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Company: Southwest Gas Holdings (SWX)
Business: Southwest Gas distributes and transports natural gas in Arizona, Nevada and California. It operates through its natural gas distribution and utility infrastructure services, as well as its pipeline and storage segments. Southwest Gas is currently pursuing a separation of its utility infrastructure services company, Centuri Group, which is expected to be completed by the first quarter of 2024.
Stock Market Value: $4.1B ($57.76 per share)
Percentage Ownership: 5.81%
Average Cost: $60.68
Activist Commentary: Corvex was founded in 2011 by Keith Meister, Carl Icahn’s former lieutenant who served as CEO and vice chairman of Icahn Enterprises. Corvex is a highly concentrated, fundamentally driven hedge fund that uses activism as a tool, but not a primary strategy. The firm’s preference is not to be an activist, with a proxy fight being a last resort. Rather, Corvex would prefer to amicably be invited on boards.
Corvex intends to have discussions with Southwest Gas’s board and management to discuss options to unlock the value of the company’s core utility franchises and its investment in Centuri Group. These include improving earned returns on capital, further restructuring, as well as a potential sale of the company.
Utilities have not historically been a common target of activists, but in the current environment we are seeing a lot more of it, particularly from Corvex (MDU Resources and Exelon). There are several characteristics that make regulated utility companies attractive investments today. First, these companies have largely been benefiting from the green energy transition, leading to annual growth ranging from 4% to 7%, versus 2% historically. Second, domestic utilities are not negatively impacted by geopolitical risks like wars and uncertainty with China. Third, interest rates provide an intriguing dynamic for utilities. Utility investors generally chase yield. With higher interest rates, many may sell and buy bonds, so it could affect stock prices in the short term. However, high interest rates do not affect the earnings of a regulated utility: If interest expense goes up, then the company puts that amount into the rate base, which gets included in the allowed return. As a regulated rate-based utility, a company is allowed to make a regulated rate of return of approximately 9.5%, offering significant downside and inflation protection.
In March 2022, Carl Icahn made what we believe to be a genuine offer of $82.50 per share for Southwest Gas when the stock was trading at about $79 per share. Since then, revenue has increased from $3.7 billion to $5.4 billion, and EBITDA increased from $741 million to $972 million. Also, Icahn received four board seats (including one for Icahn portfolio manager Andrew J. Teno), replaced the CEO, got Southwest Gas to sell the former Questar pipeline business and successfully advocated for the spinoff of Centuri (expected to be completed in Q1 2024). Icahn is currently the largest shareholder, holding 15.2% of shares. Despite all this, the company’s stock has declined to roughly $57 per share. This is a prime example of an activist “J” curve where companies can often trade down in the middle of an activist campaign. This is due to the interest rate dynamic discussed above and the current structure in which the company operates: a regulated utility and an unregulated infrastructure services company under the same corporate structure.
A foregone conclusion that has been proven in the past, notably at Exelon and MDU, is that regulated utilities companies trade better when they are pure plays. Southwest is in the midst of that transformation and should be a pure play in a few months. Centuri should be able to garner a valuation of 8 to 12 times earnings before interest, taxes, depreciation and amortization. Assuming the low end of that range, the remaining regulated utility business will be trading at one times rate base, versus 1.5 to 2.0 times for peers and utilities historically. With Icahn involved at a board level, this discount should not persist for long.
After Centuri’s spin off, there are two potential outcomes. One possibility is that Southwest Gas becomes a pure-play utility with the right cost of capital that trades at a good valuation. In that scenario, it could have the ability to invest $2 billion in growth projects, which could trade at 1.5 times rate base and be a solid public company. Alternatively, this industry is consolidating at 1.5 to 2.0 times rate base valuations, and Southwest Gas would be an attractive asset for a larger utility. If the company continues to trade close to rate base it would become a takeover target for another utility. Following the spin-off, it would not surprise us to see the commencement of a strategic review, including a possible sale of Southwest Gas. Given Icahn’s inclination for a strategic play here last year and the potential upside of a buyout if the standalone could garner a multiple near 1.5 times rate base – we would expect Icahn to use his four board seats and voice as the largest shareholder to maximize value.
Separating the regulated utility business from the services businesses is the same roadmap Corvex orchestrated at Exelon and MDU Resources, where the firm created value for shareholders. So, Corvex is certainly on board with the strategy. Moreover, Keith Meister, founder of Corvex, was formerly Icahn’s right-hand man and knows his abilities as well as anyone. Meister is likely happy leaving the heavy lifting to Icahn here, so we do not expect him to increase his activism in any way other than supporting the veteran activist.
Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments. Southwest Gas is owned in the fund.