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Welcome to Episode 40 of the Special Situation Investing podcast.
Today’s topic of discussion is the recently announced spinoff of Knife River Corporation from its mother company, MDU Resources Group (NYSE: MDU).
Upon our initial assessment, it’s not so much the valuation of the spinoff itself, nor the business model of Knife River or MDU that are particularly intriguing in this situation. But instead, what initially caught our attention was the possibility of value-creation via the breakup of the mother company.
But before we get into the details surrounding the spinoff, let’s review some background on MDU Resources Group.
Today, MDU is a Fortune 500 company with operations and customers across the country and approximately 16,000 employees during peak construction season. The beginnings of the company were much more humble.
The company was founded in 1924 as a small electric utility serving a handful of farm communities on the border of Montana and North Dakota. The company grew by consolidating other small electric utilities. As it grew, it began hunting for its own power fuel sources. This led it to create subsidiary companies within natural gas exploration and transportation in 1927, and coal mining in 1945. The company began trading on the NYSE on Sept. 20, 1948, with $59 million in assets and $11 million total revenues. MDU’s expertise in the coal mining industry led it to venture into the aggregate mining business in 1992. Aggregate worked so well, or coal didn’t, that in 2001, MDU sold off its coal mining business. And finally, in 2005, MDU exited the natural gas E&P business, leaving it with the four primary segments it’s comprised of today: electric & natural gas utilities, pipeline, construction services, and construction materials.
The first segment, the company's regulated natural gas and electric utilities, provides service to 1.2 million customers across eight states. Subsidiary companies service customers in Oregon, Washington, Minnesota, North Dakota, South Dakota, Idaho, Montana, and Wyoming. The combined utility business has a rate base of $2.8 billion and it generated $321 million of EBITDA in 2021.
Next, the regulated pipeline segment is comprised of WBI Energy and provides natural gas transportation and underground storage services throughout the Rocky Mountain and northern Great Plains regions. It also provides other energy related services such as non-regulated cathodic protection. It generated $78 million of EBITDA in 2021.
As the third segment, MDU Construction Services Group is unregulated and provides contracting services across the US, primarily electrical and mechanical, and transmission and distribution services. This segment is comprised of 16 local operating companies with more than 8,500 workers. It generated $169 million of EBITDA in 2021.
MDU’s last segment is comprised of Knife River Corporation, which is the company to be spun out. Knife River provides construction materials and contracting services throughout the western, central and southern US. According to MDU’s website:
“Knife River produces and delivers aggregates and markets crushed stone, sand, gravel and related construction materials, including ready-mix concrete, asphalt and other value-added products. It also distributes cement and asphalt oil. Knife River has more than 1 billion tons of aggregate reserves, 110 ready-mix plants, 50 asphalt plants and a combined 410,000 tons of liquid asphalt and cement storage. It also performs integrated contracting services for most types of aggregate-related construction, including roads, freeways, bridges, residential properties, schools, shopping centers, office buildings and industrial parks.”
MDU also highlights Knife River’s track record of growth. In just the past four years, it completed 12 acquisitions and increased its revenues by 23%. And finally, in 2021, Knife River generated $293 million of EBITDA.”
Having that background under our belts, we’ll now take a look at the few details that are currently available concerning the upcoming spinoff of Knife River. Most of the information is from MDU’s initial press release about the transaction released on August 4th.
The spinoff is projected to be completed in 2023 and like most spinoffs, it should be a tax-free distribution to MDU shareholders. The number of shares of Knife River to be distributed is yet undetermined, but regardless of the number, they are expected to be distributed on a pro rata basis. Post spinoff, the mother company (which will still be called MDU Resources Group) will retain the other three segments - electric and natural gas utilities, pipeline, and construction services. MDU claims it will maintain its dividend policy consistent with its historic practice. Knife River’s dividend policy is yet to be determined.
That’s about all the information specific to the spinoff released thus far. Given how early it is in the transaction and that its expected completion is in 2023, we will look for more details to trickle out over the coming months.
But even with much information still to be determined, a question worth asking at this early stage is, why. Why is Knife River being spun-off? Answering this question can help an investor determine if a spinoff has the potential for value creation, and if so, how to best position themselves.
As is expected, in its recent communications, MDU lists generic reasons for the spinoff. It says the transaction will unlock the inherent value within the two new companies, it will allow for enhanced strategic focuses, optimized capital structures, tailored capital allocation strategies and two unique investment opportunities. That’s all pretty standard jargon and doesn’t help us understand the why. Although we may never know for certain the reason, or reasons, MDU is choosing to spinoff Knife River, some information scattered throughout the spinoff announcement and the 2Q call, provide a plausible rationale.
Reading through all the available forms and documents on the spinoff, one thing stands out because it’s mentioned multiple times. That is that, post spinoff, the vast majority of MDU Resources Group’s earnings will come from regulated businesses. In the press release, MDU states that the spinoff “enhances MDU Resources' strategic focus on regulated utilities, natural gas pipelines and related infrastructure services.” In the Q2 call, Dave Goodin, MDU’s CEO, said, “we expect approximately 70% of the pro forma EBITDA to be generated from our regulated businesses, providing low risk and stable return to shareholders.” That right there is key. As the economy suffers through a volatile period, MDU sees an opportunity to distinguish itself as a stable, low risk option for investors by focusing on its regulated businesses - primarily its natural gas and electric utilities.
Since regulated companies, such as utilities, are know for their stable business model and stable dividends, such companies attract individual investors and funds looking for that stability, and even more so during volatile times.
Other reasons for the spinoff that I believe we can cross of the list as not likely are: 1) MDU is jettisoning a losing or unwanted part of their business. This seems unlikely as Knife River is very profitable, although highly capital intensive; 2) MDU is seeking to burden Knife River with a large portion of the company’s liabilities. This also is unlikely, but remains to be seen.
Another interesting side to this spinoff is the involvement of an activist investor. On August 8th, Corvex Management run by Keith Meister, filed a Form 13D showing that the company had bought up a 4.99% stake in MDU. Miester, previously Carl Icahn’s right-hand man, is known for investing in company’s, often conglomerates like MDU, when he sees an opportunity for value creation by breaking the company into its different parts.
In fact, earlier this year, Meister was involved in the breakup of another energy conglomerate that like MDU, prior to its breakup, was composed of both regulated and nonregulated businesses. That situation involved regulated energy company Exelon Energy and the spinoff of its nonregulated energy producer, Constellation Energy (CEG). We covered that spinoff in episode six released on February 1st. In that episode, we argued that CEG was well positioned as a “high barrier to entry business” and “the largest carbon-free energy producer in the US.” How did that situation turn out?
Well, let’s consider two hypothetical examples. First let’s say you wanted to own both the regulated and nonregulated businesses. So you bought 3 shares of Exelon on February 1st and thus were entitled to 1 share of the CEG spinoff. Since Exelon traded at $41.24, buying three shares would have cost you $123.72 and you got your distribution of 1 share of CEG for free. At today’s prices of $44.08 and $81.07 for Exelon and CEG, respectively, your investment would be sitting pretty with a 72% return over the last seven months.
As a second example, let’s run the numbers as if you had decided to buy only CEG after it began trading as a separate company. A single share of CEG bought on February 1st at a price of $49.78 would now be worth $81.07 for a 63% return over seven months. I bet Meister would be pretty pleased with the results from either of these two cases.
There’s no way to know for certain whether the MDU/Knife River situation will turn out as well as Exelon and Constellation have so far. But there are a lot of positive aspects to this situation: 1) both MDU and Knife River are strong companies; 2) it’s likely that each stock could be rerated higher once they are valued separately, one as a regulated and one as an unregulated company; 3) the potential for additional spinoffs exists as MDU will still be composed of three independent segments, the most likely spinoff candidate is its unregulated construction services segment; and 4) MDU’s refocusing on a stable, regulated business model could pay off if market volatility continues.
If nothing else, these reasons make this situation worth watching as it transpires over the ensuing months. As more information about the spinoff is released, and more due diligence is accomplished, we can determine with more confidence whether the most value is in owning both businesses, only one of the businesses, or none at all.
As always, stay tuned for future value-adding updates about this spinoff and a host of other investing special situations.
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