Description

Overview:

Mueller Water Products, Inc. (“Mueller,” “MWA,” or “the Company”) is an under the radar and misunderstood pure play water infrastructure company trading at a nearly 50% discount to peers. The water industry is an attractive business and Mueller has an extremely strong competitive position with the #1 or #2 market position in its key product categories. In our view, Mueller will be the beneficiary of several multi-decade tailwinds including the increasing failure rates of public water infrastructure (water main breaks, etc.) due to an aging water infrastructure and the ongoing digitization of water infrastructure, which is likely to accelerate in a post-pandemic environment due to municipalities’ increased desire/need to monitor their assets remotely. In addition to significant long term growth drivers, Mueller should be aided in the near/intermediate term by the potential for increased federal spending associated with water infrastructure projects (spending on water projects is a key component of the proposed federal stimulus) and residential construction, which is experiencing strong growth following 10+ years of residential housing underbuilding in the wake of the Great Recession. 

Company Description and Background:

Mueller is a leading manufacturer and marketer of products and services used to transmit, distribute, and measure water in North America. We see Mueller as well positioned in this attractive industry (repair and replacement comprise ~two thirds of its net sales), with more than 75% of its net sales generated from products that hold the #1 or #2 market share position in their respective categories. During FY 2020, MWA generated $964 million in net sales: $886 million (or 92%) from its Infrastructure segment (hydrants, valves, etc.) and $79 million (or 8%) from its Technologies segment (digital meters, pipe assessment and leak detection products, etc.).

Mueller was founded in 1857 in Decatur, Illinois, by Hieronymus Mueller, a German immigrant who built a career as an inventor and entrepreneur. During the Company‘s early years, Mr. Mueller and his sons created a number of products ranging from sporting goods to faucets and obtained over 500 patents for their various inventions. They eventually began focusing on water distribution products, having invented water pressure regulators, the first sanitary drinking fountain, and a method for “hot tapping” pressurized water and gas lines using a machine that remains the industry standard to this day with only slight modifications. 

Mueller has been shaped by a number of acquisitions since its founding. In 1933, Mueller acquired Columbia Iron Works, which produced fire hydrants and large gate valves, and by 1955 it changed the Columbia name to Mueller. In 1996, Mueller, then a subsidiary of Tyco International, acquired Henry Pratt (valves, valve actuators, and control systems) and the James Jones Company (fire hydrants and valves). In 2001, the Company acquired Hydro Gate (sluice gate valve manufacturer), which it followed with the 2003 acquisition of Milliken Valve, a plug manufacturer. 

The business that constitutes Mueller has changed hands a number of times over the past ~30 years. In 1998, industrial conglomerate Tyco paid $350 million for Mueller Company, making Tyco a leading player in flow control products. In 1999, DLJ‘s merchant banking unit acquired portions of Tyco‘s flow control division, including the Mueller Company, Grinnell Supply Sales, Grinnell Manufacturing, and Henry Pratt Company, from Tyco for $938 million. Under the auspices of DLJ, Mueller took a number of actions to increase its manufacturing capacity, reduce operating costs, enhance operating efficiencies, and boost overall profitability. Seeking an exit from its investment, DLJ considered several monetization events for its Mueller stake and even considered taking the Company public, filing an S-1 for the business in 2004. However, Walter Industries emerged as an acquirer in 2005, paying $1.9 billion for Mueller, which then consisted of the Mueller and Anvil divisions. These businesses were combined with Walter Industries‘ existing U.S. Pipe operations to form Mueller Water Products. In May 2006, Walter Industries completed a partial IPO (~25% stake) for the Mueller business at $16 per share and then distributed the remaining Mueller shares to its existing Walter Industries shareholders in December 2006. 

Why Does This Opportunity Exist?:

Significant capital investment: Mueller is currently in the midst of a heavy capital investment cycle intended to drive growth and improve profitability. Mueller arguably underinvested in its business in the first ~10 years after its 2006 IPO as it was primarily focused on delevering, paying down more than $1 billion in debt. Under the leadership of MWA’s CEO Scott Hall who joined the Company in 2017 from Textron, the Company has pivoted from debt pay down to improving profitability by upgrading its facilities that will enable the Company to consolidate its manufacturing footprint, improve its market position in a key valve category (where it currently has the #2 market position) and realize other efficiencies. The modernization is expected to generate an incremental $30 million annual gross profit improvement from both revenue and cost synergies by ~FY 2023. However, the upgrade is not without its costs and capex has been elevated in recent years.  Following the modernization initiative, capex is expected to decline to less than 4% of sales (vs. ~7% in FY 2021) when its new brass foundry in Decatur, IL is completed in ~FY 2022/FY 2023

Unprofitable technologies segment: Mueller has been investing heavily within its Technologies segment to develop products that utilities can use to monitor their systems. MWA’s fledgling Sentryx platform (SaaS revenue component) is a promising new platform with significant growth potential that enables utilities to monitor their entire water infrastructure. Mueller’s tech investments have masked its true level of profitability, with ~$67 million in cumulative segment operating losses over the past 4 fiscal years (FY 2017-FY 2020). However, with the segment on the cusp of sustained profitability, MWA should experience improved free cash flow generation. Although COVID-19 is pressuring MWA’s digital businesses in the near term (through an inability to install meters at customers’ homes), the pandemic could accelerate future digital adoption, as water utilities will likely desire to have greater resilience against future shocks (so that remote monitoring capabilities, etc., are in greater demand). 

Misunderstood: Shortly after its 2006 IPO, the residential construction market accounted for ~50% of Mueller’s business. In addition to its residential construction exposure, Mueller had exposure to a number of other cyclical end markets (oil and gas, etc.). However, following the 2012 divestitures including U.S. Pipe (2012: Non residential construction) and Anvil (2017: oil and gas, among others) coupled with the acquisition of Singer Valve (2017: automatic control valves for the water industry) and Krausz (2018: repair tools for the water industry) Mueller has narrowed its focus on the water industry while retaining a less cyclical and more profitable business. 

Overlooked: Mueller is not included in any of the major S&P indices. However, we see no rationale for the exclusion and believe that the prospect for inclusion could enable the Company to attract a wider investor base and therefore the potential to garner a higher multiple, closing the valuation gap with its peers. 

Pensions and tax overhangs: Mueller has successfully resolved meaningful tax and pension issues in recent years, which previously served as a significant overhang for the shares. It’s possible that the resolution of these items is still not appreciated by investors. 

Competitive Advantages:

Strong brands and large and growing installed base: Mueller is the most recognized brand in the North American water infrastructure market. As already noted, Mueller boasts the #1 or #2 market share position in all its key product categories. The Company has also built a leading install base of its products, with many of its brands having 100 years of history or more. The Company‘s 2006 S-1 filing stated that over 3 million fire hydrants and 9 million iron gate valves bore one of the company‘s brand names, and we suspect that industry penetration has risen even higher since the IPO (~15 years ago) due to the Company‘s leading market share. The following statement from Mueller‘s 10-K filing helps reinforce the importance of the Company‘s install base: “Most municipalities have approved a limited number of fire hydrant brands for installation within their systems due to their desires to use the same tools and operating instructions across their systems and to minimize inventories of spare parts.” Accordingly, it is extremely difficult for a new entrant to make inroads in this mature industry, and brand recognition is very important: customers are very slow to transition to brands other than their historically preferred brand. As a result of these dynamics, and the favorable industry landscape (discussed later) Mueller enjoys good pricing power with its utility customers. 

Advanced/low-cost manufacturing: During the early 2000s, Mueller invested heavily in its manufacturing, seeking to become the industry‘s low-cost provider. Between 2000 and 2002 Mueller invested $124 million to implement low-cost manufacturing technologies, including the lost foam casting process used to manufacture its hydrants and many other products. In addition to the favorable cost benefits (reduced need for machining operations), this process also offers favorable performance attributes (production of high-quality products) and environmental attributes (reduced water usage and energy usage, etc.). Notably, MWA is the only company in the industry with lost foam technology capabilities. 

Customer relationships and product specifications: MWA boasts long-term relationships with its key customers. A number of these relationships have been in existence for a very long time. For example, New York City has used the Company‘s products for over 150 years, and cities such as Boston and Chicago have been using them for over 100 years. A key factor in sustaining these long-term customer relationships is product specifications. It generally takes 1 year to receive product specifications from a municipality, though in some cases securing customer approval for a particular product has taken more than 5 years. With 50,000 water utilities and more than 14,000 wastewater utilities in the U.S. and Canada, the approval process is a cumbersome one that any new entrant would find daunting. Although a 1-year approval period is clearly not an insurmountable barrier to entry, the existing players, which have already received their product specifications and have a large installed base, enjoy certain benefits. During a 2018 investor conference, MWA CFO Marietta Zakas stated that once a municipality adopts a product, “they‘ll tend to replace it with like for like.” MWA‘s most recent 10-K filing notes that Mueller‘s iron gate valve or fire hydrant products are specified for use in the 100 largest metropolitan areas in the United States. During FY 2019, the Company‘s valves and hydrant products represented ~80% of the Company‘s FY 2019 sales. 

Key Investment Considerations:

Favorable competitive landscape: Mueller’s infrastructure segment operates in an industry whose favorable competitive landscape offers several long-term tailwinds. The oligopoly composition of the water infrastructure market in which MWA competes has resulted in a rational pricing environment and has enabled MWA to command good pricing power and generate strong margins (FY 2020 Adj. EBITDA margin: 19.8%). Mueller has a large install base (over 3 million hydrants and 9 million gate valves), and its customers, a number of which have been using MWA’s products for over 100 years, are unlikely to switch manufacturers after products are installed, lest doing so require new tools and spare parts. In addition to the moat established from its large install base, the nature of the Company’s products (bulky, heavy, etc.) helps to insulate it from foreign competition. 

Aging water Infrastructure: In the U.S., more than 2 trillion gallons of treated water is lost annually, for reasons ranging from leaks to water main breaks. The average age of water pipes in the U.S. has increased to 45 years in 2020, up from 25 years in 1970. According to a study by the American Water Works Association, restoring the existing water systems and expanding them to serve a growing population through 2050 will require a $1.7 trillion investment. We believe that Mueller will be a beneficiary of this potential industry spending given its strong competitive position.The prospect for approval of a federal stimulus to address the industry’s problems could also provide a nice tailwind for the Company although this would not be something that should be counted on for an immediate financial impact (delay in deploying funds to states, etc.).

Increasing failure rates: Water infrastructure spending is typically not a discretionary item, especially if the infrastructure fails or is unable to deliver safe, clean drinking water to a municipality‘s consumers. The number of failures per 100 miles of infrastructure has increased by 27%, from 11 breaks per 100 miles in 2014 to 14 breaks per 100 miles in 2018. Perhaps more troubling, the breakage rates of cast iron and asbestos cement pipe, which constitute 41% of the installed water mains in the U.S. and Canada, have increased by more than 40% over the 2012-2018 time frame. The average ages of a failing water main (~50 years) and of the water infrastructure (45 years) suggest that failures will continue to increase going forward.

Residential housing growth: In the wake of the housing crisis, new construction has not kept up with demand. According to Realtor.com, just 5.9 million single-family homes were built between 2012 and 2019, well below the 9.8 million household formations over that time frame. Such underbuilding, coupled with record low interest rates, has created significant pent-up demand for housing, which should drive strong levels of new construction going forward (more housing communities, more hydrants, valves, etc.). According to a recent report by the National Association of Realtors, new home construction in the past 20 years was 5.5 million units below long-term historic levels. The low current housing inventory reinforces the view of the significant underbuilding. At the end of May 2021, there was just a 2.5 month supply of homes on the market (at current sales pace), well below the typical 6-9 months supply. 

Digitization of water infrastructure: We believe the ongoing digitization of the water utility industry will accelerate in the wake of the pandemic and Mueller is uniquely positioned to capitalize on this trend. Mueller has been investing heavily within its technology segment to develop products that utilities can use to monitor their systems. MWA’s fledgling Sentryx platform (SaaS revenue component) is a promising new platform with significant growth potential that enables utilities to monitor their entire water infrastructure. Mueller noted recently that it continues to convert existing customers to its Sentryx software platform, which is expected to facilitate additional digital sales to existing customers. Although COVID-19 is pressuring MWA’s digital businesses in the near term (through an inability to install meters at customers’ homes), the pandemic could accelerate future digital adoption, as water utilities will likely desire to have greater resilience against future shocks. A 2019 report by industry researcher Bluefield Research projected that the digital water market will increase at a 6.5% annual rate between 2019 and 2030. However, Bluefield noted in April 2020 that COVID-19 will likely pull forward the digital transition by ~2-3 years (despite some near-term pressure on digital revenues as a result of the pandemic, such as delay in installing/adopting meters that require access to consumers‘ homes), resulting in annual growth rate of 8.7% through 2030, compared with its prior projection of 6.5% growth. Although MWA’s cost structure has benefited from lower travel related expenses, trade shows and the like remain a key component of the sales process for Mueller, especially for digital technologies, as it provides an opportunity for water utilities to network with each, which ultimately tends to spur adoption of new technologies. Accordingly, the reopening of economies, and increased business travel that will likely occour as the pandemic fades, should have a favorable impact on future results. 

Strong balance sheet and cash flow generating abilities: MWA boasts an extremely strong balance sheet, with leverage (net debt/Adj. EBITDA) of just 1.1x and no L-T debt maturities until 2026. Since its 2006 IPO, MWA has paid down over $1 billion in debt—a testament to MWA’s strong cash flow generating abilities. MWA has recently addressed two significant overhangs on its shares, including pension and tax liabilities. Its improved financial position has also given it the flexibility to pursue acquisitions, invest in the manufacturing capabilities needed to drive future growth, and return value to shareholders. MWA’s FY 2020 results were not immune to the pandemic but held up well, with FY 2020 net sales and adj. EBITDA declining by just 0.4% and 3.8%, respectively. (In 3Q FY 2020 net sales and adj. EBITDA were down 17% and 33%, respectively.) However, in November 2020 after a better than expected 4Q FY 2020 and a strong FY 2021 outlook for sales and adjusted EBITDA (net sales expected to be between flat and up 3% with adjusted EBITDA forecast to increase between 4% and 7%), MWA reinstated its share buyback program ($145 million outstanding) on the heels of a 5% dividend increase (yield: 1.6%) announced in October 2020. It should be noted that MWA has increased its FY 2021 outlook twice since initially communicating it in November 2021 with consolidated net sales now expected to increase by 8-10% and adjusted EBITDA to be up 9-12%. Although MWA has not repurchased any shares through the first six months of FY 2021, we would not be surprised to see MWA begin to repurchases shares aggressively and/or continue increasing its dividend, especially as the pandemic wanes.  

Valuation:

At current levels, Mueller trades at ~12x trailing EBITDA, which is on par with recent precedent industry transactions, which have occurred at an average of 11.2x on an EV/EBITDA basis. However, MWA trades at a large discount to publicly traded peers, which sell for over 20x. It should be noted that Mueller’s trailing EBITDA represents somewhat of a depressed level as it includes pandemic related weakness. It should also be noted that Mueller‘s EBITDA margins (~20%) are in line with the average of its publicly traded peers‘. 

Risks and Mitigants:

State and Local Government Pressures: The prospect for lower tax receipts and local water revenue could have an impact on the project-related portion of the municipal market (~10% of MWA's net sales). However, the strength of the residential housing market is expected to more than offset the pressure in the project portion of the market. Longer term, municipal water spending budgets are expected to increase meaningfully. During MWA’s 2Q FY 2021 earnings call, Mueller CEO Scott Hall stated, “But I still think in front of us the same thing I've been saying for the last three or four years is that budgets by necessity will have to increase. I think we'll have some timing bumps over the next 5 to 10-year horizon. But water infrastructure, wastewater, wastewater infrastructure, storm water and storm water management and retention of storm water all are going to face 100 basis points, 150 basis points, 200 basis points better than GDP spending into the foreseeable future to kind of fix the mass we created. And so, I think you'll see a dip in the near-term, but in the 5 to 10-year windows – 5 and 10-year windows, budgets have to increase in all three of those.”

Unfavorable/large acquisition: Although the risk that MWA completes a pricey acquisition is possible, we note that management appears very disciplined in their approach to acquisitions. In 2018, Mueller CEO Scott Hall noted to industry publication Global Water Intelligence, “We‘ve seen some pretty crazy valuations in the technology space, but as a responsible player in the market, we‘re not just going to pay any multiple that somebody dreams up. You would have to believe in some fairly healthy adoption rates in what has been a traditionally slow-moving industry—as well as low interest rates for a very long time—to justify those sorts of valuations.” Subsequent to the end of 2Q FY 2021, MWA announced a small $20 million acquisition to bolster its digital capabilities. Although the multiple paid can’t be determined at this point, the acquired business looks complementary (pressure management solutions) to the Company’s portfolio and expands MWA’s digital monitoring capabilities. 

Distributor concentration: Mueller derives a large percentage of its sales from its top distributors. In fact, the Company’s two largest distributors accounted for 35% of the Infrastructure segment gross sales in FY 2020. Although Mueller does not have long term contracts with its distributors, it has long term relationships with its partners spanning multiple decades. It’s also worth noting that the distributors have an interest in maintaining a relationship with Mueller in order to participate in future growth opportunities, especially in digital products. For example, Mueller recently worked with its top distributor Ferguson in securing a multi-year contract for an advanced metering infrastructure product. 

Commodity Inflation: Mueller is currently dealing with commodity price inflation. However, the Company has recently implemented price increases across a majority of its products that are expected to more than offset the impact of inflation and aid margins.

Catalyst

• Capital investments to modernize manufacturing facilities are expected to produce both revenue and cost synergies and drive improved profitability

• Continued residential housing growth due to several years of underbuilding

• Potential for the optimization of the Company’s underlevered balance sheet via outsized share repurchases and/or increased dividends

• Reduced capital expenditures following modernization initiatives

• Improvement within the Company’s Technologies segment due to the prospect for an acceleration of the digitization of the water infrastructure industry

• Potential inclusion in an S&P index could help attract a wider investor base and narrow the valuation disconnect with peers.