Description

We initially looked at Knife River with a long bias as it checked several boxes: an optically high quality business being spun off from a parent whose core business was in an unrelated biz line (in this case MDU, a utility). However, we came away very unimpressed by the historical business performance and initiatied a short position in the company recently. We believe this business is much lower quality than peers despite trading at a comparable valuation. FWIW we are also long in equal size CRH, which we believe is the best in class company with a catalyst of a US re-listing to drive alpha. We see 20% near-term downside and longer-term 60%+ downside if people start valuing the company on FCF vs EBITDA. 

Biz Performance Has Been Worst in Class

-KNF organic growth (which we estimated based on historical M&A spend, 8x acquisition multiples and 10% margins) has been anemic a 1.8% CAGR over the last 6 years. This is worst in class. 

-The business hasn't expanded EBITDA margins in 6 years. Moreover, while typically I would expect a margin expansion story from the spin, its not at all apparent to me what exactly would cause this business to improve. This was a quality business/premium multiple business within MDU that received the bulk of the capital. While management points to handwavy pricing initiatives and their EDGE cost program, I find this unconvincing.

-Cash conversion for KNF also worst in class, which is one of the things I care most about. Capital allocation solely focused on M&A, which I'm skeptical of given elevated multiples in the sector. 

KNF Valuation Doesn't Fit Fundamentals

KNF mostly pitches itself as an aggregate company. I get why they want to do this given everyone agrees aggregates are great, local monopoly businesses with steady pricing. However, the reality is KNF is not an aggregate busienss. In fact, only 19% of their EBITDA comes from upstream building product segments that get higher multiples. The majority of KNF's business comes from downstream (Asphalt/Concrete), an odd cement import business in Hawaii (likely impacted by recent fires) and a road paving business. These businesses all tend to get much lower mulitples than building product companies. Illustratively, I assigned multiples across each segment that I believe are directionally consistent with sector norms (albeit note I do believe in the case of CRH, my 8x building product and 6x Europe are draconian. Check out the Breedon thread for summary of Europe and we believe CRH's building product business is best in class). Anyway, the message is clear: KNF should trade at a significant discount to any of the big three US pureplays (SUM, MLM, VMC).

However, that isn't what you see. KNF trades right on top of SUM at around 10x EBITDA (and a very large 3x discount to CRH). 

 KNF also operates in states I wouldnt want to be in long-term

While not a key focus on the pitch, I don't like where the company operates. Their focus is mostly on the west coast (their Texas business is very small). While management points to their states growing above average, I doubt the next 10 years will look at as good for the West Coast as the prior 10. Moreover, you are seeing the West receive the lowest amount of DOT awards of any region, implying recent infrastructure bills will not be as much of a boon for them as other players.

Fair Value and Opportunity 

Business will do around $360mm of EBITDA this year. The company expects LT capex to be 6% of sales (or $160mm, they noted this year they are underspending a bit). Interest expense is $65mm. Taxes of $34mm (25% tax rate). That gets you to $100mm of FCF before NWC. NWC is normally a drag of at least $30mm a year. That results in runrate FCF around around $70mm or 19% of EBITDA (note this is better than average performance over last 3 years). If you value the business at 8x EBITDA that gives you TEV of $2.9bn less net debt of 771mm, gives you a FV of $37/share (~20% downside). Note even at my valuation, the stock isnt particularly attractive at a ~3.3% yield. Realistically, I think this business should trade at a 6-7% yield so if the market switches from an EBITDA to FCF valuation framework and values stock at 6.5% yield on $70mm FCF, it would yield a stock price of $19 or 60% downside. Regardless, I think KNF is an exceptional relative short to the rest of the infrastructure stocks.

In terms of why the opportunity exists? I think people dont really know KNF yet. People are lumping it in with the aggregates companies. Most agree its not a VMC/MLM but are lumping it in with SUM and I think this business has performed much worse than SUM over time with worse business mix. Everyone wants to find an infrastructure stock to play all the stimulus coming so guys are buying first, asking questions later. Over time, we believe this business will be revealed to be an inferior play that is better expressed elsewhere.

Catalyst

Earnings misses

Sellside Coverage