A 12%-15% riskless arb opportunity exists due to the price discrepancy between Mueller Water Company’s Series A shares (MWA) and Series B shares (MWA.B). The trade is to be long the Series B shares and short the Series A shares.  The two shares classes are identical except with respect to voting rights- Series A shares receive one vote, while Series B shares receive 8 votes.  Despite the increased voting rights and having 3x the shares outstanding (89 million Series B shares O/S vs 28 million Series A shares O/S), the Series B shares typically trade at a 12%-15% discount to the Series A shares.  The primary cause of the mis-pricing was the addition of the Series A shares to the Russell 2000 in June 2007, thereby creating buying pressure from index-tracking funds.  Catalysts are the collapsing of the dual classes into a single class structure, which we expect to occur in Q1 2009, or the replacement of the Series A shares in the Russell 2000 with the Series B shares given their superior liquidity and voting power.  Disclaimer- we may be long/short either security and sell/cover at any time, and recommend investors perform their own due diligence.

 

Mueller Water Products (Revenues: $1.9 Bln ttm, Market Cap: $1.5 Bln) manufactures water infrastructure and flow control products for use in water distribution networks, water and wastewater treatment facilities, and gas distribution and piping systems in the United States and Canada. It has three segments: Mueller (hydrants and valves), U.S. Pipe (ductile iron pipe), and Anvil (fittings and couplings).  Walter Industries acquired a then-private Mueller Water in October 2005, and combined it with Walter’s U.S. Pipe segment.  Walter spun out the combined company via IPO in May 2006.  Prior to the IPO, only one class of common stock existed, all of which is held by Walter Industries. Shortly before completion of the IPO, Walter Industries completed a recapitalization creating two series of common stock-  Series A common stock and Series B common stock- to preserve the tax free nature of an eventual spin-off of the Series B shares to Walter shareholders.  Shares of Series A common stock and shares of Series B common stock have identical rights in all material respects, except for voting.  Series A common stock has one vote per share, while Series B common stock has eight votes per share.

 

In the May 2006 IPO, Walter Industries sold all 28.8 million Series A shares to the public at $16.00, representing approximately 25% of the company.  The Series A shares began trading on the NYSE under the symbol MWA.  Walter Industries continued to hold all 85.9 million Series B shares outstanding.  In December 2006, Walter distributed all 85.9 million Series B shares it held in the form of a pro rata common stock dividend to Walter Industries’ shareholders. The Series B shares began trading on the NYSE under the symbol MWA.B.

 

Despite having 8x the voting rights and 3x as many shares outstanding, the Series B shares have historically traded at a discount to the Series A shares.  From the time of the Series B distribution in December 2006 until the end of May 2007, the spread between the two Series was minor, typically staying under 5%.  We believe this was due primarily to retail investors who were unaware of the existence of the Series B shares.   The company received significant coverage in the retail investing press as a means to gain exposure to water infrastructure industry, and nearly every article cited the ticker as MWA.    The spread grew to 12%-15% in June 2007 due, in our opinion, to speculation that the Series A shares would be added to the Russell 2000 at the end of June, which ultimately did occur.  The spread has remained in the range of 12%-18% (it stands at 12% today) as index-tracking created buying pressure on the Series B shares.

 

The catalyst is a collapsing of the dual share class into a single share class.  Unfortunately, shareholders do not have the right to convert into the other Series, nor is the company obligated to complete a conversion.  Approval of such conversion will require the affirmative vote of the holders of a majority of the shares of both the Series A common stock and Series B common stock, voting together as a single class, with each share entitled to one vote for such purpose.   There are several reasons we believe a conversion will be initiated:

-    Reduce investor confusion: The company readily acknowledges the confusion caused by its dual share class structure, saying that it is the #1 investor relations question they receive.  They told us directly they would like to eliminate it, and want investors to focus on the business, not the discrepancy in share prices. Furthermore, a single class of stock would be inherently more stable given the volatility caused by the large short interest in the Series A stock.

-    Motivated shareholders: There are 89 million Series B shares vs 28 million Series A shares.  Obtaining the necessary majority approval (remember- the two Series vote as a single class) shouldn’t be a problem since the Series B shareholders stand to benefit from a conversion.

-     Reduce administrative costs: we estimate that collapsing into a single Series would save the company upwards of $250,000 by eliminating NYSE listing fees, Transfer Agent fees, Registrar fees, etc.  The company is focused on cost-cutting given the weakened demand for its products stemming from reduced new housing starts.

 

We expect the company to collapse the dual structure into a single class during Q1 2009.  Management told us they have examined the precedent established by other firms which have collapsed dual share classes which is to wait at least 26 months until after the spin-off before doing so to minimize the risk of jeopardizing the tax-free status of the spin-off.  Walter completed the spin-off on 12/14/2006, so the company is unlikely to collapse the dual share structure prior to February 2009 unless they obtain an acceptable legal opinion.  

 

The issue is a perennial thorn in management’s side, and it is our distinct impression that they would like to make it go away.  Again, it is the #1 question the company receives from investors.  We recognize that the lack of definite date makes estimating the annualized return difficult, but investors should take comfort from the absence of downside risk. 

 

Another potential catalyst is the replacing of the Series A shares in the Russell 2000 with the Series B shares, given their superior liquidity and voting rights, although this is highly unlikely to occur prior to the June 2008 rebalance, if at all.

 

-     The company is not obligated to collapse the structure.  It is certainly possible that the company decides to focus on operational priorities and delays the conversion beyond Q1 2009.

-     Short interest in the Series A shares is approximately 50%.  This raises the risk of a squeeze, which has occurred for very brief periods of time over the past several months.  But if you can stomach temporary volatility, the arb should ultimately succeed as the company will collapse the dual Series structure.

-     Given the high short interest, the Series A is hard to borrow, and the rebate stands at -5% today, reducing the ultimate return.