MWA

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended December 31, 2005 for Mueller Water Products, Inc. The reporting period is significantly impacted by the Acquisition of Predecessor Mueller by Walter Industries, Inc. on October 3, 2005. For accounting purposes, U.S. Pipe is treated as the acquirer, and the results of Predecessor Mueller are consolidated beginning October 3, 2005. Consequently, the Company now operates through three segments: Mueller, U.S. Pipe, and Anvil. The Company is currently a wholly-owned subsidiary of Walter Industries and has filed a registration statement for an initial public offering (IPO).

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Surge: Net sales increased by $350.1 million (269%) primarily due to the inclusion of Predecessor Mueller's results ($309.3 million) following the October 3 acquisition.
• Restructuring Charges: The Company incurred $24.1 million in facility rationalization and restructuring costs, primarily related to the closure of the U.S. Pipe Chattanooga plant. This included $19.0 million in fixed asset impairments and $3.0 million in severance.
• Inventory Adjustments: Cost of sales included $58.4 million in purchase accounting adjustments to value acquired inventory at fair value. Additionally, $10.7 million in inventory obsolescence charges were recorded for U.S. Pipe valve and hydrant inventory deemed unsellable following the plant closure.
• Debt Load: Total debt increased from zero to $1.55 billion, driven by the assumption of Predecessor Mueller's debt and the new $1.05 billion 2005 Mueller Credit Agreement used to finance the acquisition.
• Goodwill and Intangibles: Goodwill increased by $798.3 million to $856.7 million, and identifiable intangible assets increased to $849.3 million, reflecting the purchase price allocation of the acquisition.

Guidance, Outlook, and Risks

• Restructuring Outlook: Management expects to incur an additional $5.2 million in closure costs for the U.S. Pipe Chattanooga plant in fiscal 2006. A synergy plan is underway to streamline operations, with projected annual operating income benefits of $25-$35 million by early fiscal 2008.
• Raw Material Costs: Scrap metal costs declined 16% from 2004 peaks but are expected to remain elevated through March 2006. Brass ingot prices have increased up to 60% over budget, posing a risk to margins if not passed to customers.
• Internal Controls: The Company disclosed a material weakness in internal controls over financial reporting at Predecessor Mueller, resulting in restatements of prior periods. Remediation efforts are underway, including hiring new financial leadership and implementing quarterly review plans.
• Legal and Environmental: The Company faces potential environmental liabilities (e.g., Anniston, Alabama site) and litigation, though many pre-1999 liabilities are indemnified by Tyco. A federal tax controversy involving the Walter consolidated group exists, with the IRS claiming approximately $34.0 million.
• Seasonality: The business is seasonal, with lower sales and higher working capital needs typically occurring in the first and second quarters due to weather conditions affecting construction.

Investor Verification Checklist

• Acquisition Integration: Verify the progress of the synergy plan and the realization of the projected $25-$35 million in annual cost savings.
• Debt Covenants: Monitor compliance with the leverage ratio and EBITDA requirements of the 2005 Mueller Credit Agreement, which restricts dividends and additional borrowing.
• Internal Control Remediation: Assess the effectiveness of new controls implemented to address the material weakness identified in Predecessor Mueller's financial reporting.
• Raw Material Hedging: Review the Company's ability to pass through increased costs for brass ingot and scrap metal to maintain gross margins.
• Environmental Liabilities: Confirm the status of the Anniston, Alabama cleanup costs and any potential exposure beyond the accrued $4.0 million.