MWA - Mueller Water: A Cybersecurity Incident Is Not Ideal But Appears Cheap

2023-11-08 07:57:47 ET

Summary

• Mueller Water Products recently experienced a cybersecurity incident, causing a delay in the release of its financial statements.
• The incident may be creating downward pressure on the stock price, potentially making it undervalued.
• The company's restructuring efforts, optimization of the Sentryx platform, and new distribution agreements could contribute to future growth.

Mueller Water Products, Inc. (MWA) recently found itself fighting a cybersecurity incident, which is making investors wait a bit longer for new financials. As a result, lower demand for the stock may be creating downward pressure on the stock price. Given recent restructuring announcements, further optimization of the Sentryx platform, and new distribution agreements in Canada or outside the United States, MWA could be trading undervalued right now.

Mueller Water Products, And The Recent Cybersecurity Incident

Mueller Water Products manufactures and sells products for the management, measurement, transmission, and distribution of water. Its products are mainly used by municipalities for the management of water flows in residential and non-residential housing constructions. At present, the company maintains relationships with the municipalities of more than 100 high-population urban centers in the country, but also in Canada and the rest of the world.

The organization of its business is given in two reportable segments, solutions for water management and solutions for water flows. The income they represent for the company is close to 50% for each segment, without major differences in that sense. The first of these segments includes the marketing of the aforementioned iron valves and other types of valves as well as other products made from various metals. The water flow solutions segment includes, in addition to hydrant products, repair and installation, leak detection, pressure control, and measurement and control software among others.

With that about the business model, it is worth noting that Mueller recently reported a cybersecurity incident , which disrupted the IT systems, and impacted the ability to end 2023 financial statements. With this in mind, management provided a few financial figures so that investors could make some assumptions about the valuation of the company.

2023 net sales are expected to be around $1.2 billion with EBITDA close to $197-$203 million. Additionally, debt outstanding was close to $447 million with cash of around $160 million. Given that we have new information about net sales forecasts and net debt, I believe that we can run a DCF model about Mueller.

Debt Analysis

I studied a bit the credit agreements reached by Mueller to understand how the company finances its operations as well as to assess the WACC in my DCF model. Management reported 5.5% senior unsecured notes, 4% senior notes, and a loan related to the LIBOR. With these numbers, I believe that the cost of capital could be larger than 6% in the future.

On June 12, 2018, we privately issued $450.0 million of 5.5% Senior Unsecured Notes, which were set to mature in 2026 and bore interest at 5.5%, paid semi-annually.

An indenture securing the 4.0% Senior Notes ("Indenture") contains customary covenants and events of default, including covenants that limit our ability to incur certain debt and liens. We believe we were in compliance with these covenants at September 30, 2022. Borrowings under the ABL bear interest at a floating rate equal to the London Inter Bank Offered Rate ("LIBOR") plus an applicable margin range of 200 to 225 basis points, or a base rate, as defined in the ABL, plus an applicable margin of 100 to 125 basis points. At September 30, 2022, the applicable margin was 200 basis points for LIBOR-based loans and 100 basis points for base rate loans. Source: 10-k

More Products And Optimization Of The Sentryx Platform Will Most Likely Bring Net Sales Growth

Under my DCF model, I assumed that the company will likely continue the acceleration in the development of new products and their launch to the market as well as the optimization of the Sentryx platform, completely owned by the company, which serves to manage flows, compare statistics, and record operations for each client. More information about clients and more products will most likely bring net sales growth.

Modernization, Capex, And New Technologies Could Also Bring Further FCF Growth

I also expect further allocation of large portions of investment towards the modernization of its productive capacities, the construction of new facilities, and maintaining an active procurement strategy for the integration of new technologies. Given previous expenditures in capital expenditures, I also assumed that new capex can be expected.

Mueller Is Also Conducting Reorganization To Reduce Severance And Certain Transaction-related Expenses, Which May Bring FCF Margin Growth In The Coming Years

In the last quarterly report, Mueller noted certain strategic reorganization initiatives that I believe could bring FCF growth in the coming years. The management appears to have selected certain closures in Aurora, Illinois, and Surrey, British Columbia, Canada. In my view, if the company makes the right decisions, we may see income statement improvements in 2024.

Strategic reorganization and other charges in the three months ended June 30, 2023 was $3.9 million which primarily consisted of severance and certain transaction-related expenses. Strategic reorganization and other charges for the three months ended June 30, 2022 was $0.6 million, which primarily consisted of costs associated with the closures of our facilities in Aurora, Illinois and Surrey, British Columbia, Canada. Source: 10-Q

Further Development Of Relationships With New Water Distributors Could Bring Further Net Sales Growth

Another key point is to develop relationships with the main water distributors in new markets. In this regard, we must add that Mueller's activities are not limited to the United States, but are also present in Canadian territory. With know-how accumulated in the United States, I believe that the company may also be profitable elsewhere.

I Assumed That The Quarterly Dividend And Share Repurchases Could Bring Demand For The Stock

I believe that the company ended fiscal 2023 with a strong balance sheet and liquidity. In the last 10-Q, the company reported a current ratio larger than 1x and an asset/liability ratio close to 2x.

With the previous figures in mind, I believe that management is in a position to deliver dividend increases and stock repurchases.

On July 26, 2023, our Board of Directors declared a dividend of $0.061 per share on our common stock, payable on or about August 21, 2023 to stockholders of record at the close of business on August 10, 2023. Source: 10-QWe did not repurchase any shares of our common stock during the three months ended June 30, 2023 pursuant to this authorization, and we had $100.0 million remaining under our share repurchase authorization. Source: 10-Q

My Financial Model Based In Previous Assumptions Implies Certain Undervaluation

With my previous assumptions, I also took into consideration previous financial figures like changes in working capital, FCF, changes in receivables, changes in inventories, capital expenditures, and changes in accounts payables. I believe that my figures are conservative.

I also took into account expectations from other market participants, including 2025 net sales of about $1.366 billion, 2025 EBITDA close to $250 million, and net income of about $139 million. It is worth noting that most analysts are expecting net margin growth and FCF growth in the coming years.

Under my expectations, I included net income growth close to 3%, which implied a 2025 net income of close to $84 million, with a 2033 net income of about $109 million.

Additionally, I assumed 2033 depreciation of close to $44 million, amortization of about $30 million, and stock-based compensation of about $25 million. Besides, with 2033 deferred income taxes of about -$49 million, changes in inventories close to $99 million, and changes in accounts payable of $137 million, net cash provided by operating activities would be $291 million. Finally, taking into consideration capital expenditures of -$90 million, 2033 FCF would be $201 million.

With a FCF ranging from $62 million to $201 million, cost of capital of 6%-8.5%, and EV/FCF of 25x-28x, the implied forecast price would be about $24-$18 per share, with a median price of around $20.5-$22. The IRR would be about 10%-4%, with a median internal rate of return of 7%.

Competitors

Competition within the water distribution and management services market in the United States is high and is due to a few competitors that have a scope and resources similar to those of Mueller and small service providers with regional reach.

When it comes to valves and iron valves, the main competitors are McWane, Inc. and American Cast Iron Pipe Company. The Ford Meter Box Company, Inc. and A.Y. McDonald are competitors for metal products, while DeZURIK, Val-Matic and McWane, Inc. are competitors for the specialty valves.

On the other hand, Romac Industries, Smith Blair, Viking Johnson, AVK Group, JCM Industries, and GeorgFisher Ltd, McWane, Inc, and American Cast Iron Pipe Company also maintain a competitive presence in the hydrant products market.

Furthermore, as stated by Mueller in its reports, water measurement in the United States is undergoing a transformation from analog products to electronic products, a market in which the company enjoys a good position due to the development of its technologies. In addition, Sensus, Neptune Technology Group Inc., Badger Meter, Inc. ( BMI ), Itron, Inc. ( ITRI ), and Master Meter, Inc are the main competitors in this market.

Risks

The bulk of Mueller's activities are linked to the public construction industry nationwide, and a decrease in investment in this regard as well as changes in municipal policies towards its development could directly affect the company's operating margins. Along with this, the company reports that it has a high concentration in its main distributors, which it considers as a potential risk in the event of disruption or cutoff in its relationships with them.

On the other hand, the company's current commitment is based on the modernization of the market in general, and a mistake in this forecast or failure to comply with trends can translate into a lack of acceptance of its products, especially with regard to electronic meters and platform Sentryx.

My Takeaway

Mueller Water Products recently reported a cybersecurity incident, which may make investors wait a bit more for the new financial statements. This incident may lower the stock demand, and create opportunities in the market. Besides, assuming a successful reduction in certain transaction-related expenses, optimization of the Sentryx platform, more capacity, and international expansion through new distributors, I believe that FCF growth could continue. I did see risks from decreases in investment, changes in municipal policies, distributor concentration, or failed new products. However, I think that the company remains undervalued.

For further details see: