It’s been a long time since I’ve published updated thoughts on Mueller Water (NYSE:MWA). I wasn’t very bullish on the shares back in 2016, largely due to what I thought were inflated expectations for municipal water investment/capex spending and the Technologies segment, as well as overly ambitious expectations for margin leverage. Since then, the shares have underperformed the broader industrial group by about 30% and the S&P by about 50%, as well as more water-focused peers like Evoqua (AQUA), Watts Water (WTS), and Xylem (XYL).

I’m relatively bullish on the outlook for residential construction, including land development, and I like the company’s decision to reinvest in its manufacturing base to drive stronger long-term margins. What I don’t like is how much of the valuation still seems to depend upon governments at all levels (municipal, state, and federal) making smart decisions, doing the right things, and finding the funds to reinvest in upgrading critical infrastructure assets like water. I’m also still quite skeptical of the Technologies business – while products and services like monitoring software and leak detection should be popular, something is clearly not working in this business, as it hasn’t produced meaningful growth in five years.

Mueller doesn’t look particularly attractive on cash flow, though my model reflects my own pessimism that needed infrastructure spending will happen. Relative to Mueller’s margins, ROIC, and so on, though, the shares do look undervalued.

Will Catch-Up Infrastructure Spending Ever Materialize?

It seems as though there have been reports and position pieces on the need for a significant improvement in U.S. spending on water infrastructure for as long as I’ve been watching the sector (more or less 25 years), and not much has been done, or at least not on any consistent basis.

Although different organizations produce very different end-result figures and estimates for the level of under-investment in U.S. water infrastructure, the reality is that everybody seems to agree that major spending is needed over the next 20 to 50 years. The American Water Works Association has estimated a need for $1.7 trillion over 40 years, or about $42.5 billion, above and beyond typical annual spending (in the ballpark of $140B/year since 2007).

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Not all of that will flow through to Mueller, and in fact, not even most of it. Mueller has no leverage to “onsite work”, nor any meaningful leverage to large categories like pipes. I would estimate, though, that around 15% or so of that needed spending would be addressable by Mueller (valves, hydrants, leak detection, et al), and a $250B addressable market opportunity is meaningful even if it is spread over 40 years.

The question is whether it will happen. The Biden campaign has included increased spending on water infrastructure as part of a $2T overall infrastructure program, with a particular focus on drinking water quality and standards. Unfortunately, as far as I can tell from the details, the plan calls for only doubling Federal spending. Federal spending isn’t a big part of water infrastructure spending, and doubling from around $15 billion to $30 billion only goes so far to help. Granted, any bit helps, particularly considering Mueller’s roughly $1B revenue base, but I think it’s important to understand that, so far, the plans on the table are still short of what’s needed.

A Healthy Residential Market Should Help To A Point

While Mueller generates about 60% of its revenue from municipal water systems, a meaningful 30% comes from residential construction. Residential activity has come back strong so far as COVID-19 lockdowns have eased (and activity didn’t decline as much as feared), and I’m bullish on the near-term outlook for new home construction, and relatively bullish on the long-term outlook, given where the supply/demand balance looks to be.

The details matter, though, and I’m somewhat cautious about the outlook for Mueller here over the next year or two. There’s a big difference for Mueller between new land development and final home construction, as a lot of Mueller’s products are purchased and installed well ahead of actual homebuilding. We saw this back during the housing crash/global financial crisis, as partially-developed lots stood idle/vacant for years, and Mueller saw sales headwinds from a lack of new projects, and I’m concerned we’re going to see more growth in finished homes than in new project starts, particularly given uncertainties around COVID-19 and less willingness on the part of lenders to fund new development projects.

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Can Technologies Become Something Special?

Investors have waited a long time for Mueller’s Technologies portfolio to become a meaningful driver, and it still hasn’t happened. There has been minimal growth in the business since 2015 (for revenue), and margin leverage has been poor, with well below-company average gross margins and adjusted operating income losses in every year.

Some of the products here should be in higher demand, including non-invasive leak detection (Echologics), pressure monitoring, and monitoring software. On the other hand, it hasn’t grown enough to make a difference, and over-exposure to commoditized metering technology hasn’t helped. While I understand the arguments for improved demand for products/services like leak detection, the reality is that the company has been at this for a while now, and either the demand just isn’t there (perhaps due to budget restraints), or there’s something wrong in the company’s portfolio and/or go-to-market strategy.

The Outlook

I like the effort management has underway to modernize/upgrade three manufacturing facilities. A pandemic is perhaps not the best time to spend $130M on facilities upgrades, but the incremental margin boost (management estimates a potential 300bp positive impact relative to near-term revenue) is worth it. I haven’t been quite as impressed with the M&A efforts; selling Anvil made sense, and I don’t disagree with the Krausz (pipe couplings, et al) and Singer (automatic control valves) deals, but I thought management might have been looking to do more, and particularly in areas like water reclamation and/or water treatment.

I’m looking for around 5% long-term annualized revenue growth from Mueller (closer to 6% if you start at 2020), which is a pick-up from the 4.5% or so over the last five years (ex-Anvil). While I’m generally skeptical on the prospects for the needed catch-up spending on water infrastructure, I do still see some lift from increased infrastructure spending, along with some support from residential construction. I do believe the facility modernization will be a nice source of margin leverage, and I think the company can get to a point where it generates high single-digit FCF margins on a year-to-year basis – that is a bullish assumption, though, as the company has never been able to do that before (weaker margins in Anvil didn’t help).

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The Bottom Line

I’m expecting mid-teens annualized FCF growth from Mueller over the next decade, but that’s not enough to drive a particularly interesting fair value on a DCF basis. A margin and return-based EV/EBITDA approach is much more forgiving, though, suggesting that Mueller could trade closer to the mid-teens if it were valued for its margins, ROICs, and ROAs the way other industrials typically are. With reported earnings likely to improve from here on, I can see a catch-up trade for Mueller (especially if there’s more buzz about water infrastructure spending), but it’s still not a favored idea.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.