Description

Note:  this is a fundamental review and long term idea on Mueller B shares wholly different from the A-B share arbitrage submitted early this month.  The long term investment thesis is based on a steadily growing municipal market for Mueller’s products, and an eventual turnaround in the residential construction business.  Even under stress Mueller generates significant free cash flow.  With rather modest assumptions, free cash flow can easily reach $1.26/share in three years.  At present prices, this is a 6.8x multiple on third year FCF, or a nearly 15% free cash yield.  Downside risk is buffered by the relative stability of the municipal market.

The Company

Mueller Water Products is a leading North American manufacturer and marketer of infrastructure and flow control products for use in water distribution networks and treatment facilities. Its broad product portfolio includes engineered valves, hydrants, pipe fittings and ductile iron pipe, which are used by municipalities, as well as the commercial and residential construction, oil and gas, HVAC and fire protection industries. 

At the end of its fiscal year ’07 (9/30/07), it generated 35% of its revenue from residential construction, 35% from municipal repair and replacement, and 30% from commercial construction. 

Mueller has a #1 market share in 4 out of 5 of the water infrastructure categories it supplies, and is #2 in the 5^th.  ‘Water infrastructure’ is 70% of its business, with commercial construction the balance.

Mueller has completely refinanced its debt to lower interest rate levels, taking a one time 20.3MM net of tax benefit cash charge to accomplish this during Q3 FY ’07.

The Present Issues

Mueller has had a tough last 6 months, but moved proactively to address changes in its end markets.  Aside from falling revenues tied to the contraction in residential construction, Mueller has been moving aggressively to reduce inventory and align manufacturing pace to sales.  In the near term this has actually reduced manufacturing rates below end market consumption, with resulting reduction in overhead absorption flowing into current pieces going into inventory.  In other words, COGS is pushed higher in the short run.  That has eroded EBITDA and operating margins at present, with a 120 bps negative effect in Q4 FY ‘07.  The inventory reduction is essentially done.  While inventory dollar amounts are about flat compared to twelve months ago, the higher unit prices on inventory mean, in fact, there are less units of product on hand.  The tail end margin effects of the inventory reduction process will carry into Q1 FY ’08 (ending 12/31/07) as pieces with higher COGS associated with them are sold.  Margin impacts related to inventory reduction then ease beyond that point.

The other issue is increased raw material costs.  There is some lag between raw material price rises and Mueller product price increases.  Mueller has announced price hikes that will take effect in Q2 FY ’08.  Mueller’s competitors share the same challenges in raw material costs, so they have the same reason to support product price increases.

Mueller is also closing a manufacturing facility for its US Pipe segment in New Jersey, and will take charges on this in the coming quarter.  On a cash basis, there will be a $4MM cash charge, and $3MM of incremental expense in FY ’08.  $12MM in cash expense savings are expected to be realized as a result of the closure during FY ‘08.  The long term annualized cash expense savings is projected to be $15-17MM.  (There is a one time non-cash asset write-down of $15MM.)

Needless to say, Mueller has lowered expectations for the first half of FY ’08.

The Bull Case

So what is the basis to see the long term advantage of an investment in Mueller?

Mueller’s municipal end market has a steadily growing overhang of aging water infrastructure requiring upgrade or replacement.  By 2020, ‘aging’ pipes will make up 46% of water system pipes in the US, double the level in 2000.  Growth in the municipal spending is estimated to be 17% for the year ahead.  Mueller is projecting ~10% revenue growth in its municipal sales, based on its expectation of project mix.  Mueller has a moat in this business, as a supplier has to meet approved ‘specifications’ in each municipality before its products are marketable to that municipality.  This is a time consuming and expensive process.  It took Mueller nearly 6 years to be accepted by New York City for example. Once an installed base is in, it drives future revenue as compatibility and familiarity contain cost for the municipality.

Mueller’s residential construction business follows that market, and we all know it has tanked.  Mueller expects further contraction in these revenues in FY ’08, and expects to lag a housing construction market recovery based on the premise there are developments with water infrastructure in that will be restarted, before new ground is broken.  So, no pie in the sky expectations here on timing, but ultimately the cycle will play out and Mueller’s business here will improve.

EBITDA margin was 16.2% for Q4 FY ’07.  Taking out the inventory reduction effect described above suggests an adjusted margin of 17.4%.  Earlier this year, management suggested in optimum circumstances, 20% margins were achievable, and annual revenue growth could reach 8-10%.  These set the limits on modeling Mueller’s future.

Model Output

A simple model can be built driven on revenue growth rates in each of Mueller’s end markets, and changes in EBITDA margin.  Relatively minor assumptions involve D&A growth, tax rates, and cap ex amounts.  For simplicity, free cash generated is added to cash balances generating a low interest income rate.  Mueller has stated free cash could go to debt reductions, the small dividend, share buybacks, or acquisitions.  The model assumes modest dividend increases (i.e. cash disbursed). Any of the other three uses of cash would most likely be more beneficial than the model’s simple cash retention.

The first year of the model is easy, driven by Mueller’s own conservative guidance.  It results in flat revenue.  Mueller suggests a bottom on EBITDA margins in Q1 FY ’08, with margins ‘better’ in H2 FY ’08 than in H2 FY ’07.  Given the cessation of inventory reduction impacts and savings being generated after the shutdown in New Jersey, I believe that suggests some wide latitude to where margins may move from the 16.4% EBITDA margin rate of H2 FY ’07.  I use an identical 16.8% EBITDA margin rate for FY’08 as was achieved in FY ’07.

In FY ’09, I grow residential revenue 5% from a smaller base, continue a 10% municipal growth rate, and leave commercial flat (as I did in FY ’08).  In FY 10, I ‘recover’ residential by 12%, maintain a municipal growth at 10%, and again leave commercial flat. 

For EBITDA margin, I allow an 18% rate in FY ’09.  (Mueller achieved an 18.1% rate in the TTM ending Q2 FY’07 while still working on cost reduction initiatives.)  For FY ’10, I plugged in a 19% EBITDA rate.

On this basis, 3 years from now, Mueller will have an EBITDA of $400MM.  EV will be $2,800MM on a fairly low 7x EV/EBITDA multiple.  Market Cap is $2,118.  On 116MM fully diluted shares, the implied price is $18.26, or a 113% return over 3 years, or about 29% compounded.

Sensitivity

The key risks here are a failure of residential construction to recover in a 3 year timeframe, a failure of municipal spending to grow, and/or a contraction in commercial construction.

If I assume no revenue growth and no margin expansion above 16.8%, the model produces a $12.21 share price in 3 years, simply because of the steady accumulation of generated free cash.  (This still had the same increasing cap ex and D&A assumptions as the base case run).  Stability pays from a depressed share price.  

If I freeze municipal and residential in FY ’09 and ’10, and contract commercial so overall revenue falls 2% both in FY ’09 and ’10, and reduce the FY ’10 margin to the depressed Q4 FY ’07 rate of 16.2%, the model produces a $10.68 share price on the 7.0x EV/EBITDA multiple, and $9.44 using the present 6.5x multiple based on depressed annualized Q4 FY ’07 EBITDA.

Quite simply, there is a substantial margin of safety in the present share price against any permanent loss of capital, even with poor forward results.  Mueller’s ability to generate free cash even under stress is the driver for this protection.

Upside?  I simply change the base case in FY ’10 to allow an overall 9% revenue increase, and EBITDA margin of 20%, and an 8.0x EV/EBITDA multiple.  The resulting share price is $23.55.

I recommend a long term investment in Mueller Water Products ‘B’ shares based on the above analysis.  Disclosure:  I may buy, sell, or hold these shares at any time.

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