A Focus On Free Cash Flow Sets CNX Resources Apart In The Energy Sector

Thesis

CNX Resources Corporation (NYSE:CNX) has a unique strategy, one that emphasizes free cash flow, or FCF. The natural gas producer then allocates much of that FCF to share buybacks and reducing its debt.

It’s been a successful strategy, one that has produced Energy sector-leading returns on equity, total capital, and assets, as well as a one-year share price gain of just over 47%.

Analysts expect its earnings to fall by 21.69% this year, but they and I expect share prices will rise over the next 12 months. The bullish forecast is based on its medium-term promise of flat production, greater operational efficiency, a lower share count, and more. As a result, I’ve given CNX a Buy rating.

About CNX

CNX Resource is an independent natural gas production, midstream, and technology company that produces low-carbon intensity gas, according to its 10-K for 2023. Its operations are centered in the Appalachian Basin, and most of its operations take place in the unconventional shale formations of the Marcellus Shale and Utica Shale. It also operates coalbed methane properties in Virginia.

Its first predecessor was a coal mining company founded in 1860. It transitioned from coal to natural gas, and became mainly a gas company when it bought the gas assets of Dominion Resources in 2010. In 2017, it spun off coal producer CONSOL Energy Inc. (CEIX) and changed its name to CNX Resources.

The company released its Q1-2024 results on April 25, and what a difference a year makes:

• Revenue: down to $384 million from $1.276 billion in Q1-2023.
• Net income: $7.00 million versus $710.00 million in the same period last year.
• EBITDAX (EBITDA plus Exploration): $1.074 billion compared with $165 million.
• Free cash flow, FCF: $25.00 million versus $89.00 million.

Why the plunges? This historical chart of natural gas prices illustrates what happened:

Despite the decline in natural gas prices, the market remained bullish about CNX in the first quarter of this year. Investors pushed up the price from $20.35 on January 2, to $24.00 on April 26, a 17.93% increase.

Competition and competitive advantages

CNX reported in the 10-K that competition for natural gas producers is strong, with high fragmentation in the industry. There is no single leader, and competition is based mainly on acreage position, drilling and operating costs, and pipeline availability. It also reported competition with other large producers and a bevy of smaller producers and marketers.

In addition, it competes with oil producers that produce natural gas as an ancillary byproduct, and with alternative energy sources.

The company also claimed it has competitive advantages,

“We believe that our extensive held-by-production acreage position and development inventory, combined with our regional operating expertise, extensive data set from development and non-operational participation wells, midstream infrastructure ownership, low-cost operations and legacy surface acreage position provide us with significant competitive advantages that position us for long-term value creation.”

That’s backed up to some extent by its ROCE, which grew robustly between the second quarter of 2022 and the third quarter of 2023:

Even after the pullback, CNX still offers a strong ROCE, and, as we’ll see below, has strong margins that outperform those of the Energy industry medians. All this suggests at least a narrow moat, and perhaps even a medium moat.

Margins

The following chart shows CNX margins over the past decade:

Not surprisingly, this chart looks fairly similar to one of the United States Oil Fund, LP ETF (USO), a proxy for crude oil prices. It shows the downtrend that began in the mid-teens and the recovery that started after the COVID-19 pandemic began to ease. However, CNX has recovered more than USO in recent quarters.

That’s also true when compared with the Energy sector:

• Gross margin [TTM]: 62.46% versus the Energy sector median of 46.38%.
• EBITDA margin [TTM]: 182.71% compared to 37.00%.
• Net income margin [TTM]: 117.64% versus 13.36%.
• Return on total capital [TTM]: 23.16% versus 8.24%.

Growth

Based on forward ratios, CNX outperforms one sector median, but falls behind another:

• Revenue growth [FWD]: 13.24% versus 2.08%.
• EBITDA growth [FWD]: -5.56% versus 4.82%.

The company’s growth plans are contained in its 7-year plan, unveiled in 2020. The goal is to generate long-term value for shareholders, and tactically, that means increasing free cash flow, then using that FCF to repurchase shares, and reduce debt.

Q1-2024 marked the seventeenth consecutive quarter of positive cash flow, according to its earnings presentation:

As the following slide shows, it has made significant progress toward those goals:

As it goes forward, then, CNX should show improving margins as it reduces its interest payments. Its earnings per share also should rise as it reduces its share count. This chart shows how normalized diluted EPS began growing:

As noted above, CNX had a stronger rebound than oil prices, and the 7-year plan will have been a component of that. CFO Alan Shepard explained in the Prepared Remarks for the Q4-2023 earnings call,

“We are going to hold production flat and focus on capital efficiency. And when you do whole production flat, you end up needing to turn in line fewer and fewer wells each year. So the ‘25 plan is going to you should expect to see fewer shales and with that comes lower capital, right, particularly on the completion side. So, that’s really the big driver there.”

For 2024, CNX expects production between 570 to 590 Bcfe, and it expects to stay at that level in 2025. It does not offer guidance for revenue, EBITDA, or earnings.

Wall Street analysts are forecasting 2024 revenue of $1.68 billion, which would be a decrease of 51.52%. For 2025, they expect $1.86 billion, a 10.34% increase.

Turning to EPS, the analysts expect a dip this year, followed by increases in 2025 and 2026:

In all of these estimates, remember that this is a petroleum company, where black swans are quite common.

Management and strategy

CEO Nicholas Deluliis has occupied the corner office since 2014, and thus led the company’s 7-year program and gets much of the credit for the gains of the past four years. He is a registered engineer and has been at CNX for more than 30 years.

Alan K. Shepard is the Chief Financial Officer, a position he has held since 2022. Before that, he held senior leadership positions since 2020. Prior to joining CNX, he held the CFO position at privately-held EdgeMarc Energy.

The company described its strategy in the 10-K as, “CNX’s strategy is to use our substantial asset base, leading core operational competencies, technology development and innovation, and astute capital allocation methodologies to responsibly develop our resources and create long-term value for our shareholders.”

Tactically, that is supported by its 7-year plan which involves growing its free cash flow, buying back shares, and reducing its debt.

The focus on FCF is an interesting approach, which makes intuitive sense. Cash flow is the lifeblood of any organization, and having it means having the resources to grow a business profitably.

Valuation

Overall, the Seeking Alpha Quant system gives CNX an A- rating for valuation, based on a mixed bag of ratios:

• P/E GAAP [TTM] is 13.59 versus 10.46 for the Energy sector median.
• P/E GAAP [FWD] is 16.44 compared to 11.17 for the sector.
• EV/EBITDA [TTM] is 3.39 while the sector is 6.04.
• EV/EBITDA [FWD] is 6.30, versus 5.96 for the sector.

Earnings revisions have a bearish flavor. In the last 90 days, two analysts have raised their expectations, while four have revised downward.

Management said in its Q4-2023 Prepared Remarks that it sees share repurchases as a “compelling capital allocation opportunity for creating long term per share value for our owners.” By reducing debt as well, it helps derisk the company’s finances.

What’s more, since Q3-2020 it has bought back about 34% of its shares outstanding, and in theory, at least, has pushed up the price of shares by about a third. Management said the CAGR of the share repurchase program is roughly 12%, which it believes is “top tier across the capital markets”.

If you plan to become an investor in CNX, then you should prepare yourself to monitor its FCF, and give less attention to the conventional metrics of revenue, EBITDA, and earnings.

Does the CNX system work? Have shareholders been rewarded by the strategy of focusing on FCF? This excerpt from the Profitability Metrics page at Seeking Alpha shows it has (the first column provides CNX results, the second shows Energy sector results):

Ultimately, strong returns on equity are what investors want–and CNX is delivering.

It seems the market is reacting to the promise of CNX rather than its earnings. In the past year, the share price has advanced 59.15%, and over five years it is up 128.79%:

Investors with at least a three to five-year horizon should enjoy good total returns, based on longer-term earnings growth and the upward price pressure from buybacks.

The Wall Street analysts’ average price target represents a modest gain in the next 12 months:

Their forecasts have been quite accurate over the past several quarters:

Watch for the share price to be a tug-of-war over the next year. There will be a negative pull as earnings are expected to be down next year, but on the positive side, there are the returns on equity, total capital, and assets, as well as the company’s practice of reducing the number of shares and its capital expenditures. I believe the positives outweigh the negatives and target $25.50 in a year’s time.

Along with that, I give it a Buy rating. There have been no other SeekingAlpha ratings in the past 90 days. The Quant system gives it a Strong Buy, while the Wall Street analysts offer two Strong Buys, seven Holds, and two Sells.

Risk factors

First, this is an oil and gas company, an industry in which most players are price takers, and prices are driven by exogenous factors including geopolitical events and economic cycles. To some extent, CNX is mitigating this by reducing its costs, and especially its slowing capital expenditures.

The company does some hedging to protect itself, but hedging can also prevent it from fully capitalizing on price increases above the level of the hedges. In addition, it may be unable to find suitable counterparties for its hedges in the future.

CNX owns its own midstream facilities, but depends on third parties to gather, process, and transport its natural gas to market. Any disruptions to those external facilities could have a material effect on its operations and financial status.

Developing, producing, and operating natural gas wells is inherently risky on several fronts; unforeseen events could adversely affect its operations and financial conditions.

Oil and gas assets are declining assets, and if CNX is unable to maintain its reserves, it could be left with unused or underused facilities that have unavoidable fixed costs. We might think of water in the same way, since it is needed for hydraulic fracking processes.

Conclusion

Over the past four years, CNX Resources has used its free cash flow strategy to cut its share count by a third and significantly decrease its outstanding debt. As a result, it is far more profitable than most companies in the Energy sector, including its return on common equity.

2024’s earnings are expected to dip, but I still expect the share price to rise over the 12 months. I consider this a strong stock and have given it a Buy rating.