Description

CNX Resources (CNX) is an investment opportunity where you don’t need to believe much of anything to get a double and have a chance to get much more over time.  CNX is one of the largest natural gas producers in the Appalachian Basin.  It started out as the natural gas division of what is now Consol Energy – a 150 year old coal producer in the region.   CNX participated in the explosive growth of the Appalachian Basin and became a standalone company in 2018. 

I think of CNX as a bit of an “orphan” security.   At the time of the separation, they detailed their strategy to programmatically hedge as much of their natural gas exposure as possible.  As a result, the typical oil and gas investor (or generalist) looks at their hedge book and sees the massive amount of volume hedged in the mid $2s (over 70% for 2023 and over 60% for 2024) vs $9 spot and says “what a bunch of idiots” and moves on.  

I originally owned CNX Midstream which I viewed as a cheap way to get exposure to the growth in the basin without being exposed to some of the craziness in the region.  People seem to forget that the “shale revolution” was funded by a massive investment bubble that led to growth at any cost type drilling behavior.   In the Appalachian Basin, this gold rush mentality led to growth at the limits of takeaway capacity which kept a ceiling on national natural gas pricing while creating chaos in basin (pricing approaching zero, forced shut ins, etc).   To CNX’s credit, management saw this coming and wanted no part of it.  Their view was that they had decades of drilling inventory and were the lowest cost producer (in large part because they own all their midstream assets).  The CEO tried to hammer this point home at the time of the CNX merger in 2020 (following a period of low prices):.

So if you look at the all-in cash expenditures for the entire company, you would get a per Mcfe cost of approximately $1.41, which is well below the current gas realizations we receive under the current forward strip, generating a substantial margin. And what is even more remarkable is looking at this every dollar spent cost method relative to our peers. As you may remember, we showed previously that the average cash production cost of our peers is approximately $1.37. So our everything-and-anything, all-in cash expenditures for the year on an Mcf basis are basically equal to the average cash production costs of our peers.

Let me say that one more time. Our fully, fully burdened costs are in line with our peers' operating cash cost. Once you add in interest costs, SG&A costs, other operating expense costs and the capital our peers need to spend each year to maintain flat production, our all-in cash cost per Mcf is substantially below our competitors. This cost advantage ensures that CNX can operate successfully and produce substantial free cash flow at price strips where the peers cannot afford to hold their production flat and be cash flow neutral. 

I held onto my shares after the merger and have accumulated more opportunistically, including at recent prices.  I believe that CNX is an attractive investment at current levels based on the following:

• Undemanding valuation.  Mkt Cap of $3.3bn, net debt of $2.2bn implies TEV / EBITDAX of 3.9x at current depressed hedge pricing.

• Conservative operating strategy.   1 rig program to maintain production level at around 1.6 BCF/d.  Midstream assets fully owned.  Relatively “easy” to increase production opportunistically if takeaway capacity opens up.

• 2022E FCF of $700mm for current FCF yield in the low 20s.   Likely to be higher in the future based on continued opportunistic hedging leading to higher blended realizations than currently reflected in the hedge book.

• Exceptionally focused capital allocation.

• Possible natural gas re-rating.  Not necessary, but could be a nice kicker.  Plenty of valid reasons (especially on the supply side) why oil stocks have traded at significant premiums on a btu equivalent basis but not sure why natural gas companies won’t close the discount / re-rate given much better long term outlook.

I will discuss some of these points further below but will start with a brief overview of natural gas and the Appalachian Basin for those who aren’t familiar with some of the history / dynamics.

Background

The US is by far the largest producer (and consumer) of natural gas in the world.  Production, however, was stagnant for about 40 years starting in the 1970s.

In the late 2000s, drilling in the Utica and Marcellus shales of the Appalachian Basin began in earnest, and this happened:

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It’s hard to overstate the significance of this.  On its own, the Appalachian Basin would be the third largest producer of natural gas in the world after the rest of the US and Russia.  It also single handedly increased US production by 50%.  

As you can see below, US consumption of natural gas began to track higher as this new supply came online:

Increased consumption has been primarily driven by natural gas usage for electric power generation.  Unlike the BEV threat hanging over the oil market, the natural gas demand outlook seems much more robust.   It’s very hard to see an alternative to natural gas for baseload power generation in the foreseeable future.  While wind and solar represent the majority of new power adds each year (because they are cheaper before subsidies), natural gas plants continue to be built both for reliable baseload and peaking purposes.

The rest of the increase in natural production has been consumed by decreasing imports from Canada and, of course, exports / LNG:

In the Appalachian Basin, production growth has consistently been constrained by available takeaway capacity.  In the past, this has led to chaotic in basin pricing, shut ins and the collapse of many smaller competitors.  Numerous additional pipelines have been proposed and have failed, mostly for permitting related / NIMBY reasons.  The Mountain Valley Pipeline was 90% completed in 2019 and required Manchin to hold up the $300B IRA bill to potentially get it over the finish line.   While various new industrial users and power plants will continue to increase in basin demand, future pipeline additions look unlikely in the near term.

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As a result, all of the large Appalachian Basin producers are now following some version of the CNX playbook and have cut rigs to the levels needed to maintain production while harvesting cash flows for debt paydowns, dividends or buybacks.  Current production in the region is being maintained with a third of the 2011 rig count. These changes have not only stabilized in basin dynamics but have also led to higher pricing on a national level.

US self sufficiency / surplus in oil and gas is a significant competitive advantage that seems to be lost in all the inflation noise.   That is clearly not the case in Europe which is almost completely dependent upon imports for its natural gas needs, including about 15 BCF/d from Russia.  The replacement of that 15 BCF/d will likely result in significant tightness in the LNG market for many years (30% of current LNG flows).

Capital Allocation

With $700mm of FCF, it shouldn’t take an excel whiz to see that a double over the next 4-5 years is a fairly reasonable base case.  One could argue that CNX is exposed to inflation since their revenues are largely fixed in the near term.   With just 440 employees ($8mm revenue / employee – take that Apple), most inflation will be tied to drilling and production cost (steel pipe, diesel, etc).  The $700mm FCF figure already includes significant inflation this year (about $30-$50 million), and it seems likely that any further inflation will be more than offset by higher price realizations as they layer on more higher priced hedges.

The real crux of the investment thesis is that the future FCF will almost certainly flow to shareholders in one form or another, preferably buybacks.  I guess it shouldn’t be surprising that management totally drank the Kool-aid on creating shareholder value since their Chairman is William Thorndike, the guy who wrote the Outsiders, but I have never come across a company so totally focused on proper capital allocation.  If you read any of their transcripts, it is actually a bit jarring how much they talk about it and how thoughtful they are.  Here is how management explained their operating philosophy after the midstream merger (a bit long but well worth reading):

Hi, everybody. I'm Nick DeIuliis, the President and CEO of CNX Resources in Pittsburgh, Pennsylvania. CNX Resources is the low-cost manufacturer of natural gas in the very prolific Appalachian Basin. What we're manufacturing, natural gas, has an outsized foundational impact on today's economy as well as tomorrow's. And the reason it enjoys that position is that natural gas provides instant quality of life to society at scale, and it does it at a carbon intensity level that is better than most other competing forms of energy, including wind and solar, I might point out.

CNX Resources is poised to generate substantial free cash flow over the next 7 years, as you'll see. How are we able to do that? We have a competitive moat that really boils down to 4 strategic advantages. First, I mentioned that we're a low-cost manufacturer in our business. Our costs are going to decline further as you look into the 7 years. Second, we methodically hedge our production of tomorrow, locking in revenues today, which, of course, is a big piece of the puzzle to derisk cash flow generation. Third, we are unique that we own our pipeline infrastructure, which allows us to control our distribution chain from the point of manufacturing at the wellhead all the way to the sales point. And then last, we require low levels of capital intensity, capital reinvestment to sustain and have the free cash flow generation come to roost over the next 7 years.

Now we're not just a low-cost manufacturer of a product vital for society, and we're not just a substantial generator of free cash flow. We are also very astute capital allocators. And what we're looking to do is to invest that free cash flow in the right places at the right times to optimize the long-term intrinsic value per share of the company.

That's what capital allocation and astute capital allocation means to us. We're going to be ruthlessly rational when it comes to making those decisions and following the math. So I hope that you're interested in our company. We look and focus upon things, as I said, being a low-cost manufacturer of a product that's crucial for society, and being a free cash flow generator and allocating that free cash flow generation under astute capital allocation methodologies to solve and optimize the long-term intrinsic value per share of the company. If you're interested in those same types of things, give us a call and we'd love to talk to you in a more meaningful way.

Also, I will point out what we're not. We are not a traditional E&P company. We're not even a traditional energy company. So you're not going to see us focused on solving for production growth, you're not going to see us being interested in becoming the largest producer in the basin or in the country, and you're not going to see us obsessing over short-term E&P-centric metrics, whether they're performance or financial. You will see us obsessing on that long-term intrinsic value per share of the company.

Followed by the CFO – Donald Rush

Thanks, Nick, and thanks for giving us a few minutes of your time today. As Nick said, we are the low-cost producer in the most prolific natural gas basin in the United States. Our competitive advantages are real and our future is bright.

We generate significant free cash flow, and our culture and team is focused on allocating that free cash flow to grow our intrinsic value per share. All that translates into the phenomenal free cash flow yield and margin numbers you see on this page.

It is a simple story when you boil it down, starting with the product we sell, natural gas. Natural gas is a fundamental building block over a modern society, with worldwide demand growth. It touches all aspects of our day-to-day lives, and it has reshaped the geopolitical, economic and energy landscape in favor of the United States. It is the most socially and environmentally sustainable way to meet the world's energy needs. And it is irrefutably a long-term strategic asset for the United States of America and will remain an important product for the world going forward.

On to our 2021 numbers versus not just our industry peers, but the broader market as well. First and foremost, we produce significant free cash flow, take any industry or index, and we stack up in the top quartile or better for free cash flow yield. Our assets and commercial strategies generate top-tier margins. And finally, our balance sheet is strong and getting stronger as we pay down debt to reach our 1.5x leverage target. And the best news yet, we expect these metrics to improve as time goes on, and we have competitive moats to protect them.

As Warren Buffett says, the fundamental basis of above-average performance in the long run is a sustainable, competitive advantage. We want our investors to know that our competitive moats are real and they're sustainable for an extended period of time. It would take our competitors well over a decade and cost them several billion dollars to replicate our business model. I won't unpack each one of these, but let me touch on 2 that are critical.

First and most importantly, our vertical integration of owning our midstream pipeline systems is unique in our industry and creates a tremendous advantage. Our competitors have outsourced theirs to third parties, which results in high fixed operating costs and constant contractual disputes with limited negotiating leverage. Owning our own pipelines gives us a cost structure that is almost 50% below the cost structure of our peers, and it allows us to control our product from source to sale. This advantage is nearly impossible to replicate and will persist for decades to come.

Second is programmatic hedging. We have the ability to sell our products years in advance at a fixed price, and due to our best-in-class cost structure, lock in a favorable margin stream. Very few industries, from consumer packaged goods to industrials, have this advantage. This tremendously derisks our capital investments, locks in returns and creates predictability in our free cash flow generation for years to come.

We now refer to our company as a free cash flow-generating machine due to its predictability and repeatability. This cash flow will improve our balance sheet as we pay down debt, and we expect our free cash flow per share to grow at an amazing 20% per year. And to be clear, this example assumes our stock price appreciates over 15% each year. If for some reason our stock price grows slower or stays flat, our free cash flow per share growth would increase, and our free cash flow yield would skyrocket higher.

This all leads to an attractive range of potential outcomes if you invest in our stock. The simplest math is that over the next 7 years, our expected free cash flow generation is enough to eliminate all of our debt and return hundreds of millions of dollars to our shareholders. This example will result in well over a 150% increase in your initial investment and continued ownership in a company expected to generate substantial free cash flow each and every year thereafter. That's a pretty good conservative case.

And of course, there's plenty of upside based on investing the free cash flow we generate into higher-returning capital allocation opportunities or returning more of it to our shareholders sooner. And as the market starts valuing us at a reasonable free cash flow yield, our stock will quickly more than double. Ultimately, an investment in CNX has an expected solid, low risk-based return with tremendous amounts of additional upside.

So boiling all this down, CNX is a phenomenal investment opportunity, especially considering the volatility and uncertainty of today's marketplace. We are the lowest cost manufacturer of natural gas, which is an incredibly important industry that is not only stable but growing. And the combination of our competitive moats, our culture and our high-caliber team will ensure success for years to come.

This is the opportunity. We are CNX. Please give us a call. We'd love to have you, not only as an investor but a partner of ours for years to come. Thank you for your time.

So that was the pitch.  Here are the results (from the Q2 earnings presentation):

Free cash flow per share has doubled since then:

And here is how management explains the chart above and their thoughts going forward (from the Q2 earnings call):

This graph includes what we have already achieved and what we expect moving forward. Looking back at the last 2 years, we have already more than doubled our free cash flow per share since 2020. Looking forward, assuming a constant enterprise value and assuming 80% of future free cash flow is allocated to share repurchases and the remaining 20% to balance sheet management, total shares outstanding would reduce by an additional 54% while still achieving significant deleveraging. In other words, free cash flow per share doubles by 2026.

Our leverage ratio declined to roughly 1x and the implied share price, again, assuming a constant enterprise value would appreciate almost $45 per share due to this rapid share count reduction. This potential share count reduction only accelerates as stock price appreciation does not keep pace with the decline in outstanding shares. When you compare this projection to the 2020 free cash flow per share, you can see 2026 free cash flow per share is over 5x higher.

Valuation

Hopefully I have made it clear that a double in in the next 4 to 5 years is a relatively conservative case for a CNX investor.  I should point out that despite its hedge profile, it will likely trade in sympathy with natural gas prices / natural gas companies.  With the company aggressively buying back stock, I view pullbacks as an opportunity for the company and investors.

My base case assumes a constant TEV as does the math by management above.  I think there is a good amount of upside to that assumption.

1. Any company that shows 20% plus FCF yields over a long period of time is likely to get re-rated at some point.

2. The entire sector seems inexpensive (although the unhedged players will be very volatile if natural gas prices retreat).

3. If you squint hard enough at the chart below, you could argue that CNX has a footprint similar to many of the much larger players – CNX just chose a more conservative development plan in the go go years. Not clear this much of a  discount is warranted over time.

4. Oil companies have always traded much higher on an equivalent btu basis.  With natural gas btus trading at 2-3x oil btus in Europe, it’s not clear that this discount makes as much sense as it used to.

5. The majors like Chevron and Exxon are relative pipsqueaks in natural gas (roughly the same size as CNX for $300-$400bn companies).  If they decide they need more “clean” fuel exposure then valuations have significant upside.

Catalyst

Continued buybacks