MDU - MDU Resources Group Stock Is A Hold Pending The Second Separation

2023-10-14 03:58:38 ET

Summary

• MDU Resources Group completed the spinoff of its subsidiary Knife River Corporation, focusing on becoming a pure-play energy-regulated delivery company.
• The separation with Knife River has led to a reduction in costs and expenses and raised MDU's net income in H2 2023.
• MDU plans to pursue another separation with the MDU Construction Services Group in 2024, which is currently the strongest earner for the company.

MDU Resources Group (MDU) completed the spinoff of its subsidiary Knife River Corporation (KNF) at the end of Q2 2023 laying off its construction materials segment. The company's future state is set to be a pure-play energy-regulated delivery company focusing primarily on utility and pipeline. Its Q2 2023 revenue of $1.09 billion missed estimates by $403.20 million and was down 36.60% (YoY) as the market priced in the incoming changes in MDU's portfolio.

Thesis

MDU Resources' decision to become a pure-play energy-regulated delivery company, according to me is a strategic opportunity to provide targeted growth and shareholder value in the long run.

Why I am pro-separation

The stock has grown less than 5% over the last 10 years and is up 11.71% in the past 5 years. As stated earlier, MDU has already finished the spinoff with Knife River which began as a coal operator before transitioning to the production of construction aggregates. Additionally, MDU is also pursuing another separation, this time, with the MDU Construction Services Group , a relationship that commenced in 1997. MDU's intention at the time was to expand and grow its understanding of constructing energy transmission & related infrastructure.

I believe that MDU now has the best of both worlds since the majority of the company's operations are centered around the provision of electrical and mechanical services. After the separation, MDU will remain with Montana-Dakota Utilities, WBI Energy (transmission company for natural gas), and other 3 utility companies.

Knife River had its IPO on September 26, 2023, and is trading just 2.1% shy of its 52-week high of $54.03 and almost thrice the price of MDU. It is no wonder that MDU distributed a share of KNF common stock for every 4 shares held by MDU common stockholders. KNF has the potential for growth seeing that it is already operational in at least 14 states throughout the US.

Manufacturing-related spending in the US is heading towards recovery in H2 2023 after the PMI in September 2023 rose to 49.0 from 47.6 in August 2023. We are looking at the growth in the construction aggregate market (in which KNF operates) boosted by the demand for private and public infrastructure into 2024. According to research, the construction aggregate market is expected to grow at a CAGR of 4.86% from 2023 to 2023. It is anticipated to reach $636.46 billion by 2033.

MDU Resources believes that earnings in the utility sector post-KNF will increase to 48% from 27% while pipeline earnings will surge 13% from 9%. MDU also plans to raise CapEx to 79% post-KNF from 57% in the prior year.

It does not stop there; MDU also seeks to part ways with MDU Construction Services Group. At this point, it is yet unclear if it will be a sale, a spinoff (like it did with Knife River), or a merger. However, in its Q2 2023 SEC filing report, MDU indicated "that it will pursue a tax-advantaged separation of the Construction Services Group." This last separation is expected in 2024.

Financial overview

Constructions Services' record 1st quarter 2023 revenue of $754.3 million was slightly replicated in Q2 2023 at $747 million (dropping just $7.4 million). Earnings, however, hit an all-time high of $38.6 million, an increase of $4.1 million from Q2 2022. The company did not include earnings from Knife River in Q2 2023 as it had reported the company as part of its discontinued operations for the quarter.

Since the total quarterly revenues stood at $1.091 billion, and with Construction Services Group contributing $747 million, it means the remaining utility and pipeline segment contributed $344.1 million. This figure is significant considering the company's gross profit was $185 million a decline of 22.25% (QoQ). The financial impact will be felt by all companies involved with MDU Resources taking a significant hit. However, MDU realized the highest quarterly revenue of $1.977 billion in the quarter ending September 30, 2022, about a month after it announced its intention to spinoff Knife Rivers to a standalone company. It continued to record revenues above $1.4 billion in the two quarters afterward until Q2 2023 when it almost matched figures last seen on June 30, 2022.

It is noteworthy also, that despite the slight decline in revenues, MDU recorded a significant increase in net income at +240.36% (QoQ) to $130.7 million. This net income also represented an increase of 84.87% (YoY) as it stood at $70.7 million in Q2 2022. The divestiture of Knife Rivers has led to a 24% (QoQ) drop in the cost of revenues and a 14.9% (QoQ) decrease in total operating expenses.

Safe to say, MDU's management led by the outgoing CEO, David Goodin was looking to reduce the company's operating expenses and costs of revenues as a means of driving future growth with the spinoff. I also think that David's exit in January 2024 will be marked by a clear separation plan with the Construction Services Group. While this segment appears to be the main contributor of revenue for MDU (relatively speaking), the company will need to focus on its utility and pipeline infrastructure service business.

Positive future growth

In its Q2 2023 earnings call , MDU's CEO stated,

"Our utility and natural gas pipeline businesses continued to perform well. The utility was positively impacted by rate relief and higher electric retail sales volumes during the quarter. The pipeline business had record quarterly transportation volumes as we continue to see the benefit of increased contracted volume commitments, particularly on our North Bakken expansion project."

MDU's pipeline business raked in $8.7 million in Q2 2023 earnings, a 22.5% (YoY) increase from $7.1 million recorded in 2022. On its part, the electric utility business' earnings stood at $16.3 million, a +250% (YoY) growth from $4.6 million in 2022. The company attributed this increase to an "interim rate relief in North Dakota and Montana" that resulted in higher retail sales. The company hopes to increase its investments in system infrastructure, electric utility upgrades, and replacements to meet growing customer demand, especially in North Dakota.

The CEO was optimistic as he further stated,

"Our utility continues to seek timely regulatory recovery for the investments associated with providing safe and electric -- and reliable natural gas and electric service to our growing customer base, as we expect to file three additional general rate cases yet this year and one more in early 2024."

On the pipeline side, three natural gas projects are expected to come online before the end of H2 2023. They are expected to add a daily capacity of about 300 million cubic feet that may rise up to 2.7 billion cubic feet per day in the future. Such a capacity upgrade as a "pure-play energy-regulated delivery company" will see MDU realize earnings in the range of $150 million to $160 million" in the long run. It also affirmed a diversified backlog into H2 2023 that will see future growth of both utility and pipeline businesses.

Risk and valuation

With the spinoff of Knife Rivers, the construction services business is now the dominant revenue source for MDU. The electric utility and pipeline space still have weaker earnings. In my view, the 2023 revenue guidance of $2.8 billion to $3 billion will largely be contributed by the construction services segment. Still, the growth of customers and systemic opportunities will upgrade earnings from utility and the pipeline business. This holds true since the company is pursuing pipeline expansion projects to counter the rising demand.

The growth of the pipeline is subject to the volatile nature of energy prices. Lower prices may dampen MDU's pipeline growth. For example, the North Bakken expansion project (with a capacity of 250 MMcf) was commissioned in February 2022. The company is supposed to raise the capacity to 625 MMcf into 2024 subject to favorable natural gas prices.

MDU's cash balance as of Q2 2023 stood at $296.8 million against a total debt of $2.7 billion. However, the cash has grown more than 218% (QoQ) and more than 353% (YoY).

In terms of valuation, MDU's P/E ((TTM)) ratio stands at 7.87 against the industry average of 19.28 (a difference of -59.20%). Additionally, MDU's price against sales ((TTM)) ratio is 0.53 against the industry average of 1.35 (a difference of 60.97%). These metrics show that MDU is highly undervalued and has significant growth potential.

Bottom line

MDU Resources' separation from Knife River has led to a significant reduction in costs and expenses and raised its net income into H2 2023. However, the separation with Construction Services Group will have a higher impact on revenues considering it is the strongest earner at the moment. Still, MDU has lined up various expansion projects that will see it augment its revenues into 2024 and grow to meet the rising demand as a pure-play energy regulated delivery company . I will wait to see how the company's new management handles this second separation in 2024 before I grow my position. At the moment, I recommend a hold rating for the stock.

For further details see: