenues, HVAC is 25%, refrigeration is 11%, industrial manufacturing is 7% and transportation equipment is 6%. In total, building construction is 84% of sales, and this further breaks down into 44% new residential construction, 46% commercial, and 10% remodels. Based on our research, we believe that many of the projects Mueller classifies as commercial are residential-adjacent, like strip centers, schools, hospitals and convenience stores constructed in tandem with housing developments. Mueller sells 70% of its building construction products into distributors like Ferguson plc (NYSE:FERG), 22% direct to HVAC or industrial equipment OEMs, and 8% via retail distribution (sold through big box retailers like The Home Depot).

• Within MLI’s primary end-market of plumbing tube sold through distribution, the company competes against Cerro Flow Products, a subsidiary of Berkshire Hathaway Inc., and Cambridge-Lee Industries, a subsidiary of Mexican industrial conglomerate Industrias Unidas, S.A. There is also some competition from East Asian imports of copper tube, manufactured by players such as Zhejiang Hailiang Co., Ltd. and Golden Dragon Group. While we have not found great market share data on the North American copper tube market for plumbing applications, we believe MLI currently has 50%+ share, Cerro Flow has ~20-25%, Cambridge-Lee has <10% and the remainder is imports.

• The company operates 29 manufacturing sites around the world, 19 in the US, 4 in Canada, and 2 in Mexico, with 1 each in the UK, Bahrain, China and South Korea.

• Copper tube and brass forgings are typically sold on a spread or processing fee above the value of the copper/metallic inputs used in production. Thus, a critical KPI for the business is the change in selling prices relative to the change in copper commodity prices, usually given by the COMEX spot price. 

Mueller is exposed to declining end demand, with cyclical and secular pressures mounting:

• Demand for MLI’s two major products, (1) copper tubes and fittings for plumbing end-uses and (2) brass forgings for industrial end-uses, has faced years of secular pressures. 

• Confronted by a dwindling supply of new labor in the plumbing trades, contractors have increasing opted for cross-linked polyethylene-based tubes, or PEX, which offer significant savings in both material cost (we estimate 40-50% savings) and installation times relative to copper tube. The transition from copper to PEX can be seen in MLI’s organic volumes within the Piping Systems segment:

Source: Company filings

• The company has noted for many years in its annual filings: “For plumbing systems, plastics are the primary substitute product; these products represent an increasing share of consumption.”

• Brass forgings have likewise declined for years, as competitive products produced overseas have replaced high-cost domestic production. This headwind is even more pronounced than that seen in the Piping Systems segment, and appears in the Industrial Metals reported results:

Source: Company filings

• As MLI puts it in the company’s 10-K: “In recent years, brass rod consumption in the U.S. has declined due to the outsourcing of many manufactured products to offshore regions.”

• While we believe MLI’s strategy of consolidating the US market in these declining applications is making the best of a bad situation, and they do occupy low-cost positions among domestic producers of copper tube and brass forgings, in reality they are a high-cost producer once international suppliers and PEX suppliers are accounted for. We do not believe MLI’s core copper tubing market is disappearing – especially in commercial and multifamily applications, where water pressure requirements are higher, copper tubes perform better than PEX and certain local building codes specify copper, but on the margin we believe there is substantial scope for PEX to further erode MLI’s position over time. Our research has suggested some contractors using PEX for commercial projects, a fairly new phenomenon as this material was once used exclusively for single-family residential.

• We believe these underlying challenges to demand mean that in a normal building construction market, MLI volumes should be negative, and that the company should undergrow the market by an even wider margin during times of cyclical weakness, as contractors seek to protect margins by saving on materials and installation costs.

• On this last point, we note the worrisome trend in US single-family housing starts and permits; as of November 2022, the run-rate starts SAAR implies a 19% decline in activity in 2023 (vs. YTD ’22 SAAR), or a 27% decline vs. 2021 levels, impacting 37% of MLI consolidated sales. Since many of the projects classified by the company as commercial are residential-adjacent projects planned alongside new housing developments, we believe an even larger portion of sales will shortly experience volume headwinds.

• Our discussions with distributors of copper tube products suggest that distributors (in aggregate, this channel is 59% of MLI sales) have benefitted significantly from the run-up in copper prices since mid-2020, since distributors capture a margin by buying at a lower COMEX-linked price and then selling at a higher price. In booming markets and with this margin opportunity to capture, we believe distributors were placing orders further out and stockpiling as much product as they could find. Today, copper prices have stabilized and demand has weakened, and distributors find themselves over-inventoried, with a real risk of selling at a loss if COMEX holds current levels. The likely result is distributor destocking on top of the decline in underlying demand. As FERG said recently on their December 6 earnings call:

“What we have absolutely done is focus on bringing our inventory levels down, and you saw that in Q1, reducing our inventories by $100 million as we started to see our vendor supply chain constraints improve and product availability improve…But as things have generally improved, we are starting to ensure that we bring our inventory levels down and you should expect that to continue through the year…”

• In fact, we can see these pressures building in the recent reported results of the company, where organic volume growth has worsened sequentially in the past 6 quarters:

Source: Company filings

• Nor is this a question of difficult comparisons driving the deterioration, as the following chart shows (volumes indexed to 2018):

Source: Company filings, our analysis

• The brief press release commentary for 3Q22 (Mueller does not hold public earnings calls) mentioned “reduced volumes due largely to inventory rebalancing, and the impacts of localized recessionary pressures on our international businesses,” but then noted that the company “ended the quarter with many of our businesses operating at capacity and with healthy backlogs.” How MLI’s volumes can be declining by -10% Y-o-Y and -14% over four years while they are simultaneously operating at capacity is unclear to us.

Mueller is over-earning:

• Given the steady spread-based nature of MLI’s business, gross margins have historically been stable. In the five years before the pandemic, gross margins in the Piping Systems segment averaged 13.6%, fluctuating between a low of 12.5% and a high of 14.8%. Over the same period, total company gross margins averaged 15.0%, with a low of 13.8% and a high of 16.3%.

• As expected, MLI’s reported selling prices have tracked closely to COMEX prices over time, reflecting stable spreads:

Source: Company filings, Bloomberg

• However, beginning in 2020, things began to change. Amidst the initial wave of lockdowns in spring and early summer of 2020, manufacturers pulled back on production, trans-Pacific supply chains snarled, and employee absenteeism climbed. Mueller’s sales volumes fell 16.9% in 2Q20. Thus supply was reaching multiyear lows when an unanticipated surge in demand for housing occurred in the second half of 2020, followed by sharp inflation in copper and other commodity prices at the start of 2021.

• The combination of lower supply levels and growing demand resulted in MLI spreads widening vs. copper input pricing. Note that MLI Piping Systems segment pricing has outperformed COMEX for the past five quarters, including by 1,500bps in 2Q22 and 1,900bps in 3Q22.

Source: Company filings, Bloomberg

• During the same period, gross margins spiked from the historical 14-16% range to the high 20s:

Source: Company filings

• The impact to MLI earnings was even more dramatic as operating leverage compounded the topline and gross margin benefits:

Source: Company filings

• One might expect MLI to benefit from a rising COMEX price, since a constant percentage mark-up on a higher underlying input cost should result in higher dollar profits. But this relationship is not present in the historical financial performance of the business; prior to 2020, the largest improvement in gross margin of the past decade occurred in 2016, when COMEX was down Y-o-Y. The following year, COMEX rose nearly 20% but gross margin and gross profit dollars declined. Likewise in 2019, when COMEX fell 7%, gross profit dollars and gross margin expanded (although aided somewhat by M&A). So the sharp increase in dollar earnings and gross margin percentage since 1H20 does not seem to owe much to the rise in copper prices, but rather to MLI taking advantage of a tight market to raise its selling prices independently of copper prices. Going forward, to the extent copper prices have buoyed earnings, at spot the COMEX price is -18% in 4Q and -17% in 1Q23, and -6% in 2023.

• We believe this idea is not a call on the direction of copper prices, since (1) recent quarters show 1,500-1,900bps of Mueller pricing outperformance vs. the copper spot price, (2) historical gross profit dollars display no consistent relationship to COMEX prices, and (3) this is a spread business where the supply and demand for copper tube should ultimately determine the spread MLI is able to command from customers, not the supply and demand for copper cathode.

Source: Company filings, Bloomberg

• All of this adds up to an interesting setup for a short: MLI is a commodity-exposed manufacturer in a secularly- and cyclically-declining end-market, earning more per quarter today than they did in any single year prior to the pandemic, with clear signs of normalization in demand already present. But this background is not even the most interesting thing about the idea, in our view.

A new low-cost entrant threatens the cozy market structure within the North American copper tube industry:

• For years, MLI has lobbied the US trade authorities to block low-cost imports of copper tube from entering the market. In 2008, Chinese and Mexican imports threatened to price MLI out of the market, then anti-dumping duties were imposed in November of 2010 and import volumes slumped by 50%. Around 2015, Chinese manufacturers began setting up export capacity in Vietnam, which quickly became the single largest source of imports of copper tube into the US. In August of 2021, more anti-dumping duties were imposed, this time on Vietnamese exports, which in turn fell nearly to zero. The lost Vietnamese volumes seem to have shifted to Thailand, which has rapidly become a leading origin market in the US customs data.

• The two charts below show the dollar value imports of copper tube into the US in percentage share and total customs value, respectively. Note that the light gray represents China, periwinkle represents Mexico, mustard brown represents Vietnam, and dark gray represents Thailand. In the lower table, we see a rebound in imports during 2021 and 2022 to decade-highs, of which about half is volume and half is pricing – evidence of increased competitive pressure for MLI, we believe.

Source: USA Trade / Census.gov

• Our research suggests that China-based Zhejiang Hailiang Co. Ltd, the world’s largest producer of copper tube, has been the leading antagonist in this unfolding series of events. Hailiang was the only firm named in the complaints for both the China and Vietnam enforcement actions. 

• Excerpt from Department of Commerce Antidumping Duty Order, August 2021:

Source: Federalregister.gov

• Excerpt from Department of Commerce Antidumping Duty Order, November 2010:

Source: Federalregister.gov

• As Mueller plays whack-a-mole to stamp out competition from imports via federal government intervention, a more formidable threat has recently emerged in the form of a new site built by Hailiang in Sealy, TX, a small town about 50 miles inland on I-10 from Houston. 

  • https://www.chinaconstruction.us/project/hailiang-texas-copper-tubing-facility/

  • https://www.cgccusa.org/en/successful-completion-of-the-foundation-of-the-hailiang-texas-copper-manufacturing-plant-was-celebrated-during-recent-ceremony/

Source: LinkedIn

Source: Indeed.com

• While online resources on the Sealy plant are sparse, we have built conviction in the timelines and scale of the effort. We believe this copper tube site consists of three phases, each adding 30,000 tons of annual production capacity, with the first slated for initial start-up by the end of 2022 or in January of 2023, and the second by year-end 2023. To put this into perspective, we believe Mueller currently ships something like 250mm lbs of copper products per year, and the US copper tubing market for plumbing is roughly 400mm lbs per year. So by our estimate, the 120mm lbs of supply Hailiang is in the process of ramping up will expand domestic supply by 30% over roughly two years, even as demand should be shrinking.

• As mentioned, Hailiang is the leading player globally, and based on MLI’s history of attempting to bar them from the domestic market, we infer that they pose a significant competitive threat. We believe Hailiang’s new plant will be a low-cost facility, with a focus on both distributors for plumbing applications and also OEMs for HVAC and industrial applications. While Hailiang has continued to import copper tube, first from China, then Vietnam, and currently from Thailand, we believe the magnitude of the new domestic capacity additions, the better supply availability and order lead-times from being situated in the US, and the lack of ocean freight costs in Hailiang’s domestic supply chain will all mark a turning point for Mueller’s copper tube businesses.

• As Hailiang’s salesforce looks to sell the new capacity from their Sealy plant, we believe the company will need to offer discounted pricing to gain traction against incumbents such as MLI, pressuring industry margins.

A normalized earnings scenario suggests ample downside to fair value: 

• As remarkable as it may sound given the market’s widely-held view of a recession in 2023, this housing-focused commodity supplier has seen its shares rise by 5% in 2022, outperforming the market by 2,400bps at the time of writing. Why is this?

• We believe Mueller is not well covered or understood by brokers or investors; Bloomberg picks up only one set of estimates, and the broker in question does not appear to model an explicit COMEX assumption, or results by reporting segment, or the components of growth (i.e., price vs. volume vs. acquisitions). As such, the “consensus” for MLI in our view inadequately accounts for the headwinds facing each portion of the business and projects earnings going forward that are 3.5x higher than anything the company ever reported before the pandemic. We have turned up no evidence of structural improvement in MLI’s operations or the market structure since 2019, and this improvement would have to be dramatic indeed to underpin such a rosy forecast. While MLI does screen cheaply on current earnings (5.4x trailing EPS), earnings were already softening sequentially in 3Q22 and have quite a way to fall.

• We believe that in normal midcycle operating conditions, the company should achieve its historical algorithm – declining shipment volumes, steady 15-16% gross margins, and earnings between $1.50 and $2.00, consistent with the results achieved in the five years before the outbreak of COVID-19. At the mid-point of this range, $1.75 of earnings, MLI trades at 35.1x today, a valuation level that we feel dramatically overstates business quality and future cash flow outlook. This scenario is our mid-case forecast.

• However, we believe that we are not dealing with normal midcycle operating conditions. We believe the demand for MLI’s products is declining sharply as the US economy slips into recession, while a new competitor threatens to disrupt the sleepy (erstwhile federally-protected) oligopoly in which MLI operates. We see Hailiang as the catalyst for a structural short case that will erode MLI’s earnings power over multiple years. If Hailiang ramps up the first two phases of its Sealy plant as expected, MLI stands to lose 10%+ of its copper tube volumes on top of the ongoing losses to PEX substitution. The impact on selling prices should be even more significant than the lost volumes, since MLI will now have a low-cost competitor fixated on market share. In this scenario, we believe MLI will earn substantially less than the company achieved before the pandemic – we assume gross margins at the low end of historical ranges and fixed cost deleverage that lands EPS at $0.75 by 2024.

Scenario 1: normalized mid-case earnings:

Scenario 2: structural bear case results in permanent margin erosion for Mueller:

We assume fair value of 13x ex-cash ’24 P/E for MLI, which we believe is generous for a declining industrial asset with elevated earnings volatility. The result is 37% expected downside from current in the normalized earnings scenario and 59% expected downside in the structural bear case.

Catalyst

Earnings results

Company commentary on Hailiang / competition