October 24, 2011 - 11:57am EST by
2011 2012
Price: 42.00 EPS $2.88 $4.12
Shares Out. (in M): 229 P/E 14.5x 10.0x
Market Cap (in $M): 9,620 P/FCF 14.5x 10.0x
Net Debt (in $M): 3,670 EBIT 1,170 1,600
TEV ($): 13,290 TEV/EBIT 11.4x 8.3x

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  • Natural gas
  • Coal


While I usually gravitate away from commodity oriented names, I believe CNX to be an extremely attractive investment at current levels.  CNX Energy Inc. is an integrated coal and natural gas business trading at a significant discount to its SOTP.  Early 2010, CNX announced a major acquisition of Dominion Recourses’ natural gas business for $3.475B.  The transaction was poorly received by market and alienated investors who owned the stock for its attractive coal assets, resulting in over 40% stock underperformance (relative to coal grp) in 2010.  As you fast forward to today, things have changed.  This  acquisition has put CNX in the most desirable shale in the US for natural gas (Marcellus Shale) and provides a free option on a new emerging oil play (Utica Shale).  In less than 18 months, the company sold a 50% interest in these two shale plays for $4.0B, more than they paid for the entire business.  Our analysis supports a valuation in the mid $50s/share, with $30/share for the company’s natural gas business and $24+ for the coal assets.   


Gas Business:
The company’s gas business is attractive due to its heavy exposure in the Marcellus Shale company (750k acres).  This has been an attractive area of focus for the E&P space due to its low cost position and high returns even in a $4-$5 gas environment (50% + IRRs).  It is for this reason that its public competitors in the Marcellus are up on average 66% YTD (RRC, COG, & EQT).   Additionally, the company has 3.7 Tcfe of proved reserves (2.9T excluding Marcellus) & 200k acres in the Utica Shale (area Aubrey at CHK claims is the next great oilfield in the US). I have approached valuing the gas business in pieces and arrive at an EV of $8.7B (see below).  For the Marcellus & Utica valuations, I am using the recent transactions, present valuing the price/acre and grossing them up to account for the entire acreage.  For the remaining producing assets, I am ascribing a valuation of $1 per proved mcfe (worth noting the company just sold part of these producing assets at $1.75/P1).  While one can argue the merits of approaching valuation in this manner, the consolidated valuation implies roughly $3.00/P1, in line with its direct competitors.  On an acreage basis, this valuation assumes a price/acre for the Marcellus of $7.1k, well below the $10k/acre + we are seeing in the public markets.  I believe this valuation to be appropriate when considering strategic players are willing to pay this kind of valuation in a $4 gas environment & publicly traded comps that suggest the valuation at or above this analysis.
1. Marcellus Valuation:   2. Utica Valuation   3. P1 Valuation    
Noble JV Deal  (08/18)                    3,200 Hess JV Deal                593 Total P1 Reserves               3,731
% Interest   50.0% % Interest   50.0% Less Marcellus                   859
Implied Undiscounted Value                    6,400 Implied Undiscounted Value           1,186 Adj P1 Reserves               2,872
Acres in JV (100%)                663,350 Acres in JV (100%)       200,000      
P/Acre (Undiscounted)  $9,648 P/Acre (Undiscounted)  $5,930 EV/P1    $1.00
PV/Acre    $7,100 PV/Acre    $4,500      Total    $2,872.0
% Haircut   -26.4% % Haircut   -24.1%      
     Total                   4,709.8      Total             900.0      
Nat Gas Business:              
Marcellus                   4,709.8            
Utica                      900.0            
Remaining P1                   2,872.0            
Marcellus Producing + Midstream                    219.0            
     Total EV                   8,700.8            

Utica Shale:

In August of this year, Chesapeake Energy publicly announced that its 1.25 million acres in the Utica Shale could be worth $15-$20 billion dollars.  While the CEO is known to be a very promotional character, any positive developments would clearly be very favorable for CNX.  The company’s remaining 50% interest in the Utica Shale could theoretically be worth an additional $1.2-$1.5B if CHK’s public commentary proves correct.  If proven out, this would translate to an additional $3.25-$4.50/share above our valuation on the stock.  It is also worth noting that Chesapeake has released well results that are supporting of this valuation range.  CNX is one of the only companies with any exposure to this emerging play.


Coal Business:

CNX’s coal assets are concentrated in Appalachia.  The company produces roughly ~62mm tons/yr of which >80% is tied to the steam coal business (Utility Mkt).  While the company does have some high quality met coal exposure, it is relatively small and viewed as largely upside optionality to the extent the coal mkt improves.  While investors are inherently skeptical about placing a valuation on coal related assets in this kind of economic environment, this bottom-up approach values the business under the assumption of a recessionary environment whereby pricing is set by marginal cost.  It is for this reason that the investment thesis and downside protection is derived from the unique low cost position of its steam coal assets.  Unlike most industries where the cost curve is relatively flat, coal mines in Appalachia operate with very different cost structures.  CNX’s coal assets are by far the most efficient in the industry with cash costs ranging from $40-$45/ton to produce v upwards of $65-$70/ton for much of its competition (~15% of the market operates at this cost structure).  Given demand for steam coal is not as sensitive to economic swings, we believe it is highly probable that pricing for the product will remain at least $65/ton (marginal cost) into 2012 and beyond.  Under this scenario, CNX’s coal business can do upwards of $3.00 in eps valuing the segment at $24/share assuming an 8x multiple (see below)  While this valuation does provide meaningful upside to the current stock price, it does not take into account additional earnings upside if the economy does not go into a recession. For example, the current coal strip price suggests $4.50-$5.00 in eps for the coal business.  It is worth noting that the dilutive nature of the gas business on an eps basis disguises the inherent earnings power of the coal business

Unlike some of the other coal businesses, CNX’s profitability held-up relatively well during the downturn of 2008-2009.  This can be attributed to the unique position within the cost curve of CAPP coal.  The fact is that in an uncertain market, it is very difficult to accurately predict commodity prices on a go forward basis, but if you can build a thesis that rests on a steep cost curve, one can earn an attractive return even under difficult economic environments.  To fact check the valuation, I also looked at the coal assets under a replacement cost based approach.  Using approximately $120/ton for a new long wall build, the replacement cost of the assets would indicate roughly $7.4B.

Thermal Coal Marginal Cost Analysis:        
Cost Advantage (CAPP Pricing):  $55.00  $60.00  $65.00  $70.00  $75.00
Cash Cost Advantage  ($45/mt)  $10.00  $15.00  $20.00  $25.00  $30.00
Production               50.0             50.0                       50.0             50.0               50.0
Implied Cost Advantage              500              750                     1,000           1,250             1,500
D&A                387              387                        387              387                387
EBITDA (Thermal Coal)              887           1,137                     1,387           1,637             1,887
EPS (38% Tax Rate)  $1.35  $2.03  $2.71  $3.38  $4.06
(Note - tax rate has historically run in the low 30s)      
Inc EBITDA at $150 Met 290              290                        290              290                290
Inc EPS    $0.82  $0.82  $0.82  $0.82  $0.82
Adj EPS (Unlevered)  $2.18  $2.85  $3.53  $4.20  $4.88
Int Expense (Total Co)           235.0           235.0                     235.0           235.0             235.0
Int Expense (Coal Only)           110.3           110.3                     110.3           110.3             110.3
Adj EPS    $1.88  $2.55  $3.23  $3.91  $4.58

Valuation Notes:

It is worth noting that the company is about to close on a couple JV deals, thereby significantly changing the capital structure & FCF profile of the company.  For the purposes of this analysis, I used the EV, capital structure, & acreage ownership pre-JV transactions.  It is relatively easy to adjust the acreage and approach the valuation on a post closing basis, but would require further explaining on the structure of the cap ex commitments of its JV partners.  Clearly the above numbers are rather simplistic in nature, but they do a decent job outlining how to think about a normalized/conservative level of cash flows during various market environments.  On the met coal side, I am assuming roughly $150/ton, roughly the marginal cost in the industry.  While pricing is well above that today ($250/mt), I do not have a strong view as to the sustainability of this pricing L-T.


Mgt Team:

This management team is acutely focused on shareholder value.  While unlikely in the near term, the opportunity does present itself to split up the two businesses in the future.  While this may sound contradictory to the actions of this team over the past couple years, it is quite clear the market does not fully recognize the significant value in the assets today.  The sell-side analysts are all coal guys and heavily discount the gas business.  They are used to valuing assets on earnings & EBITDA rather than reserves in the ground, and NAVs.  The company has taken some action to try to mark its gas business to market with two recent JVs, but this has failed to result in fixing what it likely a structural issue (two different classes of investors).  We believe such an action would not only prove to unlock shareholder value, but would close a chapter on a very successful series of transactions for this management team.   


While it is difficult to point to any near term catalyst for the name, there are many potential options for appreciation.  As noted above, the prospective acreage in the Utica Shale could turn out to be significantly more valuable than assumed.  Secondly, Marcellus Shale assets are in high demand given the attractive IRRs and the potential to deploy billions of capital into the space.  There have been numerous transactions in the space including the Chevron/Atlas Energy transaction last year.  While it is impossible to predict any such events, like an opened ended straight draw in poker, there are many potential outcomes that could result in appreciation to CNX. 





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