MWA - Taking My Mueller Water Products Chips Off The Table

Summary

• The company has recently released results, and the market seems to really like them. This reaction leaves me scratching my head. The results were "Ok, not great" in my view.
• The combination of mediocre financial results, and a dividend yield well below the risk free rate has me a bit "freaked out" as the young hippies say.
• I often sell deep out of the money put options, but there's no opportunity to do that here at the moment.

It’s been just shy of 2 ½ months since I wrote my latest bullish piece on Mueller Water Products Inc. ( MWA ), and in that time the shares are up by about 20% against a gain of 2.8% for the S&P 500. I obviously take some pleasure in this, for two reasons. First, I’ve made some money on my capital, which is always nice. Second, and far more importantly, it gives me a chance to brag. The fact that I prefer bragging to making money offers some insight into why my social life is in its sorry state. Seriously, though, the returns are great, but I need to review this name again because a stock trading at $14 is, by definition, a more risky investment than the same stock when it’s trading at $11.65. The company has issued results since, that the market seemed to like very much. In this article, I’ll review those financial results, to see if I agree. Additionally, I want to review the valuation to see if it makes sense to buy more, hold, or take profits. Finally, I did well previously by selling deep out of the money put options, and I want to explore whether or not that’s a possibility once again.

My regulars know that I am absolutely obsessed with making the lives of my readers as pleasant as possible. It’s the first thing I think of when I wake up in the morning, and the last thing I think of before I sleep. One thing I’ve learned is that readers love to save time, and for that reason I offer a “thesis statement” paragraph at the beginning of each of my articles. These allow you to get in, get the “gist” of my thinking, and then get out before getting bogged down in a particularly labyrinthine article. You’re welcome. Anyway, when I review the latest financial results here, the market’s highly optimistic reaction leaves me scratching my head. The results were “Ok”, but certainly nothing warranting a 13% uptick in price over the past five days. The valuation is now either “rich” or “very rich” depending upon how you measure it, and for that reason, I’ll be selling my stake here. Although I like this business a great deal, I think the chances are high that the price will come down, and I want off of this train before that happens. I expect the price to come down, and when that happens, I’ll buy back aggressively. Finally, the stock is so richly priced that I can’t execute a decent short put trade at the moment.

Financial Snapshot

I think you could easily build a narrative that the most recent financial results were quite good, which would make the recent market activity seem reasonable. For instance, the top and bottom lines for the quarter just past were up by 15.6% and 16% respectively when compared to the same period a year ago. Additionally, interest payments have declined by a healthy 14% when compared to this time last year. My issue with this line of thought is that we don’t live in a world of percentages, we live in a world of dollars, and when expressing the difference between last year and this in those terms, things look less impressive. For instance, gross profit and net income are up by a mere $5.6 million and $3.1 million respectively when compared to the same period last year. Net income rose from $19.4 million last year to $22.5 million this as a result of the fact that strategic reorganization swung from a charge of $2.4 million last year and a benefit of $3.7 million this year. That $6.1 million swing accounts for the $3.1 million uptick in net income over the same period last year. We might reasonably conclude that this is a passing thing. More ongoing is the $6.6 million uptick in SG&A expenses from last year to this one.

Additionally, the capital structure has deteriorated, although not by much. Long term debt is up a mere $100k, yet cash on the balance sheet is lower by about $81.7 million.

Thus, I’d characterize the most recent financial result onomatopoeically as “meh.” I think the unchanging dividend is still secure, so I’d be willing to buy more of this stock, but it would have to be at a very attractive price.

The Stock

As my regular readers know, my insistence on buying stock that is attractively priced has cost me some profitable trades over the years. In response to this criticism, I'd point out that I'm of the view that it's better to miss out on some gains than lose capital, just because of the pernicious math around losses. For instance, if you lose 50% in year one, you need to make 100% in year two just to get back to breakeven. So, capital preservation is always key for me.

In addition to being a bit of a coward, my regulars also know that I consider the "business" and the "stock" to be quite different things. Every business buys a number of inputs and turns them into a final product or service, like devices that help with the transmission and measurement of water, for instance. The stock, on the other hand, is an ownership stake in the business that gets traded around in a market that aggregates the crowd's rapidly changing views about the future health of the business, future margins, and so on. The stock also moves around because it gets taken along for the ride when the crowd changes its views about "the market" in general. A reasonable sounding, if counterfactual, argument can be made to suggest that some bump in the value of Mueller Water relates in some small way to the rise in the S&P 500 itself since I bought. It's impossible to prove this point definitively, but it's worth considering. In any case, the stock is affected by a host of variables that may be only peripherally related to the health of the business, and that can be frustrating. Finally, the crowd can sometimes decide to fixate on something, or interpret mediocre results in a very positive way, which drives the stock higher.

This stock price volatility driven by all these factors is troublesome, but it's a potential source of profit because these price movements have the potential to create a disconnect between market expectations and subsequent reality. I absolutely hate to sound like I’m bragging about it, but this is exactly how I generated a very decent return on my Mueller Water investment over the past two and a half months. The market was overly pessimistic, and I took advantage of that. I don’t want to be too repetitive, but in my view this is the only way to generate profits trading stocks: by determining the crowd's expectations about a given company's performance, spotting discrepancies between those assumptions and stock price, and placing a trade accordingly. I've also found it's the case that investors do better/less badly when they buy shares that are relatively cheap, because cheap shares correlate with low expectations. Cheap shares are insulated from the buffeting that more expensive shares are hit by.

As my regulars know, I measure the relative cheapness of a stock in a few ways, ranging from the simple to the more complex. For example, I like to look at the ratio of price to some measure of economic value, like earnings, sales, free cash, and the like. I like to see a company trading at a discount to both the overall market, and to its own history. In case you don't have your copy of "Doyle's Almanac of 2022 Trades" in front of you, I was most recently very bullish on this stock when it was trading at a price to sales ratio of 1.467, and the dividend yield was sitting at 2.03%. Although the dividend yield was less than the 10 Year Treasury, I was comfortable with that given that the valuation was so attractive. Fast forward to the present, and the shares are now about 16% more expensive, and the dividend yield has collapsed by about 37%, and is now yielding about 229 basis points less than the 10 Year Note per the following:

One more thing my regulars know is that I want to try to understand what the crowd is currently "assuming" about the future of a given company, and in order to do this, I rely on the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit dense, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and then infer what the market is currently "expecting" about the future.

Anyway, applying this approach to Mueller Water at the moment suggests the market is assuming that this company will grow profits at a rate of about 7.3% from here. That is up from 3.5% previously. In my view, that is a pretty optimistic forecast. Given all of the above, and given that I’m in the mood to preserve capital, I’ll be taking my chips off the table at this point.

Options As Alternative

My regular victims know that I’m a big fan of selling put options, particularly deep out of the money put options, because I consider these to be win-win trades if the premia is high enough. If the shares remain above the strike price, I collect the premia. If the shares crash in price, then I’m “forced” to buy, but do so at a price that’s acceptable to me. I’ve droned on about the risk reducing, yield enhancing potential of these for years now, and if you haven’t heard that story from me yet, you’re not paying attention.

Anyway, in the missive before last , I recommended selling the August 2022 Mueller Water Products puts with a strike of $12.5 for $.55. I sold 10 of these, and was exercised on them, which swelled my stake here. I was happy to buy more at a net price of $11.95, and that trade’s worked out pretty well since.

While I like to try to repeat success when I can, I don’t think it’s possible to sell puts at the moment here, because the premia on offer isn’t high enough in my view. For example, the August 2023 puts with a strike of $12.50 are only bid at $.25 at the moment. Given that I think the shares are likely to come down in price, this isn’t enough to compensate for the risks here in my opinion. I will definitely revisit the name when the shares inevitably drop in price, but for now I have no alternative but to sell my stake, and preserve my capital for when the price drops from here.

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