MWA - Mueller Water Products: TINA Doesn't Live Here Anymore

2023-08-12 06:10:34 ET

Summary

• I'm trying to decide whether or not to buy back into Mueller Water Products, given the recent drop in share price.
• The financial performance of the company is impressive, but the shares are not cheap enough to justify the risk of stock ownership.
• I prefer the risk-adjusted returns of government debt over the potential returns of the stock.

It's been about six months since I took my 20% capital gain on Mueller Water Products Inc. (MWA), and in that time the shares have returned about 4% against a gain of about 8.6% for the S&P 500. I thought I'd check to see if it makes sense to buy back in to the stock, given that it dropped nicely after the most recent quarterly report. I'll make that determination by looking at the most recent financial performance, and by looking at the valuation. To remind readers, I don't care as much about "returns" as I do "risk adjusted returns", so this decision is going to be made against a backdrop of a 10-year Treasury Note that's yielding about 4.14% at the moment.

The weekend's upon us, and I'm assuming that my readers have to decide which amazing experience they're going to choose. Do they hang out with the supermodel, or do they take the jet to Maui to watch the stars? For my part, I've hours of Young and The Restless to catch up on, and then there's a Dungeon's & Dragons game on Sunday, so we're all busy, and are all pressed for time. This is why I write a thesis statement near the beginning of each of my articles. With these, my readers can get the "gist" of my thinking immediately, so they won't be exposed to "Doyle mojo" and correct spelling. I hope they appreciate this effort. I'm going to continue to eschew Mueller Water Products for the time being. Although I am impressed by the financial performance, the shares aren't sufficiently cheap to get me excited. I'd be happy to buy at the right price, but in a world where I can get over 4% on a 10-year Treasury Note, why take on the risk of stock ownership? Buying at current valuations may have made sense in the world of "TINA", but TINA doesn't live here anymore. In my view, you can earn a very decent risk-free return in government debt, and if rates fall, you'll pick up a nice capital gain. Given that, a stock, even one as compelling as this one is in some ways, must be very cheap to get me excited. The only thing I'm excited about at the moment is whether Victoria Newman is going to throw her support behind a merger of Newman Media with Adustus-Kirsten. I'm playing catch up on my Y&R, so if you know, please don't throw down any spoilers in the comments section.

Financial Snapshot

Most of the drop in net income during the most recent 3 quarters relative to the same period a year ago can be blamed on the $12.6 million, or 7.2% uptick in SG&A expenses. That's somewhat troublesome, but it's not so awful that it's going to drive me from the shares. Since dividend payments still only represent about 42% of net income, I'm not too concerned by the recent slip in financial performance. I think it's worth reminding investors that, relative to the pre-pandemic era, this company has grown massively, with revenue and net income up by 39%, and 189% respectively. Additionally, the balance sheet remains quite strong in my view, given that cash represents about 32% of long term debt. Given the above, I'd be very happy to buy back into these shares at the right price.

The Stock

I've written it before, I'm about to write it again, and no doubt I'll write it in future: the stock and the business are two very different things. A business can make money by instruments that measure water flow, while a stock represents a claim on the future cash flow generating capacity of the business. The latter is obviously affected by what goes on at the company that it supposedly represents, but it's also affected by a host of things that are peripheral to the business at best. For instance, the stock price is affected by the ever-changing demand for "stocks" as an asset class. The stock might be driven by changes in interest rate policy. The stock might be affected by a note put out by a fashionable analyst, even one that may not have a great track record. All of this causes the stock to go up and down in price much more rapidly than should be warranted given the changes to the business. Because I'm the type to absolutely beat the proverbial dead horse, allow me to demonstrate this point further by using a thought experiment involving Mueller stock. Let's imagine that investor A buys this stock on August 8, and investor B buys this stock on August 10. Investor A is up 4.4% as of this morning, while investor B is basically flat on their investment. Not enough happened in these two days to account for that variance in returns. We may sometimes think "we don't buy stocks, we buy companies", indicating that we sometimes think things that are incorrect. We very much buy stocks.

In my view, you do best when you buy stocks that are cheaply priced, because these represent the best combination of risk and return potential. They offer lower risk because much of the bad news has already been "priced in" to the stock. This is why they're cheap. They offer higher reward potential because any bit of pleasant news will move the proverbial "needle" massively, potentially causing the price to spike higher.

My regulars know that I measure cheapness in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the relationship between price and some measure of economic value, like earnings, free cash flow, and the like. One of the reasons I decided to sell previously was because the shares were trading at a price to sales ratio of about 1.7 times, and the fact that the dividend yield was yielding about 229 basis points less than the 10-Year Note. I concluded that being paid less than the risk-free rate for a risky stock made no sense.

Fast forward to the present, and here's the lay of the land.

The shares are identically priced on a price to sales basis, but the delta between the risk-free rate and the dividend yield has blown out an additional 13 basis points, and now the 10-Year Note is offering 2.42% more than is the dividend. While I'll admit that there's room for growth in the dividend, this delta is quite extreme. The dividend would need to grow at a CAGR of about 9.15% over the next decade to match the current risk-free rate. Getting paid less while taking on more risk makes little sense in my estimation.

While I think ratios can be instructive, I always try to understand what the market is currently "thinking" about a given company's future. In order to do this, I turn to the work outlined in books like Penman's "Accounting for Value" and Mauboussin and Rappaport's "Expectations Investing." The idea expressed by these are that stock price itself has some interesting information embedded within it, including the market's "assumptions" about a given company's future. The greater the expectations, the more risky the investment. According to the approach outlined by Penman's work, the market currently "thinks" that Mueller will grow at a rate of about 7.8% from current levels, which is up from about 3.5% previously. I consider this to be a bit rich.

Given the above, and given the alternatives available, I'm going to continue to avoid these shares. I may miss out on some gains, but I'd rather that than risk capital. I'm very, very willing to bore investors by being repetitive, so I'll remind them again: we're not seeking "returns." We're seeking "risk adjusted returns." In my view, the potential returns on this stock aren't sufficiently great against the backdrop of the risk-free alternative.

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