CNX Resources: Investment Thesis

July 31, 2022
Ticker: CNX US
Price paid: $16.3
Shares outstanding: 195mn
Market Cap: $3.2bn
Net Debt: $2.2bn
EV: $5.4bn

Three weeks ago, I increased the size of my CNX position at $16.3. My average cost is $14.28, and the total weight in the portfolio of about 8%. This is primarily a value call with a little bit of growth. I expect shares to re-rate to $27-31 (13-15% FCF yield).

CNX is a low-cost gas producer run by a team with a strong track record of value creation, which has generated $460mn organic FCF in 2021 and is on track to deliver over $600mn in 2022 (FCF yield of 14% and 19%, respectively). Even more importantly, the company is spending its FCF on paying down debt and share repurchases. It bought back 12.9mn shares in 2021 ($245.2mn) and repurchased 12.4mn in YTD ($248.5mn), reducing its share count by 6% since the start of the year. At the same time, unlike many other E&P companies, CNX has been growing production and expanding its reserve base. The company has also consistently reduced its costs.

I think a more reasonable valuation for CNX would be a 10-15% FCF yield based on a normalised FCF per share of $4, suggesting around a $33/share valuation (~100% upside). There is an additional upside to long-term FCF coming from production growth, net debt reduction (reduced interest expenses), lower share count (per-share FCF), better hedge price as the forward gas price moves higher in a tighter market and potential cost optimisation (higher productivity).

Key risks: collapsing energy prices, an expensive M&A deal, geology/operations, retirement of the CEO, default of a counterparty in a swap transaction (hedging), and regulations including higher taxes.

Operations

CNX Resources (CNX) is a former gas division of the coal company CONSOL Energy (CEIX). In 2017, it spun off its coal business into a new publicly listed company, Consol Energy (CEIX), while the remaining company (CNX Resources) kept the gas operations.

The company boosted its gas operations in 2010 by acquiring Dominion Resources E&P assets.

The company's main assets are unconventional shale formations in the Appalachian Basin, primarily the Marcellus Shale (526,000 net acres) and Utica Shale (610,00 net acres), in Pennsylvania, Ohio and West Virginia. Additionally, CNX operates Coal Bed Methane properties in Virginia (8% of '21 production). CNX also owns midstream operations to process and transport natural gas, including 2,600 miles of gathering pipelines.

The total proved developed acreage of the company is 376,850 acres (net to CNX), with an additional 41,605 proved undeveloped acres. At the same time, the unproved acreage is almost 10x bigger, representing a significant upside to the company's total resources and future production potential. Net unproved acres amounted to 3,442,159 at the end of '21.

Most of the production is natural gas, with only 7.5% of total volumes represented by liquids (primarily natural gas liquids such as propane and butane).

A low-cost gas producer

CNX has one of the lowest lifting costs of just $0.08/mcf (these are the costs related to the extraction of gas out of the ground, not including costs to drill a well, process gas and ship it to the final destination). All-in cash operating costs (including SG&A) amount to $1.1/mcf, still considerably lower than gas spot prices ($8/mcf) or 5-year average prices. ($3.4/mcf).

Costs to drill a gas well and prepare the necessary infrastructure amount to $0.8-0.9/mmscf (5-year average - $1.5/mmscf).

All-in costs, including Capex and interest expenses, were $2.1/mcf in 2021 and $3.1 for the past five years.

The company has been consistently driving costs down (see chart).
Diagram of EPAM's share of personnel by location ><meta itemprop=
Source: CNX Resources, Hidden Value Gems
This cost reduction was primarily due to improving efficiency as management learnt more about the assets, picked the best locations to drill wells, optimised its production process, and used better equipment (higher productivity). However, I would not expect this trend to continue for much longer. There are limits to both geology and technology. If anything, costs would like to start rising soon, given bottlenecks in the supply chain and personnel shortages. The good thing is that with starting level being so low, even if costs double from here, the company will still be profitable.

The company is also actively hedging its future production, another factor limiting the downside risks. Contrary to many publicly listed E&P companies, CNX is not selling its gas at the market's peak, facing a 70-90% decline in profitability if prices normalise.

Finally, the company wholly owns its midstream business which transports its gas to the selling point. This is an important asset that should help CNX keep its costs under control, especially during high inflation.

A growing business

Unlike many of its peers, CNX is not maximising FCF by under-investing in its operations. Quite the opposite. The company has been growing production by 16% annually since 2012. The only year when production declined was 2020.
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources, Hidden Value Gems
This production growth was supported by the expansion of the reserves base and is therefore sustainable.
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources, Hidden Value Gems
This production growth was supported by the expansion of the reserves base and is therefore sustainable.

I know many investors are excited about the energy names today. Still, it is essential to differentiate those companies that under-invest and are losing production straight away or are about to face a decline. A company can maintain flat production by boosting output from existing reserves, thus offsetting declines. However, as its Reserves-to-Production (R/P or reserves life) ratio drops to 10x or less, production starts falling. It cannot be reversed easily (at least organically).

I also encourage investors to deduct the rate at which production declines from the FCF yield that companies report. For example, if a company reports a 25% FCF yield but loses 10% of its output yearly, then the actual FCF yield is about 15%. At such a decline rate, its production would be half in just seven years, which also means that FCF would drop assuming prices remain the same. With reduced output, unit costs typically rise due to the negative scale effect, which pushes FCF further down.

Capital allocation

The sector has learnt by now that chasing volume growth doesn't create shareholder value. CNX is not an exception.

Here is a direct quote from the company's latest Proxy statement:

"CNX's strategy is to foster a sustainable business model ("SBM") that applies the nonreplicable advantages of low cost, low capital intensity, and operational flexibility to generate regular and substantial free cash flow ("FCF"). We then prioritise injecting that FCF back into our business through (1) investments in human capital, (2) optimisation of our asset base, (3) investments in our region, (4) debt reduction, and (5) return of capital to our shareholders. We then measure success through the lens of generating FCF per share that presents an attractive, reasonably priced investment opportunity for our shareholders."

Here is what the company's CEO, Nick DeIuliis, said about returning capital to shareholders:

"We've got two ways of doing that: through dividends or share repurchases, which one we pick is going to follow the clinical math of risk-adjusted rate of returns in the context of long-term per share value."

When asked about the possibility of dividends, DeIuliis said:

"Stock price is one of those important metrics and variables when we're calculating the best per-share value creation avenues. The philosophy doesn't change, the equations don't change, just some of the variables. And when you update share price, gas forward strips, the free cash flows that basically would be produced from that under our activity set that we've laid out, then you look at things like free cash flow yields and free cash flow per share, what those risk-adjusted returns are. I think, at this stage, we are still comfortable following that math, that share repurchases are the best avenue for shareholder returns. That can change to your point over time. We're not against dividends philosophically, but we think again, looking at the math and the risk-adjusted returns, clearly the best path continues to be share repurchases versus dividends."
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources, Hidden Value Gems
I should also note that the company has been actively divesting its non-core assets with total proceeds of $1.1bn over the past six years. These assets represent primarily gas assets that the company has no plans to develop in the near- or medium-term (for example, because they are too remote from the core operations or pipelines). By selling them to interested buyers, CNX can monetise these assets faster. Proceeds from the sale of non-core assets are included in total FCF, which is then spent on debt repayment and buyback.

The company has reduced its net debt from the peak of $3.6bn in 2015 to $2.2bn in 2021. The ratio of net debt to operating cashflows has improved even more dramatically - from 10x to just 2.4x.
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources, Hidden Value Gems
In 2020, CNX also completed the acquisition of its Midstream business by issuing 37.1mn new shares (share count increased from 187.4mn to 224.5mn) for $357mn.

Aligned management

87% of the CEO's compensation is directly tied to CNX's share price performance. The same case is for other senior executives. Since becoming the CEO in 2014, DeIuliis's regular base salary has not increased.

CEO owns a 1.3% stake in the company (2.6mn shares worth approximately $46.8mn at $18/share). I don't know the total net worth of Mr DeIuliis, but I think a very significant part of it is in CNX shares, especially given that he receives a relatively modest base salary for the chief executive ($0.8mn a year). Mr DeIuliis has been working for CNX for over 30 years.

Most board members have been buying stock on the open market and so far have not sold their shares.

It is also worth noting that the company's chairman is William Thorndike, the author of Outsiders, one of the best books on management according to Warren Buffett. The book discusses how best CEOs create shareholder value through capital allocation. He purchased 30,000 shares of CNX back in 2015 and has not sold them yet.
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources, Hidden Value Gems

Attractive valuation

I estimate that CNX can generate about $629mn FCF this year, excluding the proceeds from the sale of non-core acreage and working capital changes. The company is on track to earn $1,147mn of revenue from hedged sales of gas (474 Bcf of gas pre-sold at $2.42/mcf price) with an additional $821mn revenue from sales of gas and liquids at market prices. I used a mid-point of the company's '22E guidance for the share of liquids in total sales (7.5%) and assumed a $48/bl ($8/mcfe) realised price.

For unhedged gas prices, I assumed a price of $6.5/mcf ($6/mmbtu) which is lower than spot - $8.5/mcf ($8/mmbtu) and year-to-date price of $6.7/mcf ($6.3/mmbtu).

US gas prices have been highly volatile historically, trading in the $2-6/mmbtu range for the past decade with an average of $3/mmbtu. One of the critical issues is whether the current prices represent a new reality or a short-term spike before falling back to their historical levels.
Historical Henry Hub gas spot prices ($/MMBtu)
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: Trading Economics
My view is that in light of the recent geopolitical events and on the back of long-term under-investment, a call on US gas will rise, and domestic prices will reflect international benchmarks rather than the historical cost of production. So $6-10/MMBtu is likely a new mid-term price range.

But even if we assume that gas prices correct to $3/mmbtu for gas and $24/bl for Natural gas liquids (NGL), the company should be able to generate $1.1/share of FCF ($205), which is equivalent to about 6.5% FCF yield.

Management has also been guiding for a continued reduction in costs, including corporate and interest expenses, from $0.34/mcf in 2020 to zero in 2026. This represents $200mn in annual savings ($1.3bn if capitalised at a 15% rate).
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: Hidden Value Gems
I should also note that CNX's hedge book does not cover all future production. The share of hedged volumes in total output declines over time. This means the company can raise its realised price over time as long as solid gas prices prevail.
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources
Lastly, CNX has accumulated tax-deductible operating losses, which allow the company to minimise its actual tax payments and may make it attractive for a larger player. CNX has $1bn of federal operating loss balance as well as amortizable intangible drilling costs of c. $600mn, $100mn of federal tax credits and the ability to utilise accelerated depreciation for federal tax purposes.

At the same time, once CNX has generated $3.5bn of cumulative FCF, it will start paying full taxes at a rate of 20%. So far, the company has generated $1,158mn of FCF since the start of '20, and with $700mn FCF guidance, it can start paying taxes already in '25E. At $700mn annual FCF, the annual tax expense could amount to about $120mn, assuming $100mn are various non-cash tax-deductible expenses.

I do not have a strong view on the geology of the company's assets and its ability to increase production further (as well as required costs). Hence, I do not give any credit to future prospects. I mainly focus on near-term production and FCF yield. In my view, $4/share FCF is a realistic earnings power of the company in the mid-term. I think a 15% FCF yield is a reasonable valuation yardstick. It may look conservative, but I consider commodity price volatility and possible geological/operational risks. I would be looking to sell a part of my position above the $27/share price. However, if the company can grow its production at a reasonable cost and continue to retire shares, the per-share fair value will likely increase further, in which case I will postpone my decision to sell.
Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
The company a little disappointing Q2 22 results with XXX% sequential decline in production and a very weak FCF of just $62mn. Besides, management raised '22E Capex guidance by 14% (+$70mn) without a corresponding increase in production guidance. The stock dropped 11% in just two days after reporting the results, which is somewhat understandable.

However, I think most of these temporary issues do not materially change the long-term investment case.

Quarterly production is generally volatile and has a seasonal pattern with more drilling during the mid-year, driving production higher by year-end with a potential slowdown in output at the beginning of the year. It is worth noting that CNX's production increased by 3% during the last quarter on a YoY basis.

The $70mn Capex increase is driven by three factors: 1) $25mn on drilling three new wells and running a second rig for most of H2 22; 2) $15mn on emissions reduction (e.g. converting one of the drilling rigs from diesel to electric); 3) $30mn - general inflation.

I expect the impact from additional drilling to become visible in 1H23 with higher volumes and revenues. Reducing CO2 emissions is generally a positive development too.

Inflation is, of course, a more negative factor, but in some way, it is inevitable in the current environment. It partially correlates with higher realised prices which more than offset higher costs. Besides, inflation is cyclical and will likely slow down or turn into deflation (in terms of diesel and steel prices) later.

Finally, despite the reported FCF being only $62mn when adjusted for working capital, it was actually $168mn (or $161mn if the proceeds from the sale of non-core assets are excluded).

When I would sell

  1. Price - assuming no material change in corporate structure (including share count), I would sell at least a portion of my position in a $27-30/share range.
  2. Value-destructive M&A - a significant component of my positive investment thesis on CNX relies on the assumption of a value-enhancing capital allocation policy, including high-return Capex, debt repayment and buybacks. However, if management undertakes expensive M&A transactions, increases leverage and abandons buyback - I would view it as a radical change in strategy. I would be looking to sell (even at a potential loss).
  3. Regulations - the sector regulation is often changing, especially in pipelines, drilling permits, gas flaring and taxation. I would consider selling in case of radical regulatory changes materially impacting the company's profitability and cash flow generation.
  4. Management - CNX shareholders benefit from the skills of its CEO, Nick DeIuliis, and other top managers and corporate culture. Management thinks like business owners and focuses on creating shareholder value rather than boosting short-term metrics or beating quarterly earnings. If a different group replaces the current management team with a different approach, this would be an essential signal to sell the shares.
  5. Ownership - the risk is that CNX gets acquired by another operator in a share-for-share deal. In that case, my future returns would be driven by the performance of the new entity (acquirer), which would be a completely different call.
  6. Material operational issue - if CNX's output is down considerably in one year, it may face deep financial problems because of its hedging policy. With about $2.42/mcf average hedge price for '22 and spot price at over $8/mcf, if the company cannot sell 'hedged' volumes on the spot market, it would take a loss of about $2.6bn.

Historical financial and operational performance

Diagram of Top 5 nd Top 10 EPAM clients in revenue (2010 - 2021)><meta itemprop=
Source: CNX Resources
Thank you for taking the time to go through this piece. I hope you found it useful. I would be interested to hear your feedback which you are welcome to send to ideas@HiddenValueGems.com.
    DISCLAIMER: this publication is not investment advice. The main purpose of this publication is to keep track of my thought process to better assess future information and improve my decision-making process. Readers should do their own research before making decisions. Information provided here may have become outdated by the time you read it. All content in this document is subject to the copyright of Hidden Value Gems. The author held a position in the stock discussed above at the time of writing. Please read the full version of Disclaimer here.

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