Long-Term Riches on Tap

In the mid-1960s, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) chairman Warren Buffett began meeting with other disciples of Benjamin Graham's value investing theories to discuss the current state of the markets. Every time they met, they'd ask each other the same question: "If the stock market shut down for 10 years, what one stock would you buy?"

If posed that question today, I'm not entirely sure how I'd answer. But my list of serious contenders would definitely include Motley Fool Hidden Gems pick Mueller Water Products (NYSE: MWA  ) (NYSE: MWA-B  ) .

Staying power
Buffett's group's question brilliantly forces any prospective investor to focus on a business's true economic advantages. At a minimum, I'd argue that any satisfying response should have:

  1. A durable competitive advantage
  2. Able and honest managers
  3. Low capital expenditures

Buffett's most successful investments, the ones that made him millions or billions, easily pass these tests. American Express (NYSE: AXP  ) , Coca-Cola (NYSE: KO  ) , and Gillette -- now a part of Procter & Gamble (NYSE: PG  ) -- have all performed magnificently for Berkshire shareholders over the years, generating consistent returns from steady consumer demand for their products. Like the desire for a clean shave or a cold bottle of Coke, I highly doubt that humanity's thirst for clean water will diminish anytime soon, making Mueller a savvy possibility for long-term excellence.

Waterworld
In June 2006, Mueller was spun off from another Hidden Gems pick, Walter Industries (NYSE: WLT  ) . Walter acquired Mueller in 2005, essentially to merge it with two of Walter's existing subsidiaries, U.S. Pipe and Anvil. Combined with these two firms, the new Mueller was spun off again as a pure-play water infrastructure company.

Mueller is a leading manufacturer of water infrastructure components. It arguably offers the industry's widest product line, and most of its products occupy the No. 1 or No. 2 spot in their respective markets.

Mueller's success bodes well for its prospects, given the potentially booming market for water infrastructure in the coming decades. According to the American Waterworks Association (AWWA) and the EPA,

  • Wastewater and drinking water systems are aging, with some components far more than 100 years old.
  • A study conducted in June 2001 by the AWWA concluded that more $250 billion of additional investment is needed over the next 30 years to upgrade and repair existing water infrastructure.
  • Existing water infrastructure gets a "D" grade from the American Society of Civil Engineers.

Competitive advantages
Despite two major competitors, privately held ACIPCO and McWane, Mueller seems especially well-positioned to profit from rising demand for new water infrastructure:

  • Mueller products are approved in more than 90% of water systems.
  • One out every two fire hydrants on the ground is a Mueller product.
  • Mueller already has a vast installed base of above- and underground products. This bodes well for future revenue growth, since customers have major incentives -- lower costs, less inventory buildup, and quicker turnaround time -- to use the existing installed products.
  • The company has the most modern manufacturing plants in its business, with a unique process that keeps costs especially low. Rivals would need four to five years to duplicate Mueller's innovation. MWA also has a plant in China.

Once water infrastructure parts are in place, customers must return to the original supplier for replacements -- good news for Mueller, since its products are already so popularity. That popularity may also sway water municipalities seeking reputable, well-known products to best improve their city or town's infrastructure.

Chinese rivals are beginning to manufacture parts like Mueller's, but their efforts are small and scattered. It could be years before any serious threat from China appears; meanwhile, existing infrastructure must be serviced by the market's current suppliers. Even if China does become a serious rival, I doubt U.S. municipalities will just simply hand over our water pipes to a rival superpower.

True, Mueller's currently feeling the housing market's pain, but so are other industry leaders such as USG and Pulte Homes. With share prices temporarily bogged down by a nationwide trend beyond Mueller's control, this might be the most opportunistic time to consider investing in water infrastructure.

Right now, Mueller is getting its house in order. During 2006, the company consolidated and closed underperforming locations. These benefits are finally taking effect; the company's latest 10-Q includes significantly reduced operating costs, and the company's Q1 2007 net income has tripled its entire net income for fiscal 2006.

Beware the undertow
Rosy recent results notwithstanding, investors should be mindful of the company's drawbacks as well:

  • Forty percent of Mueller's 2006 revenue was driven by housing starts. Mueller's revenue stream may partly slow to a trickle during the housing decline.
  • Home Depot is Mueller's largest distributor, accounting for far more than 25% of its business. That's not extraordinary, considering Mueller's impact on the housing market, and Home Depot and Lowe's close ties to that market. If Home Depot dumps Mueller for some reason, the company could take a hit. But Mueller's sterling reputation, broad array of products, and recurring revenue streams from its existing installed base make that an unlikely scenario.
  • Thirty percent of Mueller's 2006 revenue comes from the commercial construction market. Rival Chinese products have recently begun to creep into this segment.
  • Mueller remains susceptible to increases in the costs of raw materials. It's mitigated this risk by hiking its own products' prices and investing in a mini-mill plant.

Splish, splash, cash
Water is the essence of all societies, and there's no doubt that American water systems will need a serious upgrade over the next few decades. Mueller's established reputation and strong existing infrastructure provide just the sort of competitive advantage that long-term-oriented investors should look for. It's the sort of pick to which even Warren Buffett might raise a glass.

A splash of further Foolishness:

Get Tom Gardner and Bill Mann's full list of small-cap value stock picks with a free 30-day trial to Motley Fool Hidden Gems.

Fool contributor Sham Gad is launching Gad Investment Funds, a value-oriented investment partnership based on Buffett's model. At time of publication, he held positions in Mueller, Walter, USG, and Berkshire Hathaway. Berkshire and Home Depot are Motley Fool Inside Value picks. The Fool has a crystal-clear disclosure policy.


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