Mueller Water: Margins Poised For Rebound As Manufacturing Challenges Fade (NYSE:MWA)

Funding Thesis

Mueller Water (NYSE:MWA) is a high-quality water infrastructure firm with robust moats. The corporate has invested closely in modernizing its amenities, which has led to momentary manufacturing points and decrease margins. EBITDA Margins had been 20% earlier than the initiatives and are actually 15%. As these operational points are resolved, margins ought to return to their pre-investment ranges of roughly 20%, if not larger. The departure of the CEO and the appointment of activist buyers to the board recommend a renewed deal with shareholder worth.

Enterprise

Mueller Water performs a vital function in guaranteeing that water reaches our properties in an environment friendly and uncontaminated method. The corporate’s merchandise are integral parts of the water distribution and measurement methods that span from therapy vegetation to our faucets.

Water utilities are the corporate’s main clients, accounting for 60-65% of its income. These gross sales are characterised by stability and recurrence, as utilities depend on Mueller’s merchandise for vital restore and substitute functions.

Mueller additionally serves the housing and gasoline utility sectors, with gross sales of 25-30% and 10%, respectively. Home markets account for 90% of the corporate’s gross sales, with the remaining 10% generated in Canada.

The corporate stands to learn from years of pent-up demand for water infrastructure upgrades, fueled by a long time of uncared for funding on this vital sector. Mueller’s merchandise contribute considerably to water conservation efforts, serving to to scale back losses because of leaks and guaranteeing that valuable water assets are used responsibly.

Aggressive Benefits

Mueller Water holds a commanding place within the water infrastructure market, occupying the highest or second spot in main product classes comparable to valves and hydrants. The corporate operates in secure oligopolies characterised by unchanging market shares.

Excessive Switching Prices

Mueller’s dominance is bolstered by its huge put in base of over 3 million hearth hydrants and over 10 million iron gate valves, a testomony to its 100-year legacy. This in depth community creates excessive switching prices for municipal clients, who prioritize reliability and security over value concerns.

To streamline upkeep and reduce spare elements stock, many municipalities undertake a restricted variety of authorized manufacturers. As soon as a municipality selects Mueller’s merchandise, it’s extremely more likely to proceed utilizing them, as interim CEO Zakas summed up, “Municipalities have a tendency to exchange like with like.”

Regulatory Hurdles and Economies of Scale

Coming into the water infrastructure trade is additional sophisticated by stringent security rules. Every product requires regulatory approval from the hundreds of water utilities and wastewater therapy amenities throughout the US and Canada. This approval course of can take as much as 5 years, posing a barrier to entry.

Furthermore, the low gross margins within the trade, sometimes hovering round 30%, make it unattractive for brand spanking new entrants. To attain profitability on this enterprise, firms want to attain vital economies of scale. Mueller, with its low-cost manufacturing technique, has established a formidable presence, making it difficult for newcomers to compete.

Why Does This Alternative Exist?

Mueller’s true profitability is being hidden. Manufacturing woes are obscuring the corporate’s true profitability, inflicting buyers to undervalue its inventory. Previous to embarking on main capital investments, Mueller’s EBITDA margins stood at a wholesome 20.4% in 2019. Nonetheless, margins have since plummeted to a disappointing 15.9%, regardless of gross sales growing from $1.0 billion to $1.3 billion.

The basis of those manufacturing points lies of their getting old brass foundry. The foundry is essential for changing uncooked metallic, primarily brass, into castings and elements utilized in Mueller’s ultimate merchandise. Any disruptions on this course of reverberate all through the corporate, resulting in delays, elevated prices, and a decline in profitability.

In 2019, Mueller launched into a $150 million funding plan to deal with years of underinvestment in its amenities. The primary two initiatives – a amenities consolidation and a capability growth – have been largely accomplished. Nonetheless, the third challenge – a brand new brass foundry to exchange the over century-old facility – has been sluggish to completely ramp up.

As demand soared in 2022, Mueller’s previous foundry was pushed to its limits. Getting old gear malfunctions led to manufacturing disruptions, inflicting the foundry to function at lower than half its capability at one level. This resulted in underutilized labor and different fastened value inefficiencies.

To compensate for these manufacturing shortfalls, Mueller turned to buying brass from third events at a premium. This additional eroded their already skinny gross margins, together with the affect of their high-fixed value operations, led to a disproportionate decline in total profitability.

Mueller’s new brass foundry was anticipated to alleviate these manufacturing woes. Nonetheless, its startup has been delayed because of provide chain disruptions and labor availability challenges. Because of this, the preliminary startup was pushed from 2022 to 2023, with the elements approval course of extending into late 2024.

Activist Traders

Mueller’s operational struggles haven’t gone unnoticed. In late 2022, activist personal fairness agency Ancora acquired a stake within the firm, gaining management of two out of ten board seats. This shift in energy culminated within the CEO’s dismissal in August 2023, marking a turning level for Mueller.

Nonetheless missing a everlasting CEO and with the current appointment of an skilled mergers and acquisitions banker to the board, there may be hypothesis that the corporate could also be on the market if operational enhancements stay elusive.

Catalyst

As soon as Mueller’s manufacturing points are resolved, they’re well-positioned to regain their former profitability and entice the next valuation.

To make clear, the corporate’s manufacturing points usually are not structural however slightly momentary challenges associated to its development trajectory. As soon as the brand new foundry is totally operational, it should considerably improve profitability by eliminating the necessity for outsourced brass, decreasing time beyond regulation hours, and permitting for the closure of the previous, much less environment friendly facility.

The brand new brass foundry started preliminary manufacturing in early 2023, however as anticipated, it should take a while to succeed in full capability. This phased strategy is critical for high quality assurance, as every half produced undergoes rigorous testing and approval procedures. Initially, the main target is on producing the highest-volume brass parts to maximise effectivity and price financial savings.

Encouragingly, the corporate demonstrated progress of their most up-to-date quarter, attaining a big growth of gross margins by over 540 foundation factors to 31.4%. And so they achieved this regardless of headwinds from decrease volumes because of broad weak point of their finish markets.

The brand new foundry is predicted to succeed in full capability by the top of fiscal 2024, upon which the corporate can shut down its previous foundry. It will remove the redundant prices related to working two foundries concurrently. Administration anticipates returning to pre-investment ranges in 2025.

Valuation

Mueller Water’s present valuation seems undervalued, buying and selling at solely 12x its 2023 fiscal yr EBITDA. Given the corporate’s place within the secure and rising water infrastructure trade, the next valuation appears warranted.

Assuming Mueller Water can return to its pre-investment margins of 20.4% and keep its present income degree of $1.3 billion, it might generate roughly $265 million in EBITDA. At a barely larger valuation a number of of 13x, this might translate to a inventory value of $20, representing a big upside potential from the present value of ~$14.

These conservative assumptions are based mostly on the expectation of no income development and a return to pre-investment revenue margins. Nonetheless, there may be vital potential for upside as Mueller Water is more likely to expertise income development and margin growth sooner or later. Moreover, the corporate’s nearest publicly traded peer, Xylem, trades at 20x EBITDA, additional reinforcing the potential for the next valuation for Mueller Water.

With the vast majority of its capital expenditures behind it, the corporate is poised for a big improve in free money movement. Capex is predicted to say no from 7% of income to 4% over the following few years. It will result in cumulative free money movement over the following decade that is the same as 84% of the corporate’s present market capitalization. This extra money movement will likely be used for share buybacks and dividends, theoretically permitting the corporate to repurchase as much as 84% of its shares excellent over the following decade based mostly on the present valuation. My estimates right here embrace income development of 4.4% and margins in the end reaching 25%.

Infrastructure Optionality

In November 2021, america Congress handed a historic $1 trillion infrastructure invoice, allocating $55 billion particularly for bettering clear ingesting water infrastructure. Whereas the invoice’s passage marked a big milestone, its implementation has been slower than anticipated because of bureaucratic processes. Nonetheless, current developments point out that the funding is lastly beginning to movement, and a considerable acceleration is predicted by the top of 2024. This favorable backdrop of elevated funding is poised to gasoline Mueller’s development and growth within the coming years.

“Poised to learn from the elevated federal infrastructure funding past fiscal 2024” says CEO Zakas on their most up-to-date earnings name.

Dangers

Mueller’s reliance on the cyclical housing trade exposes its income to fluctuations in rates of interest. Housing, at the moment dealing with a downturn, could possibly be additional extended if mortgage charges stay elevated.

Volatility in uncooked materials prices, significantly brass and metal, may erode margins. In intervals of risky commodity costs, Mueller might not be capable to move on larger materials prices to clients, as seen in the course of the Trump tariffs of 2018 and the current inflation surge. Nonetheless, this can be a momentary phenomenon till pricing can totally regulate to prices.

Buyer focus poses a big threat. Two main distributors account for a 3rd of Mueller’s gross sales. With roughly 50,000 utility clients unfold throughout the nation, Mueller depends closely on its distributors’ in depth attain to attach with them.

Conclusion

Mueller Water, a well-established water infrastructure firm with aggressive benefits, is undervalued because of transitory operational headwinds. The corporate has demonstrated promising indicators of restoration and is ready to reclaim its pre-investment profitability. As margins normalize and capital expenditures diminish, Mueller is poised to generate substantial free money movement, which ought to gasoline a valuation reassessment. The corporate’s attractiveness is additional enhanced by activist engagement on the board and the upcoming movement of federal infrastructure funding, making a compelling state of affairs for vital upside potential.