Insiders Fill Up on Water Shortage Play

By Michael Brush
July 20, 2006

While potential shortages of energy grab the headlines every day, it’s actually a shortage of another essential ingredient of life that may get us in the end: drinkable water.

Photos of the earth from the recent space shuttle trip reminded us that our blue planet is awash in water. But very little is available to drink. About 97% of it contains salt. Two thirds of the remaining 3% is locked up in polar ice caps. That leaves about 1% of all the earth’s water for us -- and much of that is polluted.

The upshot: There are now shortages of fresh water on every continent, says Brean Murray, Carret & Co. analyst Michael Gaugler. The Southwestern region of the U.S., of course, has had problems for years. In China and the Middle East big projects are under way to create new supplies. Parts of Africa and India have shortages that create ongoing crop failure and mortalities.

These trends have sparked investor interest in water-related stocks -- or the companies that not only sell water but also supply the equipment that purifies it and desalinates it, and pipes it to your kitchen.

So it should be no surprise that insiders were buying heavily when some of the stock of one of the biggest water infrastructure equipment companies, or Mueller Water Products (MWA), was spun out of its parent company. In the first ten days of June, they purchased $3.4 million worth of Mueller stock for prices between $15.26 and $16.

Mueller was only taken over last year by its parent – the conglomerate Walter Industries (WLT). But now Walter Industries has reversed course in an effort to increase shareholder value by hiving off various divisions.

Mueller, as a leading supplier of water infrastructure equipment and a pure play in this space, should benefit from the following big-picture trends.

• Water scarcity. Shortages of fresh water are a major problem in both developed and developing countries. Companies that sell equipment used to transmit or purify water should benefit.



• Infrastructure build out. The pipes, valves and pumps that transport water throughout many parts of the U.S. are over a hundred years old and in bad shape. So a major replacement cycle lies ahead.

The Environmental Protection Agency (EPA) estimates that the U.S. will have to spend about $277 billion by 2019 on water infrastructure. (The Congressional Budget Office puts the number at $12.2 billion to $21.2 billion a year, which works out to about the same as the EPA estimates.)

Of that $277 billion, the EPA thinks transmission and distribution will take the lion’s share -- or $184 billion over the next two decades. Treatment is next on the list, with $53 billion in expected spending. That’s bad news for people who pay the water bills. But it’s good news for Mueller since these are two of its strong suits.

Abroad, developing countries like China are in the early stages building out their water infrastructure. Mueller doesn’t sell in China yet, but it’s working on it.

• Consolidation. There are about 54,000 water companies in the U.S. – many of them tiny, serving just a few thousand customers. They don’t have the money to upgrade their systems or meet tighter regulations being imposed by the EPA without increasing rates too much.

A better option may be to sell out to larger water companies that can deal with these challenges. These pressures will lead to a wave of consolations, says Gaugler, of Brean Murray, Carret. As the consolidation trend plays out, the infrastructure upgrade will kick in to higher gear.

Risks

Though Mueller stands to benefit from all these trends, there are near-term risks for the stock. Walter Industries still has to spin out 80% of Mueller shares. That will happen in the second half of this year. That could cause selling pressure since many investors simply sell stock that gets spun out to them.

Next, a little math suggests that speculators might be shorting Mueller stock and going long Walter Industries ahead of the spin out. Based on the value of Mueller stock trading in the open market right now, all of its shares together are worth about $2 billion. That leaves an implied value of $500 million to $700 million for the rest of Walter Industries, or about one third of its true value, estimates Gaugler.

If he’s right, speculators may be going long Walter Industries and shorting Mueller as a hedge – to make money in an arbitrage bet that Walter Industries will approach its true value.

All of this means that Mueller shares could become more volatile in the months ahead. But the level of insider buying in Mueller shares suggests the near-term volatility may be nothing to worry about in the long run.

Gaugler thinks that Mueller Water Products stock could trade up to $20 in a year from recent levels of $16.

The bottom line: That arbitrage play and the knee-jerk reaction of many investors to simply sell stocks that get spun out to them could put some downward pressure on Mueller shares in the months ahead. But we don’t really know that will happen. Meanwhile, the long term-trends and insider buying are compelling enough to suggest Mueller is a buy right here – despite the possible risk of some turbulence in the coming months.

Disclaimer
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column. Mr. Brush is an independent columnist for this web site.
For more on Insiders Corner disclosure, see the disclosure section in About Insiders Corner: http://www.investorideas.com/insiderscorner/. InvestorIdeas.com Disclaimer: www.InvestorIdeas.com/About/Disclaimer.asp. InvestorIdeas is not affiliated or compensated by the companies mentioned in this article.