With its Q2 results, CNX Resources (CNX), the Appalachian producer, provided its guidance for the next year.
Given CNX’s hedges cover most of its production in 2020, the company’s solid results for next year look pretty much set in the stone. This development also means hedges reduce the upside potential of the company’s forecasted free cash flow.
Yet gas prices will impact the natural gas producer in another – significant – way.
Image source: CNX Resources
No surprising results over the next couple of years
(In its financial statements, CNX consolidates its interests in CNX Midstream Partners (CNXM) because of GAAP accounting. But for a clearer representation of CNX’s operations, I discuss CNX’s E&P standalone results only unless noted otherwise).
With its front-loaded capital program of $920 million in 2019, CNX can still grow its production in 2020 spending only $165 million. As a result, earlier this year, management had highlighted its free cash flow potential of $500 million in 2020.
But management has also been discussing its focus on growing the company’s NAV per share. Thus, it decided to increase the 2020 capital program to a range of $540 to $620 million. This update corresponds to a production growth of about 12% year over year.
Assuming an average NYMEX price of $2.55/MMBtu in 2020, the company’s adjusted EBITDA + distributions and free cash flow will reach $793 million and $135 million, respectively. (“Distributions” refer to the dividend and fees CNX receives from CNXM). This forecast is based on the midpoint of the 2020 production guidance of 582.5 Bcfe.
But given hedges cover 86% of the company’s expected production in 2020, gas prices won’t impact 2020 results in a meaningful way. For instance, the company will still generate $100 million of free cash flow if the average 2020 NYMEX price drops to $2.25/MMBtu.
Source: Q2 2019 presentation
Hedges also reduce the upside potential. The company will generate only $35 million of extra free cash flow if NYMEX prices average $2.85/MMBtu in 2020 compared to the base case of $2.55/MMBtu.
And the company will report similar results in 2021. Management discussed the possibility of holding production flat in 2021. Besides, at the end of the last quarter, 2021 hedges covered 416.2 Bcfe. These hedges correspond to 71.5% of the midpoint of the 2021 estimated production.
Also, CNX hedged its production at similar prices over the next two years. “NYMEX only” and “Physical Fixed Price Sales and Index” 2021 hedges will average $2.92/Mcfe and $2.49/Mcfe, respectively. In 2020, these hedges will average comparable prices of $2.94/Mcfe and $2.42/Mcfe.
Thus, given the strong hedging position, investors can estimate the company’s results with a fair degree of certainty.
Assuming management won’t change its plan of holding production flat by 2021, adjusted EBITDAX + distributions will reach $793 million. This estimate corresponds to a NYMEX average price of $2.55/MMBtu. But as I discussed above, the impact of gas prices won’t be significant.
At a share price of $7.03, and with net debt of $2 billion, the market values the company at an EV/(adjusted EBITDAX + Distributions) ratio of $3.32 billion / $793 million = 4.19.
In its 2018 investor day presentation, management estimated the company’s maintenance capex at about $350 million for an annual production of 507 Bcfe. As the midpoint of the 2020 production guidance corresponds to 582.5 Bcfe, I extrapolate the maintenance capex at $400 million.
Thus, assuming about $100 million of interests, I estimate the potential free cash flow, while holding production flat, at $793 million – $100 million – $400 million = $293 million. The market values the company at only 4.5 times my free cash flow estimate, which corresponds to a free cash flow yield of 22.2%.
Besides the limited impact of gas prices, the company’s free cash flow will depend on tax items, distributions from CNXM, and costs. But the point is the volatility of gas prices won’t impact the company’s results and free cash flow in a meaningful way.
Given its stable strong free cash flow potential, CNX seems to be an attractive investment proposition for prudent investors.
Taking advantage of gas prices
The volatility of gas prices won’t disturb CNX’s operating results, but it will impact the company in a different – and significant – way.
At the end of Q2, the company’s leverage ratio of 2.3 remains high (leverage defined as net debt / (adjusted EBITDAX + distributions)). But given the predictability of the company’s results, thanks to its hedges, management has some options to allocate its free cash flow.
CNX’s management highlighted its capital allocation process. In contrast with some producers that focus on production growth or dividends, it prioritizes the growth of NAV per share.
For instance, during the last earnings call, Nick DeIuliis, the CEO, said:
“Now, these advantages, they’ve helped us execute a consistent strategy and a philosophy, which is built around generating risk adjusted returns to grow our NAV per share, while at the same time we’re making sure that we retain a healthy balance sheet.
We follow the math in everything we do. […] It drives several capital allocation opportunities.”
As an illustration, the company repurchased 12% of its shares outstanding over the last 12 months.
Besides, despite CNX’s solid hedges over the coming years, the market still values the company based on gas spot prices.
Thus, taking into account management’s focus on growing the company’s NAV per share, I expect management to take advantage of the stock price relative to gas prices.
Considering the attractive 20%+ free cash flow yield because of the decrease in natural gas prices, the company can buy back its shares at a cheap price. Investors should pay attention to the management balancing buybacks and net debt reduction to keep leverage at a reasonable level.
But if gas prices soar, management will instead increase the company’s capital program to grow production. Current hedges don’t cover any potential increase in production. Thus, thanks to higher prices and increasing production volume, the EBITDA upside potential from production growth isn’t restricted. And with higher EBITDA, leverage will automatically decrease.
And if CNX’s stock price becomes expensive while gas prices stay low, which doesn’t seem likely in the current environment, management can focus on reducing net debt.
Attractive investment proposition
The main risk in investing in a natural gas producer remains gas prices. But given CNX’s strong hedges over the coming years, gas prices must stay low for many years before the company gets into trouble. With this scenario, the company would not have the opportunity to keep on hedging its production. And the downside protection of the company’s free cash flow will disappear in the medium term.
But if you estimate U.S. gas prices won’t stay below the base case of $2.55/MMBtu for several years, and if you value management’s focus on growing the company’s NAV per share, CNX’s 20%+ free cash flow yield seems attractive.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.