Description

Investment Thesis:

At $3.75, we believe MWA provides a unique risk/reward situation with limited downside (~$2.50) and substantial upside (~$7). Although we do not have a strong view Q/Q on financial performance due to the timing of municipal capital spending, MWA benefits from both cyclical and secular tailwinds of residential/commercial construction and repair/replace water infrastructure, respectively. MWA’s core Mueller Co franchise is remarkably stable with an installed base of >50K municipalities cultivated over 150 years with high switching costs and barriers to entry. There could be further upside potential with better visibility into new residential construction and/or demonstrated organic growth at Valves/Hydrants or Mueller Systems/Echologics.  Please see the file with all charts and tables: http://www.scribd.com/doc/100857929/MWA-Memo-July-18 

• Limited Downside, Estimated ~$2.50 Per Share: MWA traded to ~$2/share in Mar 2009 and Aug/Nov/Dec 2011. Since then, MWA has sold US Pipe (70MM EBITDA losses in last 3 years) for 94MM Net Cash ($0.60/share) and improved estimated trough EBITDA and Free Cash Flow (EBITDA – Cash Interest – Maintenance Capex) to 120MM and 30MM ($0.20/share). 12x trough Free Cash Flow of $0.20/share implies $2.40/share downside. There are no near term debt maturities (7-3/8 in 2017) and ABL availability is currently 275MM.  

• Recent Divestiture of Underperforming US Pipe / Restructure Core / Invest in Growth: now in the 4^th year of their “Lean / Six Sigma” and having completed the divesture of US Pipe, investors can now focus on earnings power and margin expansion at Mueller Co without US Pipe cash burn overhang. From growth in core product lines to new market opportunities in smart metering and pipe condition (which management estimates to be ~20% CAGR business on ~150MM base), MWA can further demonstrate the strength of their in-place franchise and ability to seize new markets.     

Business Overview:

MWA is a leading North American manufacturer and marketer of products and services used in the transmission, distribution, and measurement of drinking water, in water treatment facilities, and residential and commercial construction. MWA estimates ~75% of sales are from #1 market positions in their leading brands with an installed base of 11MM Iron Gate Valves and 3MM Fire Hydrants, and are specified for use in the 100 largest metropolitan areas in the US. Capacity utilization is currently ~50% and there have been no changes to facilities and capacity since peak earnings in FY06 (aside from US Pipe restructurings and divesture).  

• Mueller Co: primarily Valves (65%, of which ~40% of this is related to Mueller Systems and Echologics) and Fire Hydrants (23%), with the remainder consisting of Brass, Henry Pratt (larger custom Valves), and Canada. Mueller Co sells through waterworks distributors and end markets are mainly municipalities and water/wastewater utilities. Established in 1857, MWA commands a #1 position in Valves and Hydrants with an installed base of >50K municipalities. This fragmented customer base has high switching costs and their dedicated sales force of 109 sales reps and 104 inside marketing professionals have cultivated a distribution network and relationships not easily replicated. Over the past 12-18 months, Mueller Co has embarked on a new growth platform into smart metering and pipe condition assessment, which increases efficiency by changing from visual to direct meter reading (improving accuracy for billing) and increasing labor productivity. Management expects this to be a 20% CAGR market opportunity from a 150MM base, and LTM investments in SG&A (sales, engineers, service) have been a ~20MM negative drag on Mueller Co earnings. Management expects this to turn profitable in FY12, which should be a positive 20MM run-rate tailwind comp into FY13.    

• Anvil: primarily Fittings & Couplings (join two pieces of pipe together), with the remainder consisting of Hangers (rigid support for fire protection and HVAC) and Nipples (expand or compress flow between different diameters). Anvil sells to distributors and end markets include commercial and industrial construction, as well as energy drilling applications. Anvil is a top 3 manufacturer with ~17% market share and the competitive advantage is their breadth of product lines (>15K SKUs) as “one-stop provider”, whereas competitors focus on more specific subsets of overall SKUs.

Catalysts & Opportunities:

• Mueller Systems & Water Tech Investments Break-even / Profitable: we expect management to execute on their business plan and turn this sub-segment profitable in 2H12 due to their in-place distribution and relationships. MWA is the #5 player in this market and both Badger Meter (NYSE: BMI) and Itron (NYSE: ITRI) have communicated that municipalities are ramping up their spending on water metering from the 2011 drop-off around the US debt downgrades and municipal budgets. We estimate ~20MM was spent in FY11 on SG&A investments, which should be a positive tailwind of 20MM as MWA comps into FY13, if successful.  

• Water Infrastructure’s Repair & Replace Opportunity + Stronger EPA Regulations + Infrastructure Stimulus: to summarize from MWA presentations citing various sources, there is an accelerating need to repair and replace aging water infrastructure. Specific data points include: drinking water graded D-, 15-30% of potable water lost in leaky pipes, 36 states with projected water shortage, US Infrastructure ranked 16^th globally, and average life of 75-100 year old pipe converging with Valves/Hydrants generally replaced as well.

• Further Bifurcation of Water & Sewage Revenue Bonds and Revenue Bonds Versus General Obligation (GO) Bonds: Investors are rightfully skeptical of municipal budgets and access to capital markets given headlines around San Bernardino, Stockton, Jefferson County, and Harrisburg, among others. Although we do not have specific default data on Revenue Bonds, what matters is that these Revenue Bonds are secured by tolls, rents, and charges supported by real assets and not “the full faith and credit supported by taxing power”. Water & Sewage and Revenue Bonds trade tighter than GO Bonds and have continually proven their ability to access the capital markets. To our knowledge, there have been no instances of municipalities successfully plundering funds designated for Revenue Bonds. Note the 2011 Y/Y declines were primarily attributed to pull-forward effects in 2010 from Build America Bonds.

• Normalized US Housing Starts & Non-Residential Construction: without re-creating data sets and charts on the case for housing starts and commercial construction, we believe normalized (FY14 in Financial Projections) housing starts of 1.2MM and non-residential construction of 650B is reasonable.  

• US Pipe Divesture & De-Leveraging (COMPLETE): on 4/2/12 MWA completed the sale of US Pipe for 94MM Net Cash, which MWA intends for debt repayment on the ABL and 22.5MM Par of the 8-3/4’s (another 22.5MM Callable in Oct 2013) and the 7-3/8’s callable at 104% beginning June 2012. Pro Forma LTM Leverage of 4.5x (568MM PF Net Debt / 125MM Adj EBITDA excluding US Pipe) greatly improves MWA’s credit profile and more importantly, eliminates cash burn on this segment that produced over 70MM EBITDA losses over the last 3 years. Initially through 2009-2010, management was adamant to keep US Pipe as “core” and wait for the US housing turn, and we believe this divesture to be best strategic decision to maximize shareholder value.

Risks:

• Macro & Recession: Residential and Non-Residential Construction Slowdown; Municipal Bond Market Liquidity & Stress à Deferred Maintenance & No Sources of Capital; Municipal Bankruptcies à Stigma & Buyer’s Strike on All Municipal Bonds; Stressed Consumer Push-Back on Rising Water Utility Rates 

• Poor Execution on Mueller Systems & Echologics Investments: while not core to the MWA investment thesis, it would tarnish management’s credibility if they are not successful in new product development given their relationships and core competencies in water infrastructure. We would lower the Price Target by ~$1.00 under such scenario (14MM EBITDA contribution in FY14 x 8 Multiple / 164MM shares plus 30-40MM cash burn). 

• Oil & Gas Drilling Slowdown Due to Lower Priced Commodities: in FY11 Anvil benefitted from increased oil & gas drilling activity in North America and now accounts for ~20% of Net Sales from an insignificant amount in FY10. Management has indicated demand remains strong, though the rate of growth is slowing from easy comps in 2010.

Valuation Method:

• EV / EBITDA: we believe MWA should trade at 8x mid-cycle EBITDA on Mueller Co and 6x mid-cycle EBITDA on Anvil. “Water Infrastructure” related names generally trade ~7-9x EBITDA (IEX, ITRI, WTS, BMI, FLS, XYL), and a return to normalized municipal spending plus growth initiatives will focus investor attention back to the historical stability of Mueller Co. Note that Mueller Co has been successful in passing through pricing increases in 19 of the last 20 years, with the exception being 2010 with Brass/Copper +25% Y/Y and Scrap Steel +15%.     

• Free Cash Flow, P/E: multiples of 12x Free Cash Flow (8% Yield) and 15x EPS are generally within market multiples and MWA historical multiples. 

Financial Projections:

• MWA Assumptions: 

see file 

• Macro Assumptions:

see file 

• Projections:

see file 

Catalyst