Description
Walter Industries Revisited
Walter Industries (NYSE: WLT) is an undervalued conglomerate that is taking steps to realize full value under the urgings of a number of activist shareholders. This idea was written up by jazz678 in January, and he gave an excellent analysis of the Company at that time, in particular his overview of the coal opportunity. That said, a lot has happened with the Company since then, and the current stock price does not reflect (1) the level of certainty that has materialized in Walter’s metallurgical coal business with regards to pricing for 2006 and 2007 and (2) the value that has been created in the water business through the acquisition of Mueller Water Products. The main driver of value realization will come once people become focused on what a great business the water business is and the true value of the M&A synergies created through the combination of Mueller with WLT’s heritage U.S. Pipe business. Most people who look at this stock spend all of their time trying to figure out the value of the coal assets, or think that a large part of WLT’s operations are still in homebuilding (which was true in the 90s, but not currently). Walter’s water business will be spun-off next year, and we think the Water assets will garner a strong valuation in the equity markets given the attractiveness of its long-term market opportunity, resulting in a minimum of 30+% returns for WLT shareholders from the current stock price of $50.
The New Water Business (Mueller Water Products)
This summer, Walter merged its U.S. Pipe business with Mueller Water Products to create the largest pure-play supplier of water transmission products in the United States. Mueller Water Products, previously Tyco’s flow control business was purchased out of Tyco by DLJ Merchant Banking in August 1999. Since, Mueller made a number of acquisitions and capital investments in the Company and was sold to Walter for approximately 8.25x EBITDA. The strategic rationale for this transaction pertained to the combination of Walter’s U.S. Pipe business (involved in the manufacture of water and waste water transmission pipe) with Mueller (involved in end-of-line water infrastructure products including fire hydrants and iron gate valves). The combined entity is well-positioned to capitalize on a strong water infrastructure market over the next several years by providing a complete end-to-end product solution. Mueller also operates a Piping Systems business that is driven by non-residential construction projects that include HVAC systems, and fire protection applications including sprinkler systems.
The water infrastructure in America is in major disrepair. Some water systems in the Northeast are over 100 years old, with some even currently utilizing wood pipes. Our country’s water infrastructure has been the subject of numerous news articles and increasing government concern. Our extensive research with industry and government consultants, water municipalities, and public water utilities confirms this thesis. The numbers vary, but it is safe to say that hundreds of billions of dollars will be spent upgrading and maintaining the water infrastructure over the next few decades in America. Walter’s Mueller / U.S. pipe division will greatly benefit from this long-term trend of refurbishment and upgrade as it will provide virtually every aspect of the water system from the front end of the system to the home and back to the waste treatment facility. As a result of its market leading position in most of the products it sells, the combined Water business will have greater than GDP growth and will generate over 20% EBITDA margins in its infrastructure business with minimal capex and significant free cash flow generation.
WLT recently brought in a new CEO, Greg Hyland, who ran part of the Mueller business before Tyco purchased it in 1989. While at Tyco in the 90’s, Hyland ran other parts of what is now Mueller. His history with Mueller led him to accept the CEO position at Walter. Hyland is an accomplished executive in the sector and is very bullish on the macro outlook and significant cost saving opportunities within the combined Company.
Walter has already publicly opined on $25-$35 million in synergies from the Mueller acquisition, which has been admitted by management as being low due to the inability to fully understand the cost synergy opportunity before the transaction was closed. In 2006, we conservatively estimate that Mueller will generate EBITDA of over $300 million and EPS of at least $1.50, which does not take into account the pay down from the IPO proceeds ranging from $200-400MM (which management has stated it intends to do) of currently expensive debt (10-14%) at the Mueller level. Given the continued growth and compelling synergy opportunities within the combined Company, Mueller should generate EBITDA of at least $350 million (including reasonable synergy assumptions and growth), and EPS of over $1.75 in 2007. We think this business deserves at least an IPO transaction multiple of 8.5x EBITDA (most likely 9.0x +) or 15X FCF and should be worth at least $25 per WLT share and potentially as much as $35 per share once management files the S-1 with more detail regarding transaction-related synergies. Comparable companies and transactions to look at include Badger Meter, Northwest Pipe, Ameron International, Watts Water Tech, Flowserve and Home Depot’s acquisition of National Water Works (Mueller distributor done at 10x EBITDA) and 3M’s acquisition of Cuno (20x EBITDA). Given Mueller’s dominance as a supplier of water infrastructure products, it is likely the company will expand into other segments of the water industry including metering and filtration which will serve as a logical add-on to Mueller’s already vast installed base of product.
Natural Resource Update
Walter’s high quality metallurgical coal product and its reliability of delivery, given its dedicated rail and barge access to the port of Mobile, allows Walter (Jim Walter Resources) to sell its product at a premium (generally $7-10 more per ton) to its Central Appalachian and international competitors to customers that are primarily located in Latin America, Europe and the Middle East. Our extensive research and analysis that included recent conversations with international coal traders and coal industry executives leads us to believe that pricing for Walter’s metallurgical coal product will continue remain robust into 2006 (triple digit levels per ton) and 2007. Insiders are anticipating met coal contracts this year to be struck between $115-125 per metric ton (which translates into $104 to $113 per short ton (Walter’s metric). Last year, WLT contracted product at $107/short ton. In addition to selling coal, WLT sells approximately 8MBTUs of natural gas generated from its mines at a relatively low cost (approx $3.50/MCF)
The reason for continued high pricing for met coal is a function of continued increases in steel production worldwide (up approximately 8% this year) and current supply constraints in North America and Australia. In North America, two prominent met coal miners Fording and Alpha Natural Resources cited supply issues pertaining to lack of tires for mining equipment (Fording) and a lack of skilled labor in Central Appalachia and eastern rail and port congestion (Alpha). In Australia, metallurgical coal shipments are severely constrained by rail issues and congestion at the port of Queensland. Australia has some of the richest deposits of metallurgical coal in the world and miners are trying to develop the infrastructure as quickly as possible to support such demand. That said, timing issues related to this infrastructure development (port and rail expansion), in addition to difficult labor laws in Australia, make such an endeavor a drawn out task (2 to 3 years, minimum). The aforementioned factors have created the perfect storm for Walter’s met coal product for the foreseeable future.
Walter will greatly benefit from this demand and supply imbalance that currently exists in the metallurgical coal market. Currently 40% of WLT’s coal is contracted through July 2006 at $107 with the remainder contracted under a variety of different prices lower than $107. From 2006-2007, all of Walters expected 7MM+ tons of coal are up for re-pricing (including high $30s coal contracted a few years ago with the Alabama utility that will roll off this year). We feel if Walter contracts its coal anywhere north of $85 / short ton (which we think is extremely probable), the stock will go up. Considering the high quality (high vol) of Walter’s coal and its reliability to port, we feel that Walter will contract product at least at $95-100 per ton. From a cost perspective, Walter enjoys some of the lowest costs in the industry at approximately $38-40 per ton.
For 2006, we estimate Walter’s natural resources EBITDA to be approximately $380 million, with EPS of at least $4.00 (assuming $100 / ton coal and 8MBTUs of Nat Gas sold at $9 a unit). Based on ascribing a healthy discount to multiples of comparable companies (ranging from 4.5x for unreliable producers to 10.0x for Peabody), of 6.5x EBITDA or 9x EPS gives us a range of coal value around $36 to $42 per Walter share. If Walter strikes contracts in excess of where it did last year, this value could be significantly higher ($50+), not even considering the fact that the Company’s 20 years of proven reserves (with another 20 years adjacent) and 7.8MM tons of 2006 production (trending up to 9MM in 2009) would be an attractive acquisition target for an international or central / northern app producer that wanted to further diversify its product mix and geographic exposure.
Valuation
Considering $25-35 for the value of the water business and our $36-40 value of the coal business, we think WLT is worth somewhere between $61-75 / share. This value assumes no value for the homebuilding/financial assets, which have a book value of $5/share. Analyst estimates 2006 EPS, which are scant and published by regional security houses, of $6.65 per share for the combined Company, based on more aggressive coal market assumptions than ours, but more consistent with current market fundamentals. Our target price for the stock equals only 10x 2006 EPS and is very conservative. Longer-term we think the value could be as much as $85 and think the pipe business has tremendous growth prospects. At the current price of $50 there is basically no downside and there are several clear near-term catalysts to provide return of 30%+ within the next year.
Spin-off and Value Realization
Conglomerates usually trade at a discount, as is the case with WLT. In May, Pirate Capital filed an activist 13-D, pushing for the Company to break up the Company and attempt to realize the full value for shareholders. After a few rounds of exchanges, WLT has made substantial progress along this path. The Company has recently announced it will IPO 20% of the water business in 1Q 2006. The S-1 will be filed after January 1, and we believe this will provide a strong catalyst for value of the stock. Walter will spin off the remaining shares of the water business to shareholders in a tax-free manner. Walter has also engaged Morgan Stanley and Bank of America to explore all strategic alternatives for its coal business and real estate assets. We believe that these endeavors will create substantial shareholder value in 2006.
Catalysts
-Filing of form 10 in January should highlight the fact that the Company’s initial estimate of synergies from the Mueller acquisition was too conservative.
-Announcements of international settlement pricing for met coal contracts within the next month. When calculating, divide by 1.1 and add a few dollars for WLT premium.
-Completion of the IPO and spin-off of the water business forces people to focus and understand the value of it. Also since the spin-off transaction involves a partial IPO, some reputable analysts will pick up coverage.
-Final results of evaluation of strategic alternatives for Coal and Homebuilding divisions might result in sale of these businesses and further value creation.
Catalyst
-Filing of form 10 in January should highlight the fact that the Company’s initial estimate of synergies from the Mueller acquisition was too conservative.
-Announcements of international settlement pricing for met coal contracts within the next month. When calculating, divide by 1.1 and add a few dollars for WLT premium.
-Completion of the IPO and spin-off of the water business forces people to focus and understand the value of it. Also since the spin-off transaction involves a partial IPO, some reputable analysts will pick up coverage.
-Final results of evaluation of strategic alternatives for Coal and Homebuilding divisions might result in sale of these businesses and further value creation.