CNX: 2023 won't be like 2022
FCF forecasts have been cut ~40% YoY, is it time to save face and bail?
In the second quarter of 2022, Nick Deiuliis, CEO of CNX said the following:
“We built and now we manage a low-risk $700 million per year of free cash flow annuity that works year after year”
Free Cash Flow Guidance for 2023: $375mm.
I wrote a simple thesis on CNX over the summer that outlined two key assumptions: FCF would be ~ $700mm a year and they would take it and use it to buy as much stock back as possible. They have shrunk the share count by 25% since 3Q20 but the FCF assumption hasn’t held up.
It should have been a red flag to hear management of a natural gas company compare their operations to an annuity but I understand the vision they were trying to convey. It’s on my shoulders for not being skeptical enough of the high gas prices driving possible over-confidence, I should have used a multi-year normalized cash flow assumption when I made the initial purchase.
Past Year Operations
2022 was a solid year for CNX with free cash flow topping out at $702mm up 40% year over year from 2021’s FCF of $506mm. During the year they continued to shrink the share count by spending $568mm and buying back 33.5mm shares paying ~$16.90 per share. They have continued to deliver on the vision for their 7-year plan starting in 2020 to deliver $3.4B in Free Cash Flow and use the cash to “maximize the long-term intrinsic value of the company”
In short, this has meant massive buybacks.
This dedication to maximizing the per-share value is what got me interested in the first place. I have seen what can happen when you take a mature but stable company and sprinkle the magic capital allocation dust on it.
Unlike its competition, CNX orchestrates a massive hedge book to stabilize the cash flows coming through the door, giving management a greater certainty of what the future looks like. When you can predict better, you can prepare better.
The downside is the hedge book creates so much noise on the income statement that it can easily distract from the cash flow metrics that are the driving value of the company.
Currently, CNX has ~80% of their 2023 volumes hedged and ~70% of 2024. These numbers are much more aggressive than other Nat Gas players such as EQT and Range Resources who have 62% and 55% of 2023 hedged respectively.
Most of these players want the ability to get huge paydays if the Henry Hub goes through the roof again as it did in the summer of 2022 when prices >$8. The price as of today is ~$2.07. Sadly for gas guys, it’s been one heck of a warm winter.
Main Drivers of Value for CNX
1) Gas Volume Production
2) Free Cash flow Per Share Growth
Based on the guidance given in the Q4 Call, 2023 will not be like 2022 in terms of FCF or production volumes, both down year over year. It doesn’t thrill me to see two of the main variables in the thesis decreasing. Production has been guided down due to delays restarting abandoned wellbores. Is this a short-term issue? Right now, management predicts the delays to fade returning to the 2022 production level midyear and increasing in 2024. Am I tossing in my bed because of it? No, but it’s annoying.
This past quarter has held some real estate in my mind. The bearish outlook for 2023 didn’t make it any easier. I do my best to inhibit the owner’s mentality of the companies I own and this type of quarter is part of the game.
Watching the price of Nat Gas drop over the pasts 6 months didn’t give me the greatest confidence either but the focus on any one year is short-term noise in a long-term game. I have grown comfortable with the acceptance that trying to predict the direction of commodity prices is a game I am not interested in playing, CNX isn't interested either.
82%, ~70%, and ~60% of 2023, ‘24, and ‘25 volumes currently sit hedged on the books with an average price between ~$2.37 - $2.29. These numbers sit well below the NYMEX Forward Prices for the same years between ~$4.06 -$4.50. These fixed price points and the forward strip give this investor comfort.
Giving up the extreme prices, up or down, has little effect on my mindset with this company. I am not looking for them to shoot the lights out.
I want a continued focus on executing the strategy of keeping the cash flow in a tight range of outcomes and bringing the share count down over time.
Production volumes will fluctuate with short-term events and the Henry Hub will continue to bounce between peak and trough. These outcomes are uncontrollable and I concern myself only with the decisions management can make within their control, namely how they keep the financial health of the company and the allocation of extra cash. So far, both of those check out for me.
Expectations for 2023
It’s easy to get lost in the sea of uncertainty over the short-term price movement of Nat Gas over the next 12 months. The longer-term demand, in my opinion, will continue to remain constant maybe even increase a little as we transition to a greener future and CNX will have a place in that supply.
Using the PV-10 Method (a standard valuation metric used in the O&G Space, basically a DCF with a 10% discount rate for 5 years out) to value their acreage in the Marcellus and Utica Shale gives us a value of ~ $10 Bil. I think this number is a bit misleading because they use a $6.37 Nat Gas price which might overshoot.
I’d estimate the value to be in the range of $5 to $7 Billion or ~$30 - $40 a share using a much more conservative Henry Hub Price ranging ~$2.50-$3.
Fast forward to year-end 2023, I am expecting the production volumes to be in line with management’s guidance of 555-575 Bcfe as well as the FCF guidance of ~$375mm. On top of all this there should continue to be a heightened level of buybacks, should we use today’s stock price of ~$16 a share and an 80% FCF dedicated to buybacks they will spend ~$300mm on about 18.75mm shares resulting in a year-end share count of ~152mm. If this is the reality our FCF per share should be ~$2.45.
It could be easy to compare YoY results and feel discouraged. It might feel like things are going backward but progress is rarely linear and what is important is not where the puck is, but where it is going.
This year CNX is going to report less production volume and thus the FCF per share numbers will also decline. If we push past the short-term noise of any one-year result and look to 2024 positioning, we are looking back at production levels ~590 Bcfe with FCF and Capex similar to what they have been with a drastically lower share count than 2022 levels if management is able to continue to execute.
Closing Thoughts
When I think about the most recent results and remarks the word “disappointed” comes to mind for two main reasons.
1/ I am disappointed in myself. I fed into the optimistic calls for higher Nat Gas prices and it likely influenced my assumptions about the cash flow profile of the company going forward. I shouldn’t have assumed the record cash flow numbers to be the “normal earning power”. That being said, higher prices don’t affect the company as much as volume production changes do and this variable should have been given more thought in the initial thesis.
2/ I am disappointed a little with management’s communications to shareholders. For the past 2 quarters (2Q & 3Q 2022) they have included a slide that shows the potential growth in FCF per share over the next few years:
This slide was NOT in the 4Q presentation
The new 2023 estimates will not come close to the $5 in FCF shown above in 3Q22, the new guidance was $2.20 per share. If you are going to show this slide to investors, show it all the time.
Am I going to base my entire analysis on the lack of a slide previously used? No, but it didn’t sit well with me. Todd Combs said he would spend a lot of time studying what management is changing year to year. This was a noted change.
With this emotion in the subconscious and new guidance I needed to answer the question, do I want to continue to hold? Or, was this a mistake and it was time to throw this in the “too hard” pile and move on to an easier idea?
When contemplating, I kept coming back to a few key thoughts.
The intrinsic value of any asset is the distribution of cash flows discounted back to the present between now and judgment day. Through my ownership in CNX I own some of the most valuable acres in the country when it comes to producing natural gas and I can say with a high degree of confidence that the company will continue to produce natural gas and collect the spread between cash prices and their hedges for the reasonable future.
How long is that? I don’t feel comfortable saying up to 20 years but with the current valuation, I don’t have to. I have a strong conviction that it will be more than 5-6 years. Their competitive advantage of being a low-cost operator has helped them build strategic partnerships like at the Pittsburg Airport where they will supply 100% of the power generation. Something tells me they wouldn’t partner with each other if the time horizon wasn’t longer than the conservative estimate I have above.
This company isn’t going anywhere and should produce positive FCF for years to come.
1) They have the assets
2) Their balance sheet strength gives them a comfortable financial position for the next couple of years. (The nearest bond maturity is 2026).
During the past 3 years, the company has generated a cumulative cash flow of $1.6 Bil and has a goal set for $3.4 Bil cumulatively between 2020-2026. We have 4 full years left and about $1.8 Bil to go.
What does reality look like if they hit their target and continue to shrink the share count? $1.8 Bil equals out to ~$450 in FCF a year, if 80% is used for buybacks we are talking about a share count shrinkage of about ~10-12% a year based on today’s share price or ~100 – 112mm in shares outstanding in 2026.
If the cash flow is the same, we are looking at about ~$4.5 in FCF per share or 3.5-4x using today’s price. Does a company that produces consistent cash flow deserve a yield of 22%?
At a $16 share price, CNX is valued at ~6x trailing 3-year average FCF. I believe management will continue to hedge production making the company FCF positive under various economic conditions and keep reducing the share count by 10 to 12% a year. If this proves out we are looking at a ~3.5-4x 2026e FCF.
This entire thesis is driven by the increase in FCF per share and the terminal value not being $0 after 5-6 years.
I still believe the future for these two variables is strong, maybe not as strong as they led some to believe, but still strong nonetheless. For these reasons, I have no plans of selling.
In the end, I hold a firm opinion that management is focused on creating value for shareholders and Nick Deiuliis is doing a fine job running the company. He and the Chairman, William Thorndike, are making an excellent pair and I trust they are making the best long-term decisions for the company and for shareholders.
Peace and Love,
Michael
Disclaimer: At the time of this writing, I own shares of CNX.
Please be advised, Wall St Gunslinger is not an investment advisor and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.