Mueller Water Products (NYSE: MWA) is one of the largest manufacturers serving the water distribution market primarily in the United States. The company generates revenue through two key segments:
- Water Management Solutions (WMS) — The manufacturing and subsequent sale of fire hydrants is the largest component of this segment. However, MWA also offers follow-on repair and installation services for their hydrant products, as well as optional leak detection and pressure control tools. This segment accounted for 43% of FY22 revenue.
- Water Flow Solutions (WFS) — MWA also manufactures and sells iron gate and brass valves that are used in the distribution and transmission of water across cities and into buildings. This is their largest segment, accounting for 57% of FY22 revenue.
The company has had a long history dating back to 2005, when it was founded through a rollup of three smaller businesses. Since then, Mueller has expanded to serve customers around the world, even though its core business is still located in the US. US sales accounted for around 90% of FY22 revenue, followed by Canada (7%) and then other countries such as Israel and the United Kingdom accounting for the remaining 3%.
Customer Profile and Concentration Risk
As a water infrastructure company, MWA’s core customer base consists of national and regional waterworks distributors in the US. While there is objectively some customer concentration risk as the two largest customers account for ~40% of total revenue, the nature of this industry does mitigate effects of this risk. Specifically, the greater creditworthiness of these customers due to the predictability of future cash flows given the nature of waterworks industry is also attractive, and it consequently offers greater stability for Mueller’s top line as well.
Furthermore, the unique nature of Mueller’s hydrant products has made it such that the company’s largest customers will also be the most reliant on its maintenance services; as a result, MWA’s largest customers are less likely to churn than its smallest customers.
It may be difficult to mitigate this risk further in the near term. However, as new construction activity increases again, likely as a result of falling rates, waterworks companies will universally need valves, grates and hydrant products, presenting an opportunity to capture market share. However, in the current environment with stagnant and high interest rates, construction activity is expected to remain more muted, thereby limiting the number of opportunities available to Mueller to expand within the market.
Segment Overview
While the company’s segments may seem similar at first, their differing operational performance has led to headaches within the company and a lower valuation relative to peers.
MWA’s operational struggles are a direct result of poor inventory management and management’s inability to adapt to rapidly changing customer demand. Backlog is a natural result of their operations as waterworks customers traditionally have large order quantities; as end market demand increases and fluctuates, so will backlog. This backlog also usually gets resolved within two years as inventory gets shipped out.
As of June 2023, the company reported that raw material costs for scrap steel and brass products had increased 40% and 20% respectively. Under a FIFO inventory system, it is expected that inventory on hand will be bloated in the near term as a result. This is reflected in their efficiency ratios, with inventory turnover falling from 4.3x to 3.3x within the last two years and inventory days outstanding increasing by nearly 15% and 30% over the last one and two years respectively.
However, the backlog in inventory for the company seems to be concentrated in brass products. This is in large part due to their US-based brass product foundries as customer demand for brass valves has increased across the industry over time. MWA has responded by trying to build a new foundry, although construction has been slower than expected with supply chain issues and employee training on new equipment taking longer than expected. At the current pace, the new foundry is expected to be operational within two years, at which point the brass inventory backlog would have resolved itself already.
Management did acknowledge poor judgement with regards to the new foundry construction as competitors have opted to add melt and mold functionality to their old foundries, allowing them to respond quicker and have fewer non-productive labor hours which, unsurprisingly, has led MWA to have lower operating margins (10–15%) than peers (15–20%). In summary, the construction of the new foundry has been a disaster for the company and significantly limited margin expansion for MWA’s largest segment.
The company does not report sell through rates but say they have fallen for the segment; I believe that this further corroborates the conclusion above; the company is holding on to an unnecessarily large quantity of raw materials (brass specifically) without any way to process and manufacture brass valves fast enough.
Interestingly, despite these operational issues, the WFS segment still has a stronger FCF profile than the WMS segment. Gross profit margins for WFS are slightly higher than WMS (30% versus 28%) due to slightly better pricing as some of valves and grates need to be custom-made.
Ultimately, these operational issues have affected the valuation of the company, presenting an attractive entry price. Uncertainty regarding the reduction of brass valve inventory has led to shares trading at a discount.
The market is large and mature, with the WFS and WMS segments operating in $13bn and $3bn markets respectively. The industry is closely linked to construction activity, with 65% of revenue coming from municipal water infrastructure spending and the rest largely coming from new residential construction activity. There are some minor disruptions resulting from the transition from manually read to electronically read pressure meters and the company has tried to mitigate this risk by acquiring smaller players in the space. However, given the fact that these meters are often integrated into existing water infrastructure such as hydrants, incumbents with a large existing network of hydrants and pipelines have a large advantage in the industry. Future inorganic growth will likely be concentrated in this area.
Recent Developments
Historical acquisitions have had a negligible impact on shifting the company’s operational strategy. For reference, Mueller’s most recent acquisition of I2O Water, a pressure and leak detection software provider, was an all-cash deal for ~$20mm. The deal closed over 3 years ago.
While the company’s existing capital structure would be replaced following a leveraged buyout, I still wanted to highlight the lack of maturity and liquidity issues. This would allow a sponsor to acquire a minority stake instead and not refinance existing debt. There are no significant maturities before 2029, when $450mm of senior notes come due. The existing cash on hand of ~$140mm and EBITDA of ~$120mm offer a runway that is more than long enough.
Management has been somewhat proactive with regards to managing the company’s capital structure and returning value to shareholders; for example, they took advantage of lower rates and called $450mm of 5.5% senior notes early in 2021 following the issuance of $450mm of 4.0% senior notes. In a mature industry where WACC (10.5%) > ROIC (6.5%), focusing on returning value to investors and shareholders in particular is appropriate. However, it seems as if management has been inactive following the refinancing of these notes. The company has poured extra investment into WFS segment growth through foundry construction along with acquisitions and organic expansion in the pressure and leak detection space. This seems to be at odds with their stagnant 50% dividend payout ratio over the last 5 years. In my opinion, the company has no real need to retain so much cash and have such a high retention ratio with no liquidity or maturity issues in the foreseeable future. The water infrastructure industry is also relatively mature and not very volatile either, so maintaining such a high cash balance as a buffer for cash flow volatility seems unnecessary as well. The company has a 3.6x current ratio, compared to an industry average of 2.0x, further supporting the argument.
Financial Summary
Company
Revenue: $1.11bn (2021), $1.25bn (2022) >>> 12% change
Gross Profit Margin: 32% (2021), 29% (2022)
Adj. EBITDA: $211.8mm (2021), $197.0mm (2022) >>> -7% change
Adj. EBITDA Margin: 19% (2021), 16% (2022)
Water Flow Solutions Segment
Segment Revenue: $617.8mm (2021), $714.1mm (2022) >>> 16% change
Gross Profit Margin: 33% (2021), 30% (2022)
Water Management Solutions Segment
Segment Revenue: $493.2mm (2021), $533.3mm (2022) >>> 8% change
Gross Profit Margin: 32% (2021), 28% (2022)
Investment Thesis and Value Creation Opportunities
The company operates in an industry with a high barrier to entry. Municipalities limit the number of approved fire hydrant manufacturers, which ultimately prevents a mass influx of new entrants into the industry. For example, New York City has only approved two fire hydrant models and manufacturers, who will then get repeat business from the city through regular maintenance. Municipalities are also unlikely to increase approval rates in order to minimize their inventory of spare parts. As each hydrant will have different operating instructions, installation processes and spare parts, there is little reason for municipalities to increase the number of suppliers. In the meantime, incumbents in the industry such as Mueller will benefit through this razor / razorblade model. The existing dominance that Mueller has will further be strengthened by the fact that the company operates in a low innovation product category.
Some part of the company’s recent struggles can be attributed to poor management as well. With the CEO stepping down this past month with no permanent replacement announced, the search for new leadership will continue to worry investors. Bringing a sponsor with industry expertise and a team of operational advisors can rightsize operations and increase stability within the organization in the meantime. With large private equity firms such as Apollo and KKR having entered the water infrastructure industry through investments in Celeros Flow Technology and Northumbrian Water respectively, it is evident that many will have the capabilities to bring on new and experienced leadership quickly.
Download the Excel attachment for the constructed LBO analysis here.
The model reflects a few different scenarios. First, if the business is acquired at a 15% premium and sold after 5 years at the same exit multiple (13.7x EV/EBITDA), a sponsor can still achieve a ~26% IRR and 3.2x MoM on the back of decreasing net working capital driven by a reduction in brass inventory backlog. Additionally, gross profit margins for the segment will likely return to pre-pandemic levels as a result of COGS reducing over time, further driving EBITDA growth.
However, the company can also mitigate the risk that the exit multiple may fluctuate significantly over the next five years through the divestiture of the WMS segment. The maturity of the segment and predictability of its cash flows may allow for a sale of the segment at an attractive valuation. Furthermore, MWA trades at around 13.2x EV/EBITDA today but the discount is driven by inventory and operational issues in the WFS segment. A sale of the WMS segment at a higher multiple (e.g. 15.5x) could allow the company to receive cash and reduce its debt load significantly early in the holding period. Given that competitors trade at around 15.2x EV/EBITDA today, a 15.5x sale multiple for the WMS segment is not unreasonable either.
By reducing the debt load following the sale of the segment, the sponsor can dividend out all extra cash flows until it resolves the operational issues by reducing the brass inventory backlog. If raw material prices were to stabilize in the coming years, then the company may still be able to sell the WFS segment at a 13.7x multiple, fetching a 25% IRR and 3.0x MoM. If the sponsor is unable to resolve these issues and the multiple for the segment were to fall further to 11.5x, a 21% IRR and 2.5x MoM can still be achieved. An 11.5x multiple for the WFS is very unlikely however, especially if the segment is sold to a strategic acquirer at exit. Aside from training employees on new equipment, a strategic acquirer would already have a dedicated foundry for brass valves or would have refitted its old foundries. As a result, they would not have the same operational issues as Mueller and could afford to pay a higher multiple for the segment.
The option of pursuing an early divestiture of the WMS segment will likely reduce the investment IRR. This is because the WFS segment has worse EBITDA margins, so a higher exit multiple after 5 years will not increase the final EV as much. However, if the turnaround of the WFS segment was to occur quickly and WFS segment operating margins improve faster than expected, then the IRR could be higher than the scenario where the entire business is sold at a 13.7x multiple after 5 years.
Ultimately, Mueller Water Products could be an attractive investment for most large sponsors, given that there are value creation levers through operational fixes (leadership, foundry issues etc.) as well as financial engineering (WMS segment divestiture) that may allow for a high IRR. Despite recent operational struggles, the company still operates in an attractive industry, sells a product that is difficult to replicate, generates stable and predictable free cash flow and is priced at an attractive multiple today.
