Taste too strong? Just add water.

For a good example, think about fountain drinks. They're actually made by mixing syrup with water on the fly. If the mix isn't in the right proportion, you may get too much water...in which case your drink is watered down.

The phrase applies not only literally, but can be used figuratively to refer to anything having its effect dampened. Pop punk is punk with its rough edge dampened...therefore it is "watered down" punk.