Southwest Gas could benefit from activist Corvex's tried-and-true playbook to maximize value.

Company: Southwest Gas Holdings (SWX)

Southwest Gas operates in Arizona, Nevada, and California, providing natural gas distribution and utility infrastructure services, pipeline, and storage segments. The company is currently separating 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)

Activist: Corvex Management

Percentage Ownership:  5.81%

Average Cost: $60.68

Corvex, founded in 2011 by Keith Meister, was established as a highly concentrated, fundamentally driven hedge fund that utilizes activism as a tool but not as its primary strategy. The firm prefers not to engage in proxy fights and instead aims to be invited onto boards through amicable means.

What’s happening

Corvex plans to engage with Southwest Gas's board and management to explore ways to maximize the worth of the company's core utility franchises and its stake in Centuri Group. This may involve enhancing returns on invested capital, restructuring, and possibly selling the company.

Behind the scenes

In recent years, regulated utility companies have become increasingly popular targets for activists, particularly Corvex (MDU Resources and Exelon). Several factors make these companies attractive investments today. First, they have benefited from the green energy transition, leading to annual growth ranging from 4% to 7%, compared to 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 a genuine offer of $82.50 per share for Southwest Gas, which was trading at about $79 per share. Since then, the company's revenue has increased from $3.7 billion to $5.4 billion, and EBITDA has increased from $741 million to $972 million. Icahn received four board seats, including one for Icahn portfolio manager Andrew J. Teno, replaced the CEO, sold the former Questar pipeline business, and successfully advocated for the spinoff of Centuri, which is 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, which is a prime example of an activist "J" curve. This is due to the interest rate dynamic and the current structure in which the company operates: a regulated utility and an unregulated infrastructure services company under the same corporate structure.

Historically, it has been proven that regulated utilities companies perform better as pure plays. Southwest is currently undergoing this transformation and is expected to become a pure play in the near future. Centuri, with its focus on the regulated utility business, should be able to achieve a valuation of 8 to 12 times earnings before interest, taxes, depreciation, and amortization. Assuming the lower end of this range, the remaining regulated utility business will be trading at a rate base of one times, compared to 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 the spin-off of Centuri, Southwest Gas has two potential outcomes. One possibility is that it becomes a pure-play utility with the right cost of capital and trades at a good valuation. In this scenario, it could invest $2 billion in growth projects that would trade at 1.5 times rate base and be a solid public company. Alternatively, the 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 is likely that a strategic review will be conducted, 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 expect Icahn to use his four board seats and voice as the largest shareholder to maximize value.

Corvex, which was previously involved in regulated utility businesses at Exelon and MDU Resources, has adopted the same roadmap as Icahn's strategy. Keith Meister, the founder of Corvex, was previously Icahn's right-hand man and is likely happy to leave the heavy lifting to Icahn. As a result, we do not expect Meister to increase his activism beyond supporting Icahn.

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. The fund owns Southwest Gas.