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Summary Even though the expectations regarding the natural gas prices have become even more bearish recently, I continue viewing the current situation in the markets as an overreaction. Despite the positive expectations for deep Utica play and positive analyst ratings, EQT is a risky stock with a substantial downside potential in the worst-case scenario. The company is overvalued. It is struggling to generate cash while at the same time having an accumulating debt pile. The far-away outcome of deep Utica play should not overshadow the importance of the company’s present performance and financial strength. While remaining bullish on natural gas for the nearest future, I continue analyzing securities with exposure to this commodity. Even though the expectations regarding the natural gas prices have become even more bearish recently, my view on the current situation in the natural gas market has not changed – I still perceive the recent developments to be an overreaction to the real fundamentals, and I remain long natural gas despite the higher risk. The company to be analyzed in this article is EQT Corporation (NYSE: EQT ). Being a Credit Suisse’s recent pick for natural gas exposure, the company is pretty popular among investors. With a market capitalization of $9 billion, this natural gas producer might prove to be a good natural gas bet for a variety of reasons. Nevertheless, the outlook is not exactly clear for EQT, as it is for every natural gas producer at current commodity price levels. At a total natural gas and NGL (Natural gas liquids) sales volume of 155,194 Mmcf, natural gas accounted for more than 99% of total company’s sales, placing it in a good position to benefit from the possibility of this commodity rising in price. Marcellus Play EQT Corporation strongly depends on its Marcellus wells, which accounted for 83% of total natural gas sales in the latest quarter, and this number has been nearly constant over the last three quarters. Known for many years, the Marcellus Shale only started causing excitement in 2002, when the estimations of its natural gas reserves started increasing, confirming its status of one of the largest natural gas shale formations in the U.S, which is spread over Ohio, West Virginia, Pennsylvania and New York. Marcellus is the main asset of EQT Corporation, with the company owning approximately 630,000 gross acres in the Marcellus play. Marcellus has been a major contributor to the company’s proved reserve growth, making it clear that the company is not running out of its reserves anytime soon. (click to enlarge) Source: Company’s Website , (2015). The number of wells spud in the Marcellus play is increasing strongly. The company is ramping up production, as the number of completed, not-in-use wells only rose modestly compared with the number of wells online during the last quarter. (click to enlarge) Source: Company’s Quarterly Reports , (2015). Despite the positive expectations for the future potential of Marcellus play, the 22% after-tax IRR for the realized price of $2.50 sets the scene for skepticism, as the future price dynamics of the commodity are not clear. Deep Utica Play It is well-known how the bold, full-of-hope statements make it sometimes nearly irresistible for people to turn too optimistic on a company’s potential. The willingness to have a quick profit (arguably, the most vulnerable state of a man) resulted in a possible overestimation of the future prospects of Deep Utica Play, which is currently the main focus of the company and the media following it. Seeking lower production costs, the company turned its focus to the Utica shale, which is located just below the Marcellus. I will not go in too much detail here, but I would like to outline the complexity of production in the Utica Play. At the depth of approximately 13,000 feet, with only 1 well online and 2 in progress, there is a possibility of the company’s estimated costs of $12.5-14 million turning out to be underestimated. Source: Geology.com , (2015). Nevertheless, the estimated 21% after-tax IRR at a realized price of $2, combined with production and efficiency at the low-end levels is certainly better than that for the Marcellus play, taking into account the difference in the realized prices. Source: Company’s Website , (2015). It is clear that the company’s decision might prove to be very profitable in the long run, with the company’s CEO, David L. Porges, stating the following: “If the deep Utica works, it is likely to be larger than the Marcellus over time […] we’re going to be able to supply a big portion of North America’s natural gas needs from a relatively small geography.” At the same time, it is not clear whether the best-case-scenario will unfold, as it is strongly expected at the moment. “There have been fewer than 10 wells drilled and completed in the deep Utica around our acreage, so it is still too early to say that the play will be economic,” the CEO said during the earnings call in October. Even though it is not the time to turn entirely pessimistic on the company, the downside potential for the case of the company missing the Deep Utica Play expectations should be taken into the account. Good performance of Marcellus Play, combined with rising hopes for Utica have significantly contributed to the analyst ratings, with the shares of the company currently holding 10 ” Strong Buy” and 3 “Hold” ratings . With institutional ownership accounting for 85% , should the expectations be missed, the downside risk for the stock could be substantial. Even though the number of positions initiated is currently outperforming that of the closed ones, it is important to remember the downward trend the shares of the company have been following since the middle of 2014, when the price was nearly double what it is today. (click to enlarge) Hedging Activities It is important to mention the company’s hedging activities against the further natural gas price declines. In its latest quarterly report, the company emphasized the importance of its derivative transactions, role of which I expect to continue rising over the next quarters. Source: Company’s Quarterly Reports , (2015). Even though the total cash provided by derivatives does not seem to have risen too much over the last three quarters, cash-settled derivatives accounted for 14%, 37% and 24% of the total realized natural gas price during the last three quarters, with hedging-designated ones providing more than $65 million last quarter, which is impressive taking into account that quarter’s profit of $40.79 million. So far, it is hard to deny the management’s ability to hedge the risks of environment the company is currently operating in. Even though natural gas prices have a significant potential to rise in the near future, natural gas companies’ hedging operations should be paid more attention to, as long-term plans (such as the Deep Utica Play) might become irrelevant if they either do not play out or the company runs out of its cash resources. With only 1 Utica well online at the moment, the target cost of $12.5-14 million per well accounts for only 1% of the company’s total cash position at the end of the latest quarter. Nevertheless, Deep Utica might turn out to be a severe cash burning process in case the company struggles to earn money at the current price levels or its strategy turns out to be somewhat too optimistic. The company’s current hedging position for the rest of 2015 (outlined in yellow) is sufficient enough to cover almost half the amount of the company’s natural gas sales for the latest quarter. Nevertheless, it is hard to form solid expectations regarding the hedging effectiveness in the next quarter as we cannot predict the revenue growth and the adjustments to the hedging position throughout the quarter. Despite the fact that the accumulation of the company’s hedging position for 2016 is fast-paced, average fixed prices for 2015 and 2016 are declining significantly. (click to enlarge) Company’s hedging position at the end of each quarter, 2015. Source: Company’s Quarterly Reports , (2015). Fundamentals The falling natural gas prices have had a substantial impact on the financial positions of all producers, and EQT Corporation is no exception. Despite the company’s efforts to save the revenue growth, net profits have significantly decreased during 2015, with some hope emerging for the upcoming quarters. With natural gas outlook being unclear and much time required for Utica Play to start firing on all cylinders, even more attention should be paid to the company’s current hedging activities. COGS increased strongly in the latest quarter, making the gross profit margin fall to 77.5%, way below the 2-year average of 82.4%. Revenue, Gross and Operating of EQT Corporation, quarterly, Sep 2013-2015. Source: GuruFocus , (2015). Net income margins have become quite volatile lately, falling sharply in the latest quarters and keeping return on assets and equity ratios at close range. Net Margins, ROA and ROE ratios of EQT, Sep 2013-2015. Source: GuruFocus , (2015). Following the fluctuations of the company’s revenues, interest coverage ratio has shown concerning performance during the last five quarters, falling below 1 in June 2015. Even though interest expense has been nearly unchanged at approximately $37 million over the same time period, fluctuating EBIT might become a problem in the future. There is a fast-paced accumulation of deferred tax liabilities, which have been growing by 1.82% on average during the last five quarters, conquering almost 22% of the liability part of the balance sheet by September 2015. (click to enlarge) Interest Coverage Ratio (right axis), EBIT and Interest Expenses (in $ mln, left axis) of EQT, Sep 2014-2015. Source: Morningstar , (2015). Even though the debt/equity ratio of EQT Corporation has been decreasing lately and is fairly low at 0.64, it is important to remember that the large “E” in the D/E ratio is mostly there because of a large amount of fixed assets, leaving the current ones a lot of room for improvement. The company’s cash position has been increasing strongly over the last two years. Accounting for only 12.1% of total assets, it is not sufficient to cover the long-term debt of the company, however, and the accumulating current portion of long-term debt should be paid more attention to. Company’s free cash flow has been negative since 2007. (click to enlarge) Source: Gurufocus , (2015). Although the growing debt, worsening profitability and a low Altman’s Z-value of 1.36 are concerning factors, the debt maturity schedule demonstrates why it is too early to get too pessimistic about the company’s financial position. It should be understood, however, that the company might significantly decrease its cash position in the coming future if no net profit surprises follow. Source: Company’s Website , (2015). The argument in favor of a decrease in the company’s cash position sounds even more valid when the historical net changes in cash are taken into account. Net change in cash has been negative during 3 out of the 7 latest quarters. Among the remaining 4, positive net change in cash in 3 quarters can be attributed to large stock or debt issuance (it is easier to follow with the help of the table below). Debt is slowly becoming a problem for the company, while continuous stock issuance can drive the share price even lower. (click to enlarge) Net change in cash; net debt and stock issuance of EQT Corporation, March 2014 – September 2015. Source: Gurufocus , (2015). There is a certain amount of divergence between the stock’s valuation and current performance of the company. Even though it can be said that at a price/book of 1.69 (which is close to its 10-year low) the stock seems to be fairly valued, I am returning to my argument of over-optimistic expectations due to the trailing P/E ratio exceeding 42. Conclusion Despite the positive expectations for the future of Deep Utica play, the company is heading towards additional risk. The financial strength of the company is slowly decreasing, making it strongly dependent on the outcome it will face regarding the Utica play. Even though the strategy might prove to be a major success, there is a high probability of earnings disappointments and further balance sheet deterioration in the future. Accompanied by high valuation and negative free cash flow, growing debt and cash generation issues might leave the stock with a large downside risk should the natural gas prices continue their downward trend in the nearest future. High ratings among the analysts covering the stock make it vulnerable to potential downgrades, as the popularity of the stock might turn against it. Nevertheless, there are various possible reasons for the stock to outperform as well. Positive developments in the Utica play, possibility of a dividend increase (which, despite being a questionable decision, might be introduced by the company as a save-the-day solution against the falling stock price) and the overall bullish attitude towards the company might make it a market’s darling should the natural gas prices rise as I expect them to be, although the downside risk makes it a much riskier bet when compared with Gulfport Energy Corporation (NASDAQ: GPOR ), which I analyzed in my previous article. The far-away outcome of deep Utica play should not overshadow the importance of the company’s present performance and financial strength. Scalper1 News
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