Welcome to Episode 135 of Special Situation Investing.
This piece will mirror the format of my last Rabbit Holes of Curiosity episode—summarizing a handful of recent research topics, as opposed to our customary singular subject. Let’s dive in.
MDU Resources’ Next Spin-off
The situation with MDU Resources (MDU) is a classic sum-of-the-parts, spin-off special situation. It’s quite straight forward: MDU was comprised of four distinct businesses, two regulated and two unregulated, and the company wanted to become fully regulated. I first wrote about the company back in September of 2022 when it announced the spin-off of its unregulated construction materials business, Knife River (KNF).
Even though MDU made no mention of its intentions regarding the other unregulated business—Construction Services—I didn’t go too far out on a limb coming to following conclusion:
The potential for additional spin-offs exists as MDU will still be composed of three independent segments. The most likely spin-off candidate is its unregulated Construction Services segment.
In May of 2023, Knife River was spun-off. In August of the same year, MDU announced the spin-off of its Construction Services. I followed up with a piece that introduced the new spin-off (scant details were available at the time). Now, with the date of the next, and likely final spin-off, set for the end of this month, here are a few pertinent details:
The new construction services company will be called Everus Construction Group and trade on the New York Stock Exchange under the symbol ECG.
A tax free distribution of Everus shares will occur on October 31st to MDU shareholders of record as of October 21st. Shareholders will receive one share of Everus for every four shares they own of MDU.
Everus’s current chief executive officer and chief operating officer have been with the company for more than twenty years and will both continue on with the new company post spin-off.
Everus Construction Group will have two segments: 1) electrical and mechanical; focused on construction and maintenance of electrical and communication and wiring infrastructure, and 2) transmission and distribution; focused on construction and maintenance of overhead and underground electrical, gas and communication infrastructure.
Below are four charts regarding Everus taken from MDU’s most recent presentation.
The top left shows a 17% EBITDA compound annual growth rate for Everus’ combined segments since 2018. Top right shows CAPEX at an impressively low percent of revenue, indicating a rather capex light business model. Bottom right shows a positive trend in construction starts, an indication of potential growth behind Everus’ electrical and mechanical business. Bottom left shows an equally encouraging trend in transmission investments, a projected tailwind behind the company’s transmission and infrastructure business.
It appears that if the mega trends of electrification and American reshoring materialize, Everus could prove a major beneficiary.
In my last piece on this special situation, I took a high level look at the results of a hypothetical investment in MDU prior to Knife River’s spin-out. At that time, the combination of the two companies was up approximately 18%.
For an update, take a look at the two charts below.
The first shows MDU’s market cap over three years with the added blue line indicating when Knife River was spun-out.
The second chart shows Knife River’s market cap since spin-out.
Considered from a total-market-cap perspective, MDU could have bought just prior to its Knife River spin for about $6 billion. Upon spin-off, Knife River was valued at a market cap of $2 billion, so MDU’s market cap decreased from $6 billion to $4 billion as shown in the first chart. Today, MDU is back to a market cap of $6 billion and KNF is valued at $5.3 billion, for a combined total of $11.3 billion and a return of 88% in seventeen months. On the other hand, if KNF had been bought at its IPO, an investor would be sitting on a 165% gain.
In previous pieces, I disclosed that neither I or my cohost own MDU or KNF, which is still true today. All the same, watching this situation unfold has been fascinating. As MDU’s next spin-off approaches, it will be fun to see how this story concludes.
Why I Didn’t Buy PHX Minerals
PHX Minerals (PHX) is another company from our archive. I wrote two pieces on it in 2022 and 2023 because it was a nat gas royalty company with a special situation twist—transitioning its business model from capital-intensive working interests to capital-light royalties. At the time, it appeared the market wasn’t pricing in the nearly compete transformation to a higher-margin business model.
The company was in the news this past week because of the announcement that WhiteHawk Energy made a second offer to combine with PHX. Eighteen months ago WhiteHawk proposed a merger and recently it proposed to purchase PHX for $4.00 per share. In conjunction with both proposals, WhiteHawk released public letters addressed to PHX’s management where it highlights their failure to create robust shareholder returns and its belief that combining the two companies would be in the interest of all shareholders. Here’s a spicy excerpt where WhiteHawk holds PHX’s feet to the fire:
[W]e believe it is crucial to highlight the significant destruction of stockholder value by PHX management since early 2020, when the current executive leadership was appointed. During this period, management has attempted to steer PHX in a new strategic direction. However, these efforts have clearly failed to generate value for stockholders. Instead, stockholders have suffered from excessive general and administrative (“G&A”) expenses, dilutive acquisitions, minimal dividends, and as a result, persistent stock price underperformance.
Since 2020, management has returned only $11.4 million to stockholders through dividends, while spending $40.1 million in cash G&A, a substantial portion of which has been paid directly to management. While management claims that low dividends are necessary to reinvest cash flow back into the business, that reinvestment has yielded minimal returns to stockholders. In fact, the stock price has significantly lagged behind almost every sector of the market during this period, including its mineral peers, gas-weighted E&P companies, and the broader market, as demonstrated below. It is evident that the chief beneficiaries of PHX's assets at present are its management team, whose compensation has remained inappropriately high quarter after quarter when compared with stockholder returns.
The images below were provided by WhiteHawk showing PHX’s high G&A costs and poor stock performance.
WhiteHawk isn’t wrong. Years ago, I found PHX’s evolving situation interesting, but I’m thankful I never recommended it and that I nor my cohost ever bought it.
But these recent developments did caused me to reflect on why I didn’t buy PHX.
First was management’s propensity to pursue growth through acquisitions. This didn’t sit well with me because of how challenging it is for companies to make truly accretive purchases.
On top of that, it was clear management would fund these acquisitions with debt and share issuance in additional to cash flow. Since 2021, total debt increased from $18 million to $30 million and shares outstanding increased from 17 million to 36 million.
Lastly, the company made liberal use of hedging. This is common among commodity-based companies, especially those with considerable debt because there’s perhaps no worse situation than having debts to pay when the price of the commodity underlying your business craters. One could argue hedging makes sense for PHX, it is just not what I’m most comfortable with. I prefer an unleveled, unhedged business model.
That said, I have no idea whether PHX will prove a good investment overtime. Given that the stock is sitting $0.32 below WhiteHawk’s $4.00 offer, the market appears to be betting PHX’s management will maintain the status quo. We’ll have to wait and see.
Grow and Don’t Dilute
We always enjoy listening to Ian Cassel founder of Micro Cap Club, because this hardcore micro cap investor shares wisdom liberally. One of his most frequent quotes is:
The first principles of finding multi-baggers is just find a small business that’s undiscovered, that can grow revenues and earnings and not dilute you.
In an appearance on The Investor’s Podcast, Cassal uses Armanino Foods (AMNF) as an example of this type setup. My cohost, who has owned Amanino for years and recently wrote it up, was shocked to hear this obscure company mentioned on a podcast. But he agrees Amanino is a great example. Consider that since 2008, AMNF increased its earnings from $700 thousand to $8.7 million and decreased shares from 35 million to 32 million. Over that period, the company’s stock trounced the S&P’s 10.7% average annual return with an impressive 22.4%.
After listening to that episode, I wondered what other companies in our portfolios would meet Cassel’s criteria and have similar track records.
Texas Pacific Land (TPL) was an obvious answer. Over a comparable period, 2008 to 2024, TPL increased earnings from $10.9 million to $405 million and decreased share count from 30.9 million to 23.1 million (after adjusting for the 3-to-1 stock split). TPL’s result was an incredible 30% average annual return verses, again, the S&P’s 10.7%.
TPL was an outlier. Looking through my portfolio, I found it rare for companies to perfectly meet the criteria of growing earnings and never diluting. But it’s a helpful yardstick to measure companies against.
An example of a company that didn’t meet the criteria perfectly, but is still a great compounder, is OTC Markets Group (OTCM). The company’s one blemish was a 20% increase in shares outstanding which grew from 10 million to 12 million since 2008. That said, a more than 10x in earnings from $2.1 million to $27 million, overwhelmed the dilution and produced a market-beating 21.3% average annual return.
Other examples of near-misses are royalty trusts, for example, Mesabi Trust (MSB) and Sabine Royalty Trust (SBR). While shares outstanding are are held constant by regulation, the earnings don’t necessarily compound. Instead, they increase with commodity price inflation and the mount produced, which can be cyclical. One less obvious benefit these trusts have is they are a passive beneficiary of technological advancement, often leading to reserve growth. Still these trusts don’t cleanly meet Cassel’s criteria.
Two companies from my watchlist that match his framework are Eagle Materials (EXP) and U.S. Lime and Minerals (USLM). So, if you have time to kill this weekend, dig more into those two.
In summary, Cassel’s framework is an imperfect but helpful tool for identifying potential compounders—find a company early in its life that can grow earnings for a long time with management that won’t dilute you. We’d add, look for one with an asset-light business model—like intellectual capital companies—where the earnings don’t have to be plowed back into the existing business. If you can find that, you might just have the makings of a great investment.
With that we’ve wrapped up another episode of the show. If you feel inclined, we’d love to know if you know of or own companies that meet Cassel’s criteria. Sharing these in the comments would make our day. We enjoy learning from you all. So thanks. We’ll see you all in two week’s time!
Rabbit Holes of Curiosity #2