ERF vs MDU

This is strictly for investors and probably of interest to very few. But in the process of updating my "investment links" at the top of the page, I stumbled on to something interesting: a natural comparison between MDU and ERF as potential investments.

I grew up with MDU; in fact, I worked for MDU one summer during my college years. I held MDU for many, many years, but finally sold it during the worst of the recession. MDU was one of the first investments I ever made. MDU's business model intrigued me: equal parts regulated and non-regulated, seen by many as a stodgy utility, but for those of us in the know, a company with significant growth potential.

I first stumbled across ERF only a couple years ago and traded in and out over the period of six months to a year for the distribution which it paid on a monthly --  yes, monthly -- basis. When Canadian laws changed concerning Canadian royalty trusts ("Canroys") investors were spooked. I stayed with ERF for awhile but took my distributions, sold and moved on.

ERF will transition to a dividend-paying corporation at the end of the year. Management assures investors the company will maintain the payout beyond 2011, and analysts see enough cash flow to cover the dividend through 2013, possibly through 2015.

So, if one has some money to invest in energy companies, and more specifically in exploration and production, and, then, even more specifically, how do ERF and MDU compare as investment opportunities?

Similarities (all figures rounded; based on Yahoo!Financial site)

• They are both mid-cap companies, with almost identical market caps: MDU, $3.6 billion; ERF, $3.9 billion.
• They both have similar amounts of cash: MDU, $107 million; ERF, $80 million.
• Their debt diverges a bit: MDU, $1.5 billion; ERF, $0.5 billion.
• They both have similar operating cash flows: MDU, $680 million; ERF, $770 million.
• They both have similar number of shares outstanding: MDU, 190 million; ERF, 180 million.
• Even their share prices have been almost identical this past year, in an $18 - $24 trading range.

Business models and current operating environment

• Their business models could not be more different. One is a pure E&P company with a history of maximizing cash returns to its shareholders (ERF); the other is a conservative conglomerate with a fairly stable regulated division, and several divisions greatly impacted by the American economy, not just regionally (MDU). 
• Most analysts agree that the price of oil and natural gas will trend higher over the intermediate term. Everyone agrees that there is a chance that the current global recession / downturn will last longer than expected. The only disagreement is how great that chance is. 
• MDU will remain the company it is. Investors can look at history of MDU and come to their own conclusions about its prospects for growth
• ERF is changing dramatically. It is a fact that it will transform from a royalty trust to a dividend-paying corporation at the end of the year. Its most recent presentation suggests that it is going to aggressively grow its oil and natural gas production.

Growth Potential

• MDU has a longer history and one can get a gut feeling for MDU's growth potential based on the past. I personally don't see significant growth. MDU appears to going after the Niobrara to make up for missing the Bakken, but is it too little too late? It's construction and materials divisions are greatly affected by the economy and I don't see any great shakes there. Even worse, the stimulus money -- remember the $1 trillion (actually $878 billion) Obama-Reid-Pelosi stimulus? -- has pretty much run its course. The good news over the years for MDU investors has been the fact that MDU is a conservative company; the bad news for investors is that MDU is a conservative company; perhaps that's why they missed the Bakken.
• I don't know that much about ERF, having only discovered it about three years ago, compared to 30 years of familiarity with MDU. But ERF seems to have "risk" and "growth" in its blood and that comes across in its most recent presentation. 
• On growth, I give the edge, by quite a margin, to ERF. ERF's quarterly growth earnings, year over year, is 50%. MDU's quarterly growth earnings are N/A. Those numbers have to change going forward; ERF will have to work to maintain that rate; MDU can't do much worse.

Dividend Going Forward

• This one is pretty easy. MDU will stay in the same range -- paying about 3.2 percent.
• Likewise, for ERF, this is pretty easy. For the short term. ERF currently pays about 9 percent and management says it will continue this payout beyond 2011. Analysts agree that ERF has the cash to maintain that payout. However, E&P in the Bakken is a capital intensive industry and ERF may find that it needs to reconsider that philosophy. At worse, it will raise more money through public stock offering, diluting current value. It won't be the first Bakken company to do this. BEXP is famous for doing this, and even the most conservative, high profile Bakken company, CLR, just announced a $1.3 billion loan. 
• For dividends then, I give the edge, again, by quite a margin to ERF, at least for the next two years. Investors will get their dividends, but share price could be diluted if ERF needs to raise cash for CAPEX; or, ERF could take on more debt.

Bottom Line:

• At some point MDU will again be the company for conservative investors with a long-term horizon but I don't think that moment is here yet. We need to see confirmation that global recovery is real, and then confirmation that the American economy will participate. Regionally, MDU is well positioned.
• ERF just has a lot of excitement associated with it. But excitement usually means risk. The high dividend payout protects share price to some extent. It appears that like BEXP, WLL, and CLR, ERF has "risk" and "growth" in its blood.

Risks (yes, bottom lines are never bottom lines -- have you noticed?)
This is what bothers me about ERF:

• ERF will soon be a dividend-paying corporation in a very capital-intensive industry. I'm at a loss to find another mid-cap E&P company that is able to pay this high a dividend as well as promote an aggressive drilling program. Perhaps ERF's emphasis will continue to be on current income and not necessarily growth: a trust in corporation clothing?
• ERF transitions to a dividend-paying corporation just as US tax law is changing and will be more punitive toward dividends. I don't think the "no new taxes for those with incomes less than $250,000" mantra will pertain to dividends or capital gains.
• ERF is exposed to natural gas as much as oil. The North American continent is swimming in natural gas. Margins for natural gas are simply not as great as those for oil. 
• ERF is heavily exposed to Marcellus. Its most recent presentation emphasizes the Marcellus and I think there is real risk of a drilling moratorium there in light of recent events. 
• That risk is offset by ERF's oily footprint in North Dakota, albeit relatively small, and its oily footprint in Canada. 
• Somewhat off-topic, but relevant to the discussion is the capacity to bring Canadian oil to American refineries. That appears not to be an issue. The TransCanada Pipeline announced its first delivery this past week at its terminus in Illinois. The TransCanada Keystone XL project remains on schedule despite some political maneuvering which could slow it down.

I'll leave it at that for the moment. Perhaps more to follow.