Shares of MDU Resources Group Inc. (MDU) have fared rather well this year, down “only” about 12.8% so far this year, so I thought I’d look in on the name. In particular, I want to try to determine whether the dividend is sustainable or not, because if so, the shares will rally over time as investors seek income streams that are relatively safe. If not, the shares will very likely suffer. I’ll take a crack at answering this question by looking at the financial history here, and by paying particular attention to the capital structure. In addition, I’ll draw some clues from recent insider activity. As usual, there’s no escape from looking at the stock itself as a thing distinct from the actual business. I’ll round out the discussion by suggesting a short put option for people who see value here, but are nervous about buying at current levels.
The financial history here has been fairly impressive in my estimation. For example, over the past six years, revenue and operating income have grown at CAGRs of 4.45% and 6.45% respectively. In addition, the company has increased dividends per share at a CAGR of about 2.2%. Note that dividends have been increased by this company for the past 82 years, which is itself an impressive feat in my estimation. Also, long-term debt has grown, but at a much slower pace than I’ve seen elsewhere. Long-term debt has grown at a CAGR of about 1.8% over the past six years, while interest expense is up at an annualized rate of 2.1%. That said, the weighted average interest rate of 4.5% is a bit steep in my estimation, and so I would like to see the company deleverage the balance sheet over the coming years.
I’d give management only part marks for the way they’ve treated shareholders over the past few years. Obviously, the company is a dividend superstar, and management has returned just over $892 million to owners over the past six years in the form of ever growing dividend payments. The problem is that management has diluted the shareholder base by increasing shares outstanding by about 3% over the past six years. While I’m no longer an unthinking fan of buybacks, I’m certainly not enamored of dilution either.
Is The Dividend Sustainable
The most important question here in my opinion, is whether this dividend is sustainable or not. While I think earnings are a very relevant measure, and they capture very consequential things that cash flow does not, when it comes to dividend sustainability, “cash is king” in my estimation. For that reason, I’m going to compare the timing of debt payments over the next several years to cash from operations. Per the following table, we see that 2020 and 2021 are relatively light years for debt repayments. Also, the company has cash on hand of just under $66.5 million, against the $19 million due over the next two years. This leads me to conclude that the company won’t cut the dividend in the short term as a result of the need for cash to service debt.
That said, I think business slowdown is another reason why the dividend might be cut. In my view, there’s also very little reason to fear this. Over the most recent fiscal year, total dividend payments represented about 48% of net earnings, and 29.5% of cash from operations. Business would have to absolutely crater to risk the dividend in my estimation. There’s a risk of that, obviously, but I estimate it’s low.
Source: Latest 10-K
Source: Company filings
While I don’t think there’s a risk that management will end the 82 year dividend streak anytime soon, there’s obviously risk that they will. For that reason, I need to see if investors are being compensated for taking on that risk with an inexpensive stock. Investors are potentially either blessed and cursed because they access the future cash flows of a given business via the stock market. Unfortunately, the stock is often a poor proxy for the health of the underlying business in my view. In particular, if the market is too optimistic about a company’s future, risk is relatively high. The reason for this is that, sooner or later, every company will disappoint, and if the market had great expectations for that company, the shares drop precipitously in price.
For that reason, I want to determine if the market is too optimistic about the future of MDU Resources. I make this determination in a couple of ways, ranging from the quite simple to the very complex. On the simple side, I like to look at the ratio of price to some measure of economic value. On that basis, the shares seem to be trading on the low end of their price to cash from operations, as seen below. Note that I’m looking at price to CFO because it’s a less volatile measure than earnings in this case.
In addition to looking at the ratio of price to some measure of value, I want to understand what the market is currently assuming about the long-term growth prospects of the firm. In order to do that, I turn to the work of Professor Stephen Penman and his book “Accounting for Value.” In this book, Penman describes how an investor can isolate the “g” (growth) variable in a fairly standard finance formula to work out what the market must be thinking about long-term growth of the business. Applying this methodology to MDU Resources suggests the market is assuming a growth rate in the range of 5%. Given what the company has done over the past several years, I don’t consider this estimation to be excessive.
Not all investors are created equal. There. I wrote it. There are many reasons for this. First, there are the institutional investors. By virtue of talent or training, some (though certainly not all) institutional investors are better investors than the rest of us. Whether this is because they have the right emotional frame of mind or legions of analysts at their disposal is beyond the scope of this discussion. We can suffice to say that they’re generally fairly good at this. Another group that might be better at investing in a particular issue is the insiders who work there. Given that they live and breathe the business, it’s to be expected that they know the business more than any Wall Street analyst ever will. It’s this second group that I want to spend some time writing about.
Over the past month, CFO Jason Vollmer bought 1,200 shares for a total investment of just under $33,000. This purchase increased his holdings in the company by 5.5%. I think this is most relevant, because it indicates that an insider is willing to buy in the teeth of the current bear market. Also of note, in my opinion, is the fact that 2019 saw four buys conducted by three insiders (two directors and the President & CEO) totaling just under $350,000.
The fact that these knowledgeable insiders bought is obviously no guarantee of anything. That said, I think it is relevant that people who know this business better than any outsider ever will spend about $380,000 of their own capital to acquire shares. At the very least, I think if we take note of what insiders are doing, there’s a chance we might ride their coattails.
Options As Alternative
I can understand why some investors might be nervous about buying at these levels under the current circumstances. Such nervous investors are on the horns of a dilemma. They can wait for the shares to drop in price, which is, in my estimation, the definition of boring. Alternatively, they can sell put options that will generate decent premia and/or give them the opportunity to buy at a discount to the current market price. I consider this latter option superior, as it creates what I call a “win-win” trade. If the shares rally from these levels, the investor simply pockets the premium. If they fall, the investor is obliged to buy, but they do so at a price that they determined was a good entry point.
At the moment, my preferred short put options in this case are the October expiration and $22.5 strike price. At the moment, these are bid-asked at $1.45-$2.10, having last traded hands at $2.20. Holding all else constant, if the investor simply takes the bid here, and they are subsequently exercised, they’ll enjoy future dividend yields of ~4%.
The game of investing is innately risky in my estimation, and we do our best to navigate the world by exchanging one risk for another. For example, holding cash has risk (erosion of purchasing power through inflation) and buying shares has risk (potential for capital loss). When we buy shares, we trade one risk for another. Put options are no different in this regard as they, like everything, come with their own risks, and it behooves me to talk about them. I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money and the short put writer will be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices. Puts are distinct from stocks in that some put writers don’t want to actually buy the stock; they simply want to collect premia. Such investors want to maximize their income, rather than pick a stock price that represents a great long-term buy price. For that reason, they’ll be inclined to sell puts based more on the income they receive, and they worry less about the relative merits of the underlying. For my part, I’ll only ever write puts on companies that I’d be happy to own, at strike prices that represent good entry points for me.
In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This is an objectively better circumstance than the person who takes the prevailing market price for the shares. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day. There’s risk there, but it’s far less than simply buying, in my estimation. This point is driven home by looking at MDU as an example. The investor can either buy the shares today at a price of ~$24.50. Alternatively, they can sell put options that oblige them–under the worst possible circumstance–to buy the shares at a net price 13% below today’s level. In my view, that is the definition of lower risk.
I think shares of MDU Resources represent great value at these levels. I think the dividend is safe, and the company would have to suffer enormously to put the dividend at risk. In my view, as long as the dividend remains safe, the shares will find support. Alternatively, the buy activities we’ve seen over the past 15 months suggest that the people who know this business best are putting their own capital to work. For those investors who remain unconvinced, I think short put options represent a great alternative here. I’m not expecting a huge capital gain with this investment anytime soon, but I think the dividend is sustainable, and the company will survive. In the current context, this puts this company head and shoulders above many others in my view.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MDU over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In addition to buying shares, I’ll be selling the puts mentioned in this article.