Tuesday, March 29, 2016

Opening the Spigot

The dire condition of drinking water systems in the U.S. has been made glaringly apparent with the recent debacle in Flint, Michigan that has left numerous citizens in the community suffering from chronic health conditions as a result of contaminated water.  We had no further than our own coverage group to find a company that could help solve problems the drinking water system.  Mueller Water Products (MWA:  NYSE) is a supplier of water meters, pipe fittings, valves, pipe repair components, and fire hydrants.  Mueller’s Echologics leak detection solution gives water utilities details on water infrastructure operation would seem to make Mueller a go-to resource for water system owners, since early leak detection could save millions in wasted capital spending.

In the post “Water Works” on March 22nd we looked at data from the American Society of Civil Engineers (ASCE) and the U.S. Environmental Protection Agency that reveal the high cost of replacing and improving the drinking water infrastructure.  Even at the current sluggish pace of water system repair of about 5,000 miles per year, the repair portion of the U.S. water infrastructure market value is near $5 billion.  The Freedonia Group reports that world demand for water infrastructure equipment for both repair and expansion is expected to increase 6.5% to $101.7 billion in 2016.  The growth is boosted in part by expansion of water supply lines in developing countries.  Demand in developed countries is primarily for repair and upgrade of existing pipes and connections.

Mueller Water Products
No matter how it is measured water infrastructure is a large market with numerous competitors offering, in many product categories, highly commoditized components.  Strong brand recognition and a well entrenched sales network have helped Mueller win and retain market share.  The company goes head to head with the likes of Tyco International (TYC:  NSYE) with its well-developed fire and water division.  While both McWane, Inc. and American Cast Iron Pipe Company are private companies and provide limited financial information to the public, it is clear that both are significant players in the business of pipes and values.  McWane revealed sales of $1.7 billion in 2014, and American is through to be near $500 million in annual sales. 

Mueller reported $1.15 billion in total sales in the twelve months ending December 2015, representing a top-line decrease of 1.7%.  The total sales performance figure is somewhat misleading in as much as Mueller sells its pipe components and values into the oil and gas industry as well as to water system owners.  With the price of crude oil and the entire petrochemical chain at record low prices, shipments to oil and gas customers have been down.  However, sales of the couplings, valves and hydrants used in the domestic water systems have been robust.  In the most recent financial report for the quarter ending December 2015, Mueller management reported 9.2% year-over-year growth in the domestic water segment. 

In deciding whether MWA is to be your play in the water infrastructure market, sales is only one element.  In a highly competitive market, a profitable operating structure can deliver strong earnings even if sales growth remains sluggish.  Mueller delivered $57.3 million in net income on $1.15 million in total sales in the last reported twelve months ending December 2015.  Reported net income represented a net profit margin of 4.9% compared to 4.7% in the year-end fiscal year ending September 2014.  Thus while Mueller has struggled to keep its top-line up in the wake of lost business with its oil and gas customers, a lean operating structure has helped drive more profits to the bottom line. 

The cash flow from operations echoes the Mueller profit story.  In the most recently reported twelve months ending December 2015, 10.2% of sales were converted to operating cash flow.  This compares to an average of 10.1% in the previous three fiscal years.  The strong cash generation has enabled investments, debt reduction, as well as a consistent dividend payment. 

Crystal Equity Research has a buy rating on MWA because we like companies that move quickly and decisively to protect profits even when sales growth is challenged.  Mueller management has defended its share in the water infrastructure market and even more zealously guarded its profits.

Investors have only been willing to pay 16.8 times projected earnings for MWA in recent trading, which is slightly above the anticipated five-year earnings growth  rate (12.5%) for the company plus dividend yield (0.84%) that total 13.3.  Mueller has few direct peers for sake of comparison.  For perspective the broader industrial equipment and components market of which the company is a part, trades at 15.5 times forward earnings multiple.  Interestingly, the utilities sector, which includes the public water system owners that bear the risk of dated and deadly water infrastructure, is trading at a higher 17.3 times forward earnings. 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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